When conducting commercial and strategic due diligence on a potential acquisition, a private equity investor needs to have a strategy that lays out a well-defined plan for creating value. This strategy will guide both the due diligence and the post-close execution plan.

In today’s competitive marketplace, it is rare that one private equity firm can outsmart the rest of the field or have a financial advantage unavailable to its competitors; rather, the justification to pay more than other bidders must be based on the ability to create more value.   Paying more is not the only way to be successful, but it is more often the higher bidder than the lower bidder that wins.

Value arises from a greater understanding of how to succeed and/or an increased probability of success, as articulated in the value-creation strategy. The private equity firm with the strongest value­ creation strategies will win more deals, have lower execution risk and ultimately deliver greater returns to its investors.

Setting aside macroeconomic “beta driven” returns with high correlation to business cycles or the broader economy – there are at least three significant sources of differentiation that an investor should pursue to create a value-maximizing investment strategy for a potential acquisition:

1. Develop a deeper understanding of the target company’s industry. Having a more thorough understanding of the industry, where it is headed and how value is created can generate an advantage over the competition

• Create a stronger understanding of competitors and how they will evolve. The marketplace is dynamic. The competitors need to be well understood for the target company to stay ahead of the field.

• Find ways to leverage the unique capabilities of your private equity firm. The ability to increase the scale of the business or to improve supply chain performance through vertical integration or customer/supplier relationships with existing portfolio companies are ways to give your private equity firm an edge over other bidders.

A private equity buyer’s due diligence process should focus on developing and testing the value-creation strategy based on the above three sources of differentiation. Although quality of earnings and other risk factors are important to evaluate, they do not enable a bidder to separate itself from other private equity firms.

An effective strategic and commercial due diligence process can improve the accuracy of the forecast model and therefore sharpen the price and deal structure such that if the business achieves its objectives, the investment will meet or exceed target returns. This goal is best accomplished by developing and testing hypotheses for ho w the business will succeed.

This post discusses how private equity deal and operating executives can conduct due diligence and validate the acquisition opportunity by evaluating value from each of the following three sources: industry, company and private equity firm. It addresses how to gain focus and depth in due diligence despite limited time and budget. Finally, it examines some of the pitfalls common to strategic and commercial due diligence efforts.

Develop a deeper understanding of the target’s industry

Industry analysis should assess the degree of attractiveness versus risk in the market. Some key questions to ask are:

•          Is the target company’s sector attractive? Will it continue to be attractive for the private equity holding period and the next owner’s hold? Are the fundamental industry forces creating head ­ winds or tailwinds?

•          Is the industry consolidating because scale yields a competitive advantage? If so, will this consolidation create opportunities to be a buyer or a seller?

•          Are there emerging technologies that could substantially change the competitive dynamic?

As the questions above suggest, a good industry analysis typically is driven by hypotheses. For example, a hypothesis could be that value can be added by rolling up multiple companies in the industry.

Commercial and Strategic Due Diligence: Key Questions to Ask

•          Which markets does the company participate in today and which industries should it participate in tomorrow? How are its capabilities and competitive dynamics suited or not for successful positioning within each market?

•          How quickly and profitably is the market growing (compared to GDP, S&P 500 or other companies in your portfolio)?

•          Can the market be redefined by non-traditional means? Is anyone making “noise” today that should not be ignored?

•          What is driving growth or decline in the market?  Will either of these forces mitigate or accelerate?

•          Are prices stable (or declining)? What level of pricing pressure can your model handle?

•          Are adjacent markets (to the target company) exhibiting trends that may ‘spillover ‘into the target’s industry?

•          Are the costs for key inputs Increasing or decreasing? What about ingredients that are required by the suppliers (for example, how do changes in the price of oil affect or correlate to the costs of products or grades of resin purchased from suppliers?)

•          What new trends are emerging? What risks or rewards do they pose for the industry?

•          How are future changes in technology likely to affect the industry?

•          What is the potential for regulation to create or destroy value in the industry or provide benefits or risks to select participants?

