Download Business/Market Due Diligence

Business/Market Due Diligence
By Jay Lucas, The Lucas Group
Overview
Business or “market” due diligence is the process in which an investor closely examines the external
market and competitive dynamics of a company that is being considered for an investment or acquisition. Generally, the examination is performed under tight time frames and has two overarching objectives. The first and usually most immediate objective is to determine whether there are any
significant downsides that could potentially affect the target company, especially untoward circumstances or events that would have an impact on cash flows in the first 12 months to 36 months of
the investment. The second objective is for the investor to test the growth thesis for the company
and determine the anticipated growth strategy that will pave the way for a successful investment and
subsequent exit several years down the road.
Background
In past years, private equity firms largely conducted this due diligence process internally, using a
combination of deal partner and operating partner experience, informal “digging” with management and potentially accessing an industry expert and/or an occasional market study that might
be available. However, as the deal environment has become more competitive and the need to have
an “edge” in one’s investment thesis has intensified, the business/market due diligence process has
become much more structured and disciplined.
Private equity firms typically outsource much of the work that is required by seeking the assistance
of outside professionals, usually a corporate strategy firm. The outside resources are generally engaged at one or both points of the deal process. The first can occur pre-LOI when the deal is being
vetted. This is usually the case when there is a competitive process underway and the private equity
firm is sharpening its knowledge base and determining what price they would be comfortable bidding. Then, post-LOI, the firm launches a full-scale diligence process where it and its advisers are
generally given much greater access to the target company’s data, customers and management team.
Traditional elements of analysis
Having been involved in more than 500 of such examinations over the years, the author has found
that there are several traditional elements of the analytics that are present in nearly every case.
First, it is common to use secondary research and/or market studies that might be available. In most
cases, this effort yields minimal results as much secondary research is either too general or out of
date. In addition, many, if not most, target companies compete in narrow markets or niches that are
not well studied. Thus, the need for primary research follows quickly thereafter.
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This primary research generally falls into three “buckets”: market size/growth, intensive customer
interviews/surveys and competitive analysis. As there is usually some degree of urgency and because
primary research can be expensive and time-consuming, there is a need to sharply focus the effort.
Therefore, the effort is most typically directed at answering a handful of key questions that may be
most germane to the deal. It is conducted in such a way as to uncover any major obstacles or issues
early in the process, so as to avoid the unnecessary burning of resources and effort. Examples of such
questions include:
•Are there any major competitive threats looming on the horizon?
•Is the company’s market position sustainable?
•How strong is the company’s relationship with its customers – especially
those that account for a disproportionate amount of the company’s business?
•Are these relationships “sticky” – and why or why not?
•How likely are the projected “growth initiatives” touted by the company
to materialise?
•What are the growth prospects for the company?
•What are the projections for pricing flexibility/pressure?
•How much “white space” or potential for growth is there in the company’s
current market segments?
Market size/growth
The first order of business is usually to develop a solid understanding of the company’s and the
transaction’s position. This involves building an industry overview, defining and sizing the relevant
market(s) for the company, identifying key players, assessing likely growth rates going forward (as
well as the underlying drivers of primary demand) and any discernable key trends. This often involves a fair amount of research and analysis, but is quite necessary to establish the key baseline facts
of the deal. In this part of the process, the effort usually involves piecing together data from a number of sources, and triangulating and synthesising this data to form a well-developed picture about
the company.
In the author’s experience, this is one of the key elements of analysis as it builds a foundation for
all that is to follow. For instance, if the industry/market turns out to be smaller than purported, or
anticipates lower growth rates, then the opportunity to acquire the company will obviously be less
attractive.
Customer interviews/surveys
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One of the most important pieces of analysis involves customer research. This is the part of the
effort where the company’s customers, prospects, former customers, competitors” customers and
other major players in the market are contacted. These interviews are usually conducted over the
phone and often supplemented with a web-based survey. The purpose is to gather information on
the degree to which the company’s customers are satisfied and are likely to defect/be retained, as well
as any significant trends in the market that would affect the company. When done well, the research
can depict a very compelling view of customers” key buying criteria (that is, what is most important
to them), and how the various competitors rank in their estimation. In addition, various subtleties
can be probed, especially by a seasoned interviewer who possesses strong business knowledge.
An important note of caution here is related to how these interviews are conducted. Generally, no
area is more sensitive than contacting customers of the acquisition target. Management holds these
relationships dear and vital to the company’s future success. Several techniques have proven to be
successful in the past. If the interviews are conducted and it is acknowledged that the company is
sponsoring the study, the outside resource will often be described as a market research firm retained
by the company to help it learn more about how it is servicing its customers and how it can improve its offerings. If, on the other hand, the interviews are conducted on a totally “blind” basis, the
outside resource will more often be positioned as a firm conducting general research on the industry.
