Private Markets Pathway · General Partner and Investor Perspectives and the Investment Process

Due Diligence and Investment Selection in Private Markets

Updated 8 October 2026 · Fact-checked

Due diligence is the structured investigation a GP runs on a target investment and an LP runs on a GP before committing capital. You cover business, financial, legal, operational and ESG areas, test claims against evidence, flag red flags, and link every finding to the decision and the price or terms.

Understand Due Diligence and Investment Selection

Due diligence is verification. Someone makes claims: a company says its customers are loyal, or a GP says its past returns came from skill. Due diligence tests those claims with evidence before money is committed.

There are two viewpoints. The GP performs diligence on a target company or asset to decide whether to invest, at what price, and with what structure. The LP performs diligence on the GP (and the fund) to decide whether to commit capital. Same logic, different subject. Keep these apart in the exam. A question about a GP's team, track record or controls is LP diligence. A question about a target's customers, margins or debt is GP diligence.

GP diligence on a target usually has several strands:
- Commercial: is the market attractive, what is the company's competitive position, and are the growth plans believable? It looks forward and outward.
- Financial: are earnings, cash flow, working capital and debt accurate and of good quality? It looks at the numbers, often backward, and checks the quality of earnings.
- Legal and tax: contracts, litigation, ownership of intellectual property, regulatory compliance, tax exposure.
- Operational: management quality, systems, supply chain, and where value can be created.
- ESG: environmental liabilities, governance and social risks that could hurt value or exit.

LP diligence on a GP has two parts. Investment due diligence covers strategy, team, track record, sourcing, deal process and value creation, and whether past returns were repeatable. Operational due diligence (ODD) covers the firm as a business: valuation policy, independent administrator, fund accounting, cash controls, compliance, cybersecurity, key-person and succession arrangements, insurance, and service providers. Many failures come from weak operations or fraud, not weak strategy. Also review fund terms: fees, hurdle, carry, key-person clauses, governance rights, and alignment through GP commitment.

Red flags are signs that claims may not hold up. Examples are a team that has changed often, returns that depend on one or two deals, unclear valuation practices, no independent administrator, weak or reluctant disclosure, style drift away from the stated strategy, related-party dealings, and heavy reliance on one customer in a target. A red flag does not always end the process. You assess its size, whether it can be fixed, and whether price or terms can protect you.

Finally, diligence feeds the decision. Findings change the valuation, the deal structure, the covenants or protections, the 100-day plan, or lead to walking away.

Key rules to remember

GP diligence on target: main strands: Commercial + Financial + Legal/Tax + Operational + ESG; Use as a checklist. Commercial tests the market and strategy; financial tests the numbers and quality of earnings.
LP diligence on GP: two parts: Investment due diligence + Operational due diligence (ODD); Add a review of fund terms and alignment. Investment DD asks whether returns can be repeated; ODD asks whether the firm is controlled and honest.
Red flag response: Finding → size of risk → can it be fixed or priced → proceed, renegotiate, or walk away; Every red flag should end in an action, not just a list.

How to solve Due Diligence and Investment Selection questions

Use this method for any item set or essay on due diligence or investment selection.

1Identify who is doing the diligence (GP or LP) and on whom (target company or GP/fund).
2Read the command word. 'Identify' needs a short list; 'Explain' or 'Justify' needs the reason linked to the case facts.
3Pick the right strand: commercial, financial, legal, operational, ESG for a target; investment, operational and terms for a GP.
4Match each fact in the vignette to a risk or red flag. Quote the fact, name the risk.
5State the consequence: effect on return, valuation, fraud risk, or exit.
6Give the action: ask for more evidence, adjust price or terms, add protection, or decline.
7Check you answered only the number of points asked, in the order asked.

Quickest way: Who, strand, fact, action

When to use it: Use when time is short in an item set or a short essay part.

Who diligences whom? Write GP→target or LP→GP.
Label the strand the question tests (commercial vs financial, investment vs operational).
Find the one vignette fact that signals risk.
Pair it with the action: price, terms, verification or walk away.
Pick the option or write the answer that links the fact to the action.