•          Why do customers patronize the target company? What is the company’s core service or purpose? What is its unique value proposition?

•          Are competitors entering (or leaving) the market, and why?

•          Are competitors large and powerful (or fragmented)?

•          Are customers large and powerful? Are they concentrated or dispersed?

•          Are there alternative products that could compete with the target company’s?

•          Evaluate supply chain risk. Does the company have flexibility or Is it obligated to a few market-dominating suppliers?

•          How does the target company compare to the competitors in pricing/offering and cost?

•          Are any customer segments outperforming others? Why? Is there value in narrowing the company’s market focus?

•          Are any products or services outperforming others?  ls there a means to narrow the company’s product line without compromising profitability or commercial success?

•          What adjacent markets are available now or will be available in the future? Does entry into these markets leverage or dilute the core business?

The due diligence process needs to test the hypothesis by coming to an understanding of market trends, industry economics and growth drivers. In general, hypotheses can be generated and evaluated across four dimensions: market definition, size and penetration; market growth and profitability trends and outlook; competitive land­ scape; and key segment performance.

Understanding industry risks is also critical when generating and evaluating hypotheses. These risks include industry growth, price stability and ongoing cost structures or one-time restructuring costs. Risks can be assessed as inputs to company valuation or as an increased hurdle rate to penalize potential higher risk.

A deep understanding of the industry and the opportunities and challenges that it may present is the first step in the due diligence process. After the industry perspective has been developed, the next step in the process should focus on assessing the company and its competitive positioning and how that could evolve over time.

Create a stronger understanding of competitors and how they will evolve

Strategic and competitive due diligence needs to focus on whether the company’s business model will sustain its success against its competitors. Again, because all bidders in an auction sale will have the same grasp of the basics – market share, trends and leadership quality.  A successful assessment must dig more deeply into the company’s key competitive factors.

Fundamentally, there are two ways in which a com­pany can differentiate itself from the competition:

1. Premium pricing

Having a superior offering or brand position enables some companies to command higher prices. When customers gladly pay a higher price for a product, the returns are generally very attractive. Relative price advantage is typically driven by effective brand marketing and perception (perceived value), and/or by an inherently superior product/service (tangible value).

• Superior relative cost position

If a company can create relatively equal products less expensively than competitors, it can generate higher returns without relying on premium pricing.  Relative cost advantage is generally driven by more efficient manufacturing, by better buying processes or greater scale, and/or by lower selling costs.

Although such a position can be difficult to sustain, the best companies have relative advantages in both price and cost.

It is important to assess the company’s position relative to its competition. Management teams will usually sell the benefits of the company’s products or services, but the due diligence has to compare those features with what other players in the market

Once the company’s current positioning has been understood, hypotheses should be developed to understand how it achieved that position. Can its cost position be sustained? Do further savings opportunities exist? Similarly, for distressed potential acquisitions, analysis Is needed on the ability to improve internal processes and/or to upgrade core products and services.

Whether a company is healthy or distressed, how easily could competitors match the quality of its products and/or services? Likewise, why are costs lower? What could be done to further lower the company’s cost position? How long would this take? When answering these questions, it is important to recognize that the competitive landscape is dynamic. Just as the potential buyer is evaluating how a company can improve its relative cost position, other competitors are doing the same.

Hypotheses can be tested by evaluating market and competitive data. One of the my favorite hypotheses is the ‘ruthless competitor’ framework for thinking through the risks and rewards of a given strategy. This framework asks what would happen if the world’s best competitor entered this market with a business model unencumbered by conventional wisdom, legacy equipment, plant locations or support functions.  How could the target company react to the ruthless competitor’s moves, and how likely is it that those reactive moves would succeed?

This is not a theoretical exercise. Rather, the ruthless competitor framework is a way of identifying how the target company and its competitors rank in an assessment of important capabilities. How likely is it that one of the other current competitors will become a ruthless competitor? Conversely, how could the target company be made into the ruthless competitor? Answers to these questions will drive the post-close operating plan.