Both approaches can yield results. However, whenever the research can be conducted closely in conjunction with the company, its precision and effectiveness are improved.
Competitor analysis
Often one of the most difficult areas of analysis to conduct, and one of the most important, is
competitive analysis. This is the part where the market position, strategies, intentions, strengths and
weaknesses of the competitors is ascertained. Not surprisingly, this data is quite difficult to develop
as competitors do not want to divulge proprietary information about their company. However, creativity and entrepreneurialism can lead to startlingly positive results. For instance, carefully conducted interviews with suppliers and customers can often provide insights into the health and intentions
of a competitor. Stitching together information about capacity utilisation, number of employees and
real estate transactions through various forms of web research can paint a valuable picture about a
competitor’s business. In addition, over the years, a great source of information has been conducting
competitor interviews. It is often surprising to find the amount and depth of information that can
be obtained directly from competitors. One tip here is that the richest source of information is typically the competitor’s sales force as they are often eager to talk about their business and surprisingly
willing to divulge information that probably is not in their company’s best interest to share.
For example, the author once advised a client whose product – beer – was sold internationally in
countries where market share data was generally unavailable. As a way of determining market share/
position, our team went to bars at the end of the evening and swept the floors, counting discarded
bottle caps and allocating market share based on the number of caps for each supplier. The key is to
be innovative, creative and think “out of the box”.
In most cases, these three buckets form the crux of the analysis. However, the real value is derived
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when these pieces of information are synthesised into a comprehensive picture, and the overall transaction is assessed in the context of reliable market and competitor information. It is also best to link
this analysis to the transaction model, that is, the projected financial scenario for the investment.
This is where new information about inputs such as market growth rates, available market and price
trends can be used to get a deeper understanding of the investment and its future prospects. On
many occasions, rosy growth scenarios have been toned down due to such information. However,
new areas of growth and investment are often discovered as well. For example, in one recent instance, the target company’s projections for international growth were proven to be wildly optimistic
while opportunities for organic growth within its current markets were uncovered. These insights
are key for understanding the attractiveness of a potential deal and the attendant pricing/financial
structuring implications, as well as setting a blueprint for post-deal strategy.
The five drivers of value
While the three buckets described above are the traditional elements of analysis and should be
performed in most cases, our experience has shown that there are five additional measures that are
critical to diligence and over time have proven to be the key drivers of value in many, if not most,
transactions (see Figure 1).
Figure 1: Five drivers of value
Source: The Lucas Group
As time is often short and resources finite, it is important to concentrate effort on vital areas that can
drive value. In the author’s experience, here are the five drivers of value:
1. Market growth rate
It may be obvious but assessing the market growth rate correctly and aiming for areas where the
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market growth rate gives the company “wind at its back” is one of the critical drivers of value. This
is true not only because it gives a clear picture about the target company’s potential volume growth,
but also its ability to grow with the market. Also important, and often overlooked, is the extent to
which competitive intensity is lessened and price pressure/flexibility greatly enhanced in growth
markets.
Our advice in this area is to focus on primary demand. In other words, link the analysis of market
growth to the end user/customer. Moreover, rigorously assess the extent to which the customer’s
business or general economic condition will be healthy and will continue to drive the ultimate demand for the target company’s product or service.
2. Relative market share
The target company’s relative market share – its market share/size in relation to its next largest
competitor – is critical for understanding its scale advantages, or disadvantages. These potential
advantages accrue in terms of cost scale, and even more importantly in most businesses, in terms of
market leverage. Put another way, having market leverage means that the company will be able to
extract better pricing from less tangible areas – such as sales force, relationships, industry reputation and presence – that are of great value and importance.
It is key to define the relevant market correctly as a starting point. As is often the case in many
pitchbooks, the company defines its market so narrowly that it boasts an incredibly high market
share. However, the market could be much larger and there could be relevant competitors that must
be reckoned with; the company’s market position could be weaker than originally projected.
On the other hand, businesses sometimes just fundamentally misconstrue the economics of their
business and thus their market definition. For instance, there is the famous and somewhat tragic
mistake of the A&P grocery chain. The company defined its business as a national business and
invested in new store growth in its aim to build the largest grocery chain in the US. In the US,
however, the grocery retail business is fundamentally a local/regional business. Thus, dominating
regions – that is, “relative market share” within a region – is critical. A&P, unfortunately, spread
themselves too thin, opening up grocery stores in every town and hamlet – even going up against
large dominant competitors – and eventually paid the ultimate price.