Common mistakes in Due Diligence and Investment Selection

Confusing commercial and financial due diligence.
Both examine the target's performance, so they feel alike.
Fix: Commercial = market, competition, customers, growth plan (outlook). Financial = accuracy and quality of earnings, cash flow, debt, working capital (numbers).
Treating operational due diligence as a review of investment skill.
Students assume diligence on a GP is mainly about returns.
Fix: ODD tests the firm's controls: valuation policy, administrator, cash handling, compliance, cybersecurity, key-person and succession. Strategy and track record are investment diligence.
Listing red flags without saying what to do.
Students stop after naming the problem.
Fix: Add an action: request evidence, adjust price, add protections, or decline. Tie it to the client's or fund's objectives.
Mixing up the viewpoints of GP and LP.
Both use the word 'due diligence' and both appear in the same vignette.
Fix: Underline the subject in the question. Target company means GP perspective; the manager or fund means LP perspective.
Writing generic answers that ignore the vignette.
Memorised checklists feel safe.
Fix: Use the case facts. A one-customer dependency, a recent departure, or a single-deal track record is the point the marker wants.
Assuming past performance proves skill.
Strong returns look convincing.
Fix: Ask what drove returns: a few deals, leverage, market timing or the team that has since left. Attribute performance and check repeatability.

Worked examples

Example 1

An LP is reviewing a buyout GP. Fund II returned well, but two of the three partners who led its best deals have left. The GP values holdings internally with no independent administrator. Identify two red flags and recommend an action for each.

Show the solution

Identify the red flag in investment diligence: partners who drove past returns have left, so the track record may not be repeatable.
Action: attribute past deal returns to individuals, meet the current team, and seek key-person and succession terms before committing.
Identify the red flag in operational diligence: internal valuation with no independent administrator raises the risk of biased or misstated NAVs.
Action: request the valuation policy, ask for independent valuation or administration, and review audit reports; if refused, treat as a reason to decline.

Answer: Red flag 1: loss of key partners weakens track record repeatability; verify attribution and require key-person protection. Red flag 2: no independent administrator and internal valuation create valuation and control risk; require independent oversight or decline.

Example 2

A GP is considering acquiring a software company. The target reports strong EBITDA, but 60% of revenue comes from one customer whose contract renews next year. State which diligence strand identifies the customer issue and which strand tests the EBITDA figure, and explain the likely effect on the deal.

Show the solution

The customer concentration and renewal risk concerns market position and revenue sustainability. That is commercial due diligence (customer calls, contract review).
The reported EBITDA must be tested for accuracy and quality, including whether revenue is recurring and costs are complete. That is financial due diligence (quality of earnings).
The contract terms and change-of-control clauses fall under legal due diligence.
Effect: if the customer leaves, earnings and debt capacity fall sharply. The GP can lower the price, use less debt, seek an earn-out tied to renewal, or require the renewal before closing.

Answer: Commercial due diligence identifies the concentration risk; financial due diligence tests the EBITDA. The GP should adjust price or structure, reduce leverage, or require renewal as a condition, or walk away if risk cannot be mitigated.

Exam tips

Always state who is performing diligence and on what before you list anything.
Use the vignette facts. Quote the fact, name the risk, then give the action.
If the command word is 'justify', give a reason in one sentence; do not write a long essay.
Remember ODD often decides the outcome: weak controls can disqualify a GP even with strong returns.
Answer only the number of points asked, in the order given; extra points are not scored.

Due Diligence and Investment Selection in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Due Diligence and Investment Selection: frequently asked questions

What is the difference between commercial and financial due diligence?

Commercial due diligence tests the market, competition, customers and growth plan. Financial due diligence tests the accuracy and quality of reported earnings, cash flow, working capital and debt. One looks at the outlook for the business, the other at the numbers.

What does an LP check in operational due diligence on a GP?

An LP checks how the firm is run: valuation policy, independent administration, cash controls, compliance, cybersecurity, insurance, service providers, and key-person and succession plans. The aim is to reduce the risk of fraud, error and weak controls.

What are common red flags when an LP evaluates a GP?

Examples are team turnover, returns driven by one or two deals, style drift, unclear or internal-only valuation, related-party transactions and poor disclosure. You judge how serious each is and whether it can be fixed or protected through terms.

Is there a single due diligence checklist I should memorise?

No single list is required. Learn the strands: commercial, financial, legal and tax, operational and ESG for a target; investment and operational for a GP. Then adapt them to the facts in the question.