The due diligence process centers around the belief that it is more effective to assess granular aspects of a business than a business as a whole.

To illustrate this imagine that you are an automotive mechanic. One day a car owner drives up and asks you to appraise the general condition of his car so that he can sell it. While seeing the shiny new paint job and hearing about the make of the vehicle, mileage and performance to date will be helpful, it is simply not enough information for you to guarantee that the car will perform well in the future. In order to make that assessment, you will need to evaluate all of the aspects of the car individually. You will check the breaks, test the engine and look at the tires. And then, if each of the cars key parts and processes seem to be in good shape you can conclude that the car as a whole is likely to perform well going forward. If all the things that make up the car are in excellent condition, you can more reliably conclude that the car as a whole is in excellent condition.

This same logic applies to conducting due diligence on companies. Investors that simply look at the type of company, how long it has been around and how it has performed to date will typically not make as reliable judgments about the future viability of the company as an investor who takes a look at all of the individual aspects of a business that are required to create future value. The process of conducting due diligence forces investors to carefully check the competency of the management, test the strength of customer demand and look at future competitive dynamics. If all of the parts of the company are well oiled, then it is safer to conclude that the company is ready to go the distance.

“Free at last,” managers of taken-private companies might be tempted to shout. No more demands by Wall Street to meet quarterly earnings targets. No more tipping their hand to rivals through quarterly filings with the Securities and Exchange Commission. And, blessedly, no more Sarbanes-Oxley.

In reality, managers of buyout-backed companies soon encounter an even more demanding set of quarterly targets—the one imposed by bankers who don’t take kindly to missed interest payments.

In addition, bond-holders (in deals financed with privately placed high-yield debt) typically demand registration rights that allow them to exchange their privately placed bonds for bonds registered with the SEC. Unlike privately placed bonds, registered bonds are freely tradable, helping to ensure liquidity for investors. The rub: Borrowers that register their securities with the SEC must continue to file 10-Qs, 10-Ks and related documents.

As a result, targets of many of the largest take-privates from the last decade continue to file quarterly and annual earnings reports with the SEC, providing a wealth of data to investors, rivals, analysts, and the merely curious.

But relief could be on the way. Recent amendments to Rule 144, an SEC rule governing privately placed securities, reduce the time required for bond-holders, along with other investors, to wait before they can sell privately placed, restricted securities on the open market. The amendments also eliminate limitations on sales once the waiting period is over.

Attorneys speculate that once the credit crunch runs its course, borrowers may feel emboldened enough to ask bond-holders to forego registration rights since they enjoy so much more liquidity under the new rules. Registration is time-consuming for borrowers, and the ongoing requirement to file Sarbanes-Oxley-compliant earnings reports can cost companies some $2 million per year, according to one estimate. Borrowers also would prefer not to have to disclose, in a public forum, their intimate financial results.

For the moment, high-yield bonds remain such a tough sell that borrowers have limited leverage to ask bond-holders to give up registration rights. And it’s not clear whether bond-holders will ever relinquish registrations rights even in a frothy market. Peter J. Loughran, partner at Debevoise & Plimpton, sees little change for borrowers that haven’t already been filing earnings reports with the SEC. For those that have been, bond-holders might not require SEC reporting registration, provided the borrower makes the earnings reports available some other way. That said, Loughran pointed out that some investors have policies that require them to hold registered securities.

Under the old Rule 144, bond-holders had to wait at least a year after acquiring restricted securities before selling their holdings. Between the first-year anniversary and the second, they could sell securities under certain conditions, such as not exceeding caps on the number of bonds they could sell in any given quarter. After the second anniversary of the offering, bond-holders could sell their securities free of Rule 144 requirements. Not a terribly liquid situation.

So borrowers always agreed to replace the restricted bonds with freely tradable, registered securities within six months to a year of the original offering. In legal circles this has become known as an “A/B exchange offer.” Under SEC rules, the borrower files an S-4 to register the securities, then 10-Qs, 10-Ks and related documents for up to a year after that. The SEC reporting requirements may end there. But under covenants imposed by bond-holders in the private placement documents, the company continues filing with the SEC as a “voluntary filer.”

