Private equity investors are highly skilled at analyzing financial due diligence, modeling returns and transaction structuring. However, the real driver of value with any buyout is post-closing operating performance. And, there is no better way to be certain about this outcome than to engage in robust commercial due diligence as part of the investment process. Rigorous commercial due diligence encompassing competitive intelligence; voice-of-customer; supplier risks; trend analyses; demand quantification; and, operational evaluation is crucial to highlighting the true value of a target and ensuring it possesses the fundamentals to drive operating performance that will deliver superior return.
What are Current Common Diligence Practices?
When investors conduct pre and post-LOI diligence, they commonly follow one or more traditional methods to gather critical operating, customer, competitive and supplier intelligence. Some of the standard approaches include:
- Internal analyst phone calls and secondary research (internet and published industry reports)
- Entrepreneur-in-residence experts tap industry contacts and develop experiential conclusions as to trends or conditions
- Reliance on new management team members and holdover talent (each of which has different motivations as part of any transaction) to disclose insight on operations and market trends; and,
- Financial due diligence experts that extend their reach and “audit” a target’s customers and suppliers in order to generate some certainty about the impact of operations on financial performance
In each case, both the depth of the investigation is insufficient and the quality of the facts not robust enough to draw reliable conclusions. Furthermore, it is impossible to translate these superficial facts into actionable data along the lines of Quality of Earnings Reports and Market Demand Forecasts.
What is Actionable Commercial Due Diligence?
Commercial due diligence comprises the investigation, audit and analysis of all of the operational aspects of a target. Typically, third-parties with specific experience including business operations, technology assessment, markets, IT and human resources will engage to investigate the target’s condition. However, truly actionable commercial due diligence requires primary research across multiple levels of the value chain in the target’s industry sector to uncover future risks and opportunities. Examples of findings might include:
Other Actionable Diligence Examples:
- Plant floor analysis: Investment thesis depends on the potential for two facilities (portfolio company and Newco) to be consolidated into a single new facility. Plant floor and production analysis reveals that the new plant is at capacity, thus incapable of producing buffer inventory for the change-over. Furthermore, manufacturing processes are discovered to be incompatible for a single location (e.g. dusty finishing processes vs. clean-room component assembly requirements). Conclusion: increased capital expense required to expand facilities impacts return analysis
- Human resources insight: Headcount analysis by accounting team uncovers declines in personnel in certain sales positions. Management discussions suggest competitive poaching of employees. Buyer employs primary research and intelligence gathering to benchmark competitor compensation structures. Conclusion: to maintain staff at competitive pay rates, increased variable costs (bonuses) will negatively impact expected EBITDA
Actionable commercial diligence highlights risk factors, reveals flawed assumptions by management or sellers, and ultimately enables the acquirer to better negotiate value and modify return expectations for real market factors. Furthermore, commercial diligence can expose emerging trends that will impact long-term performance, require careful portfolio company management and impact exit opportunities. For private equity investors that may have no prior experience in the sector in which they are about to invest, the investigative conclusions from rigorous commercial diligence are even more fundamental to investment decision-making.
What Skill Sets Define Excellence Among Commercial Diligence Partners?
Clients say leading commercial diligence providers customarily possess a few critical attributes that are both core to delivering a high caliber of work product and of paramount importance. These include:
- Demonstrable, rapid investigative capabilities
- Relevant, sector expertise
- Global geographic coverage
- Partner/senior executive-level transaction execution experience
Rapid Investigative Capabilities:
A commercial diligence partner must have the resources to gather intelligence on the specific target enterprise in a compressed time frame, beyond traditional secondary research. All diligence springs from this foundational assumption, and any competent service provider must possess this capability.
Relevant Sector Expertise:
There is no substitute for deep sector knowledge. Such industry expertise is critical to properly interpret the commercial impact of data that is gathered. Sector knowledge should be evident across a range of prior engagements and throughout a network of industry contacts. These contacts facilitate the gathering of intelligence beyond target-supplied customer lists.
Global Geographic Coverage:
In this era of globalization, a wide array of multi-national factors can affect transaction execution and post-closing success. The ability to conduct effective research in parallel, on multiple continents in native-language, with an understanding of both cultural factors and variances in business practices is critical.
Sophisticated transaction execution expertise on the part of any advisor affords an investor advantage. These service providers understand how to interpret data, project impact and advise actions, which are value accretive to any investor/acquirer. A commercial diligence partner with deal experience, not just research experience, should be a core member of any investment team. The conclusions that such a partner provides are strong indicators of post-closing operating success and the associated superior return on investment.
Authors: Abey K. Abraham and Chad S. Eberly