Find ways to leverage the unique capabilities of your private equity firm

The third source of value creation is the potential value your private equity firm brings to the deal. Is your firm uniquely capable of increasing the performance of the target company and, therefore, justified in paying more than other bidders?

A private equity firm can bring four typical attributes to a transaction: (1) access to a unique management team; (2) experience in the industry; (3) one or more portfolio companies in the same/related industry; and (4) unique insight or skill for value creation. Strategic and commercial due diligence sets out to prove or disprove hypotheses around these levers.

The greatest value comes from pulling multiple levers. For example, having one or more strategically advantageous companies in your portfolio implies that you have both experience in the industry (#2) and a unique insight into creating value (#4). The key is not to become fixated on which concept belongs to which lever, but rather to understand where the value comes from and how much advantage it gives your firm over other potential bidders. It is not enough to ‘have done a deal’ in this industry, to ‘know the players’ or to ‘have a guy’. Such knowledge and experience may be easily replicated or hired.

Commercial and Strategic Due Diligence: Concluding Points

Strategic and commercial due diligence should codify the strategy and its value for the portfolio company going forward. Due diligence should result in a written plan that identifies what is expected to change within the company once it is acquired, and when. Ideally, the plan should also describe how the change will take place.  Who is accountable and how much value it will provide?

Due diligence is not always perfect and sometimes can lead to conclusions that are not fully thought through. Here are a few of the more common pitfalls:

1. Don’t get lost in the weeds. Time and resources are always limiting factors in strategic and commercial due diligence. The window is short, and funds are scarce at this juncture of the process. That is why the we suggest producing hypotheses to ensure that the diligence remains focused. Work hard to distinguish between information that is needed to assess the value-creation strategy and research that can be deferred until you have won the auction. If the information does not materially affect the hypotheses driving the value-creation strategy, it is not needed before the final bid.

• Evaluate the wildcards. Don’t miss the effect on the company of potential regulatory changes or unexpected cost drivers such as commodity spikes or environmental disasters. These factors can ruin a plan to compete on costs. For example, a deal involving memory foam for bedding products in the US went awry after the hurricanes in the year 2007 destroyed the chemical supplier factories, causing the cost of goods to increase by 50 percent because alternatives were not available, and passing along that spike in costs greatly reduced demand for this discretionary consumer durable and ultimately sank the investment. 

• Don’t define competition too narrowly. A plan to compete on price can stumble when competitors are misunderstood. Be careful not to define competition too narrowly by failing to account for com­ petition from low-cost foreign countries or from substitute products. Additionally, don’t fail to recognize the impact of potentially disruptive technologies. For example, improved processes and technology are changing the game in the pharmaceutical industry. Ten to 15 years ago, competition was among corner drugstores. Now, the corner drugstore is being replaced by online, mail-order or central-fill pharmacies that fill tens of thousands of prescriptions a day at a fraction of the cost of traditional competitors.

• Understand customer requirements and what the customer will pay for. The future value of any company depends on its relationships with its customers. It will be a fatal error to underestimate the impact that non-product factors – such as service, selling capabilities and brand will have on relative price. An effective value-creation strategy ensures that the key attributes that customers are willing to pay for are maintained.

• Involve target company leadership in commercial and strategic due diligence. The value-creation strategy should be more than a theory. It needs to be stress-tested by the team that will implement the plan going for­ ward – whether it is the existing management or a new team to be brought in. With either a formal approach during exclusivity or an informal approach prior to closing, the private equity investor should make sure that management ‘owns’ the strategy.

With such a plan, the private equity firm can better assess these elements:

•          Value of the target company and industry

•          Additional value the private equity firm can create from the acquisition

•          Costs to restructure or transform the company

•          Capital expenditure investments required

•          Risks that could affect value, with key mitigation plans identified in advance

With these analyses in hand, the private equity firm can do two things.  First, it can better define its valuation and sharpen its negotiation strategy. By estimating how much more value it can create than other bidders, the best private equity firms will pinpoint final bids just above rival firms. Equally importantly, it can develop an action plan to support post-close activities. Once the deal has closed, it will be time to start creating value; the value-creation strategy will provide this road map.