Under the new rules, provided an issuer continues to file reports with the SEC, bond-holders can begin selling their securities after six months, and face no restrictions on sales after that. For companies that don’t have to file reports with the SEC, the minimum holding period before selling is one year. After that, the bonds become freely tradable.

For more on the amendments to Rule 144, contact Peter J. Loughran, partner Debevoise & Plimpton, 212-909-6375; John A. Bick, partner, Davis Polk & Wardwell, 212-450-4350; or Rod Miller, partner Weil Gotshal & Manges, 212-310-8716.

For more market analysis from the editors of Buyouts Magazine head on over to buyoutsnews.com.

Golden Horn ventures is organizing a conference in Istanbul, Venture Capital in Emerging Markets. The goal is to bring together fund investors, venture capitalists from all over the world and entrepreneurs and discuss investment strategies, the right and wrong practices of venture capital in emerging markets.

Please check out http://emergetechvc.com for more information on the venue and the agenda.

Friends You Know is beta testing its LGBT social network after raising $350,000 from a cadre of Illinois-based investors, regulatory filings show.

Funding comes from CEO Matthew Small, the Eugene B. Shapiro Revocable Trust, the Vicki Lehrner Adams Revocable Trust and the Daniel T. Zagorin Trust, according to the filings.

The company has targeted $4 million for its Series A.

It should come as no that a social network for the LGBT community might attract angel financing. It’s a justifiably big market. Wikipedia reports that somewhere between 1% and 10% of the population is exclusively homosexual.

Friends You Know may face stiff competition, however. TechCrunch writer Marshall Kirkpatrick offers an informative survey of eight other social networking sites targeted at the same market. Mashable’s Pete Cashmore offers another four gay social networks launched last year.
Friends You Know’s financing is proof that social networking remains a popular place for early stage investors. More than 30 social networking companies got funding last year. My colleague Joanna Glasner had a a great story on the shocking trend (available here to VCJ Subscribers).

Oldster Network Ups Series A

In other social networking news, TeeBeeDee has increased the size of its Series A, according to a regulatory filing.

The company, which is building a social network for the elderly, announced it had raised $4.8 million last fall, but has since increased its target to $7.81 million.

It has raised $6.3 million of that target from 18 investors so far, according to the filing. Backers listed include Shasta Ventures, Monitor Venture Partners, the Melone Family Trust, David Nierenberg and Bruce Rauner.

Schilling is the man who protects Hillary’s online self from the public’s hatred. He estimates that he spends up to 15 hours per week editing Wikipedia under the name “Wasted Time R”–much of it, these days, standing watch over Hillary’s page. Hardly a news event or argument over her situation goes by without Wasted Time R’s input: He edited her page 77 times in the last month, mostly pruning away changes he viewed as inappropriate, such as a rant about Geraldine Ferraro or a stealthy effort to diminish Hillary’s role in improving the State Children’s Health Insurance Program. The fact that Schilling is married to a librarian who, he laments, “never recommends anybody use Wikipedia” (no one, no one, hates Wikipedia as much as librarians) does not diminish his vigilance. “You constantly have to police [the page],” he says, recalling the way Rudy Giuliani’s Wikipedia article declined in quality after its protectors lost interest. “Otherwise, it diverts into a state of nature.”

This is a really interesting article on how the political campaigns are being forced to monitor Wikipedia minute-by-minute. In the final analysis Wikipedians will say the system is working as it should but I say that there is something flawed about a system that fails to accommodate high stakes issues with an effective throttle to ensure that misinformation isn’t leaking out.

Jimmy Wales recently made an interesting comment about how Wikipedia is a double edged sword that “works because everything we do is extensively debated but the other side of that is in order for us to do anything everyone has to agree.”

We’re approaching a point where Wikipedia is as much a utility service as an independent foundation/website. The consequence of that is that the group of insiders that run Wikipedia simply have to accept that they alone don’t always have the right solutions and inaction is the absence of agreement simply isn’t sustainable.