By Patrick Farrelly
You are evaluating a target company that had higher than normal revenue growth in 2020. The target company presents you with a five-year forecast that maintains the above average growth experienced in 2020.
Is the target company’s spike in growth a one-time outlier event or is the growth sustainable? This is a common question many private equity firms currently face following a volatile 2020 business environment.
The answer to this question is critically important since it impacts the target company’s valuation and your firm’s return on investment.
The prior example highlights the importance of the buy-side due diligence process given the uncertainties in today’s market. In the past, your firm may have engaged a third party for only financial due diligence (or quality of earnings – Q of E). However, complementing your financial due diligence with commercial due diligence can help mitigate deal risk, increase return on investment, and improve deal structure and price.
What is commercial due diligence?
The goal of commercial due diligence is to assess the growth and profitability potential of your target company. Target companies’ future financial forecasts often project high growth and profitability over the buyer’s planned holding period. Commercial due diligence helps to validate the assumptions driving your target’s financial forecast.
Commercial due diligence requires a thorough analysis of your target’s internal and external environment. The typical approach includes examination of five key areas:
1. Target company assessment.
2. Market and/or product analysis.
3. Customer analysis.
4. Competitor analysis.
5. Future growth and profitability assessment.
Data for the analysis is gathered through primary research, such as interviews with the target’s management team and external industry experts, and secondary research, such as market research reports and databases. The final deliverable is a detailed report that includes an executive summary of the analysis.
What are the benefits of complementing commercial due diligence with financial due diligence?
It mitigates transaction risk. Commercial due diligence highlights potential commercial risks that could impact the sustainability of your target’s business and/or limit future growth potential. The analysis and data provided in the final report enables you to make informed decisions.
It improves deal structure and transaction price. Commercial due diligence provides you with a deeper understanding of your target’s business before negotiations begin. Targets typically know more about their business than you, and short exclusivity periods limit the amount of time you have to analyze your target’s business. Commercial due diligence helps to close that knowledge gap and provides you with data to use in the negotiation of the transaction structure and price.
It increases deal team capacity. Short exclusivity periods leave limited time for you to conduct thorough, detailed analysis. Hiring a third party to complete commercial due diligence increases the capacity for your deal team to focus on other value add tasks related to the deal.
It identifies growth opportunities that increase ROI. Commercial due diligence can reveal insights about untapped potential in your target company’s strategy, operations, sales channels, end markets, customers, and/or competitors. Exploiting this potential can drive growth in your target and increase the deal’s ROI. Identifying these opportunities before the deal closes allows for quicker implementation post-close.
It provides reassurance to lenders. Banks may request or require a commercial due diligence report from an independent third party as part of the loan evaluation process.
Commercial and financial due diligence are equally important components to the overall evaluation of a target company.