Deal Sourcing & Diligence

Finance 101's LBO mechanics assumed a deal already exists. This chapter covers where PE deals actually come from, and the real diligence work that happens before a fund commits capital.

Proprietary vs. auction sourcing

A proprietary deal is sourced directly by the PE firm's own relationships — outreach to a business owner, an intermediary relationship, or a thesis-driven search for companies matching a specific investment criteria, before a formal sale process (the auction from the IBD track) ever begins. An auction deal (the IBD track's sell-side process) means competing directly against other bidders, typically at a higher entry price due to competitive tension. Proprietary deals are genuinely more attractive when a fund can find them — less competition, often a better entry price — but are also harder to source consistently and scale across an entire fund's deployment needs, which is exactly why most large PE firms run both approaches simultaneously.

Commercial, financial, and legal diligence — three genuinely different workstreams

Commercial diligence assesses the actual business: market size and growth, competitive position, customer concentration and retention — often using outside consultants specifically for this workstream. Financial diligence verifies the numbers themselves are real and sustainable — this is where quality of earnings (QoE) work happens (below). Legal diligence uncovers contractual, regulatory, and litigation risk that could materially affect the deal.

Quality of earnings — the diligence work that most directly protects the price paid

A target's reported EBITDA often includes one-time items, aggressive accounting choices, or add-backs that inflate the number the LBO purchase price (Finance 101's 8x-EBITDA-style entry multiple) is actually based on. QoE diligence adjusts reported EBITDA to a more defensible, normalized figure.

Worked example: a target reports $50M of EBITDA. QoE diligence finds: $3M of one-time legal settlement costs that shouldn't recur (add back, since excluding them overstates a one-time cost as ongoing — wait, a one-time cost should be added back to reflect true ongoing profitability), and $5M of revenue from a customer contract that's not being renewed next year (subtract, since it won't recur). Adjusted EBITDA = $50M + $3M − $5M = $48M. At an 8x entry multiple, that $2M EBITDA adjustment changes the implied purchase price by 8 × $2M = $16M — a real, material swing in what the buyer should actually pay, uncovered specifically by diligence rather than simply trusting the seller's reported figure.

Why diligence findings directly change deal terms, not just the go/no-go decision

Diligence doesn't just result in a binary "proceed or walk away" — findings routinely change the actual purchase price (via the QoE adjustment above), the deal structure (an escrow holdback if a specific risk is identified but not disqualifying), or trigger specific indemnification provisions in the purchase agreement protecting the buyer against a diligenced risk materializing after close. This is the PE-specific version of the deal-protection concepts (break fees, MAC clauses) from Finance 101's deep dive — real contractual mechanisms addressing real, identified risk.

Why this matters beyond PE specifically

Every concept here — proprietary vs. competitive sourcing, and normalizing reported earnings to their real, sustainable level — applies directly to any serious buy-side investing, not just whole-company LBO acquisitions. A public-equities analyst doing real diligence on a stock is running a lighter-weight version of exactly this same discipline.