Article
Three aspects of commercial due diligence private equity firms should seek
Sept. 21, 2021 · Authored by Ed Mahon
It is no secret to private equity professionals that the current M&A market is one of the craziest in recent memory. Although the onset of COVID-19 led to a downturn in deal activity in the first and second quarters of 2020, the decline was short lived with 2021 on pace to experience a record number of deals due to a confluence of trends over the past five years.
- Global uncalled private capital focused on buyouts was $1 trillion in 2020, two times more than what was available in 2015 [1]
- U.S. private equity funds raised $1.2 trillion in capital in the last four years (2017-2020), even with the downturn caused by COVID-19 in 2020, compared with $720 billion raised in the previous four-year period (2012-2016) [2]
- Although federal funds rates increased over the previous four years, the Federal Reserve purchased $2.9 trillion of assets in 2020 in response to the coronavirus, a 75% increase over 2019, leading to a decline in the fed fund rate back to just above zero [3]
All of this capital and cheap debt has supercharged the deal market in the U.S. Even with the pandemic slowing deals in the first half, 2020 saw the highest number of private equity deals in U.S. history with 5,789 and 2021 is on pace to significantly pass that number. [4]
The increased competition for deals and the need to get capital deployed has led to high purchase price EBITDA multiples. In 2020 in the U.S., the average EBITDA purchase multiples paid by private equity firms was 11.4x, up from around 9x in 2015. Anecdotally, Baker Tilly’s transaction advisory group has seen deals in manufacturing and distribution that would have gone for 4x-6x EBITDA five years ago, now closing at 7x-9x. [5]
In this high-multiple environment, private equity firms need to achieve substantial growth to hit their internal rate of return (IRR) hurdle rates. This makes it more important than ever to undertake strong market and commercial diligence in order to provide the foundation for a strong Day One growth strategy and value improvement plan for the target company. Below are three aspects of commercial due diligence private equity firms should seek to understand as part of developing their growth strategy.
One of the main goals of a growth strategy should be to gain market share. To start to understand how to do this, an owner must determine a company’s “right to win.” A right to win is the ability to engage in any competitive market with a better-than-even chance of success consistently. This starts with truly understanding the target’s competitive differentiation.
Building this understanding starts with the typical detailed conversations with the target’s management and sales teams and a detailed analysis of sales data. But it must go beyond just those efforts and include gathering information from both their customers and their competitors. Fully grasping why their customers have chosen to buy from the target, why they chose the target over a competitor and what the customers see as the target’s strengths and areas of improvement are all key building blocks of a growth strategy. To gain the customer’s perspective, an extensive “Voice of Customer” (VoC) analysis should be undertaken (discussed further below).
Developing a keen understanding of the target’s competitors, both current and potential entrants, is also important. In diligence, a private equity firm should seek to learn the following about competitors: how they go to market, what they are known for, where are they growing and how they see their own differentiation. All of this will help in finding a differentiation path and avoid a “me too” strategy that will not lead to market share gain. In market diligences performed by Baker Tilly, we often attack this type of research in two ways. First, we seek out interviews with market participants with detailed knowledge of the competitive landscape, usually targeting former employees of competitors who usually feel more freely to speak directly about their former employers. Second, we perform “secret shopper” calls to competitors to understand how competitors are presenting themselves to the market.
The insights gained from this kind of diligence can help direct where R&D or sales and marketing investment should go post-close as well as what opportunities might be out there through bolt-on acquisitions. By the time you close the deal, you should have a clear, honest and specific idea of what your target differentiation is and how to attack the competition. This will help create a growth strategy that will give your company the right to win throughout your hold period.
An essential part of developing a growth strategy for a target company is understanding the market trends and forces impacting the target and how the company is aligned to those trends, both positively and negatively. This has become even more acute due to the effects of COVID-19 as trends that might have been more gradual are now happening more rapidly. These trends could be micro and macro in nature — from changes in demographics, consumer preferences or spending patterns to tariffs, environmental regulations, government oversight and technology advancements.
The goal is to understand which trends have the most influence on the target’s business. If the target is not fully aligned with positive-growth trends then that will clarify where to deploy capital for R&D or toward a bolt-on acquisition opportunity in order to become aligned. If the target is facing some negative trends, the growth strategy needs to have mitigation or diversification actions post-close.
At Baker Tilly, we approach diligence on trends with a combination of a synthesis of research reports, news articles and other publicly available information along with primary research including surveys and detailed interviews with market participants (trade associations and government data scientists are particularly good sources here).
Having a robust understanding of a target’s customers is one of the most important, but often neglected, parts of diligence. As mentioned in the sections above, customer calls are a great way to understand the target’s differentiation, the competitive landscape and trends in the market. In addition, conversations with clients might be the best way to understand potential risks (like customer turnover or negative market trends) and areas for improvement. Finally, customer feedback can provide insight on how the target can sell more of its existing products to the customers or what other product categories or services the target could offer to their existing customers.
Most private equity firms mandate or undertake at least a few client calls as part of diligence, but these are usually executed near the close of the deal, with clients that are sometimes chosen (or “cherry picked”) by the target’s management. This is often because of capacity limitations at the private equity firm and because the target’s management team can be reluctant to give access to their customers until the deal is more certain. This is where a third party like Baker Tilly can come in. We work with the target’s management team to conduct the calls on behalf of them, with no mention of M&A or private equity. And we can do many more calls in a short time period or conduct a survey to hit a wider number of customers (including retail customers), freeing up the private equity professionals to focus on other areas of diligence.