The key here is to define the market accurately, and then aim for targets that have strong, hopefully
dominant, market positions. This analysis is an important component of the diligence process and
can be very useful in focusing on a company’s untapped, underlying value.
3. Recurring revenues
In the author’s experience, businesses that have truly recurring revenue models are extraordinarily
valuable. These businesses are also often undervalued by the market. Thus, it is very important to
“get your nose under the hood” of the target business and develop an assessment of just how “recurring” are the revenues of the business. In some cases, the answer may be obvious, such as businesses
with long-term contracts, the need for long-term, ongoing customer service and difficult switching
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costs. In other cases, it may not be so obvious. For instance, a company may not have long-term
contracts, but it is very painful, difficult and/or costly for their customers to switch. Assessing the
extent to which these are recurring or quasi-recurring revenues will be critical to understanding the
true underlying value of the business and its franchise. This analysis is more an art than a science,
but important; if the intrinsic value of recurring revenues is incorrectly assessed, a key driver of deal
value is improperly considered.
4. 80/20 core profitability: the sweet spot
In the vast majority of cases, most businesses have “80/20” profitability. This occurs when a large
proportion of the profits results from a distinct minority of the effort. Alternatively, it can be that 80
percent of the profits are derived from one customer group, product or region and the remaining 20
percent from the rest of the business.
While it is not always possible to assess this during the diligence process, it is important to attempt
to do so. An investor needs to understand the “core” of the business prior to submitting a bidding
price or committing to a transaction. This is both because it is the health of the core that will sustain
the business during the early stages of the investment and, equally important, the investor needs
to assess how much more “white space” there may be directly in the target company’s core, which
will impact growth and profit prospects. Often this analysis suggests “adjacency” opportunities that
should be baked into the deal calculation. The caution here is that there is much less risk associated
with these core activities. Thus, “new opportunities” and initiatives that are often suggested in pitchbooks need to be carefully assessed and with some degree of scepticism.
5. Net promoter score: the leading indicator
Lastly, the extent to which customers will proactively go out and tout the target company’s business
is one of the most important barometers regarding the future health and prospects of the business.
A remarkably useful tool is to systematically develop the company’s net promoter score as part of the
diligence. In fact, most often the target’s score can be developed, as well as that of each of its major
competitors. This can lead to valuable insights into forecasted market-share shifts, customer defections and prospects.
Recently, the author investigated the prospects for an acquisition and discovered that both the target
bolt-on and the acquiring portfolio company – both in the health care industry – had very negative ratings among customers. As a result, the acquisition was immediately halted and the private
equity owners of the parent company worked with the author’s firm to develop a performance
improvement programme for the company. Once improved, the company made several highly successful acquisitions, which was not surprising since it had a strong net promoter score and customer
rating.
Taken together, the five elements in this new paradigm of value drivers can help to uncover the
value of the business in a more robust manner than the traditional three-bucket method of analysis.
The new paradigm allows the investor to focus on the key drivers of value, and hopefully find value
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where others may not. Equally important is finding flaws in a situation that may appear rosy on the
surface.
Conclusion
It is important to address one last area: complexities. While the above analysis may seem straightforward, it typically is not. Data gaps, data glitches, the need for experienced judgment calls on
analytic issues and compressed time frames greatly add to the complexity of conducting a business/
market analysis. Moreover, there are substantial interpersonal and deal complexities that need to be
managed during this process, such as a deal partner who is trying to manage a transaction and often
involving a skittish seller during this process. No one wants to lose the deal due to some misunderstanding or misstep during the diligence process.
Thus, the diligence process needs to be managed carefully, with a steady, experienced set of hands,
as it moves forward. In our view, the best way to ensure success in this process is to have a team of
dedicated professionals who are working with the private equity team on an intensive, day-to-day
basis during the entire process. Circumstances and issues tend to change on a daily basis and having
this close working relationship will be the true key to success.
Jay Lucas is the founder and chairman of The Lucas Group, a strategy consulting boutique based in Boston and focused on the needs of private equity firms. Prior to founding the firm in 1991, Jay was a partner at Bain & Company, where he led assignments for Fortune 500 companies in the consumer products,
food and beverage, and information technology industries. Jay also was a co-founder of Bain’s consulting
practice to leveraged buyout funds and their portfolio companies.
Jay is a graduate of Yale College, Harvard Business School and Harvard Law School. Earlier in his career,
he served two terms in the House of Representatives and was his party’s nominee for Governor in the state
of New Hampshire.
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