Commercial Due Diligence - Assessing the Growth Potential with Current Customers
In recent years, as acquisition multiples have increased, it is simply not enough for private equity.
In recent years, as acquisition multiples have increased, it is simply not enough for private equity firms to rely solely of financial engineering to substantiate their investment. It has become increasingly important for buyout firms to actually add value to companies and improve their operations significantly. High valuations and making it increasingly more difficult to achieve an acceptable IRR target for the investment without significantly increasing revenues and profitability. This process begins long before the deal is in the books. A number of private equity firms are now increasing the depth of their assessment of the target’s growth potential during the due diligence process, providing a clearer understanding of the target’s competitive position, and their likelihood of future growth within the current customer base. Commercial due diligence can help assess the identify the target’s growth potential as well as identify paths to capture additional revenue during the post-acquisition (operations) phase.
Professionally conducted commercial due diligence research should provide answers to the following critical growth questions:
1. Has the target company earned the right to grow within the current customers based on their level of performance?
2. How is the target company positioned against competition? Where are they advantaged and disadvantaged?
Assessing the Potential for Growth
The ability to growth share of wallet with a target company’s current customer base is something that shouldn’t be taken for granted. Investors often assume that if the market is growing then the customer revenue should grow at a similar rate, but this is often a poor assumption.
We find that there are commonly three criteria that drive customers’ choice of a vendor: relative price, perceived value, and overall satisfaction. The customer is continuously asking the following; “Am I receiving the value from my vendor for the price I am paying, and am I satisfied with their performance?
By measuring these three customer variables the potential for future growth within the current customer base is predictable.
The following charts from various customer due diligence projects, highlights how various companies were poised (or not poised) for future growth.
In Figure 1, Company A’s pricing is higher than competitive pricing (as they are rated behind competition in charging a fair and competitive price), and they are essentially equal to competition in delivering value and advantaged in overall satisfaction. Although Company A is high priced, they are delivering enough value to be on par with competitors. Company A has done a great job justifying higher prices by selling value. However, to generate future growth, Company A has to either look at reduced pricing, or offering additional value via products or services.
Figure 1 (Company A)
In Figure 2, Company B’s pricing is well below competition (as they are rated ahead of competition in charging a fair and competitive price), and they are ahead of competition in delivering value and overall satisfaction. The potential for future growth within Company B’s customer base is fairly good, in fact you could make a good case for increasing prices.
Figure 2 (Company B)
Figure 3 (Company C)
In Figure 3, Company C’s pricing is higher than competitive pricing (as they are rated behind competition in charging a fair and competitive price), and also well behind competition in delivering value and overall satisfaction. Company C has very few immediate growth options within the current customer base. In fact, losing business volume within their customer base is a much more likely scenario. As an investor, this is not a picture you would want to see.
Now that the investor has a better understanding of the targets ability for growth within the current customer base, the next piece of valuable information is how the target is positioned relative to competition on product and service attributes. After all, customers will either buy from the targeted company or a competitor, so it is essential to understand where the target is advantaged, equal, or disadvantaged relative to competition.
The chart in Figure 4 shows the “net” average performance ratings by attribute for the target company verses the aggregate average performance ratings of competition. Attributes with “red” bars represent where the target company is behind competition, and attributes with “blue” bars represent where the targeted company is ahead of competition. So, based on the data, the target company is extremely disadvantaged in the entire area of “Marketing”, and behind competition in areas of “Product”, “Packaging”, and “Deliveries and Shipments”. On the other hand, the target is well ahead of competition in “Sales Representation”, and somewhat advantaged in “Customer Service” and Problem Resolution”.
This type of analysis coupled with the Growth Potential assessment discussed earlier provides the investor insight into the operational implications associated with achieving share growth within the current customer base. For example, as Figure 4 indicates, improving marketing materials and online resources may be critical for generating growth. Information like this is invaluable to investors prior to the acquisition, providing the insight needed to better understand the changes and cost implications of growing the target’s share of customer.
The above insight is just one example of the important role properly executed commercial due-diligence can play in the pre-purchase process.