As acquisition multiples have increased in recent years, it is simply not enough for private equity firms to rely solely on financial engineering to substantiate their investment. It has become increasingly important for buyout firms to add value to companies and improve their operations significantly. High valuations make achieving an acceptable IRR target for the investment increasingly difficult without substantially increasing revenues and profitability. The process begins long before the deal is in the books. Some private equity firms are now expanding the depth of their assessment during the due diligence process to better understand the target’s competitive position and the likelihood of future growth within the current customer base. Commercial due diligence can help assess the target’s growth potential and 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:
- Has the target company earned the right to grow with current customers based on their level of performance?
- How is the target company positioned against the competition? Where are their advantages and disadvantages?
Assessing the Potential for Growth
The ability to grow share of wallet with a target company’s current customer base shouldn’t be taken for granted. Investors often assume that customer revenue should grow at a similar rate if the market is growing, 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 continuously asks, “Am I receiving the value from my vendor for the price I am paying, and am I satisfied with their performance?” The potential for future growth within the current customer base is predictable by measuring these three customer variables.
The following charts from different customer due diligence projects highlight how various companies were poised for future growth.
In Figure 1, Company A’s pricing is higher than competitive pricing (as they are rated behind the competition in charging a fair and competitive price). They are essentially equal to competition in delivering value and advantaged in overall satisfaction. Although Company A is high-priced, they provide enough value to be on par with competitors. Company A has done a great job justifying higher prices by selling value. However, Company A has to either look at reduced pricing or offer additional value via products or services to generate future growth.
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; you could make a good case for increasing prices.
Figure 2 (Company B)
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 well behind competition in delivering value and overall satisfaction. Company C has very few immediate growth options within the current customer base. A more likely scenario is that they are losing business volume within their customer base. This is not a picture you would want to see as an investor.
Figure 3 (Company C)
Now that the investor has a better understanding of the target’s 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 buy from the targeted company or a competitor, so it is essential to understand where the target is advantaged, equal, or disadvantaged relative to the competition.
The chart in Figure 4 shows the “net” average performance ratings by attribute for the target company versus the aggregate average performance ratings of the competition. Attributes with “red” bars represent where the target company is behind the competition, whereas “blue” bars represent being ahead of the competition. Based on the data, the target company is extremely disadvantaged in the entire area of “Marketing” and behind the competition in the areas of “Product,” “Packaging,” and “Deliveries and Shipments.” On the other hand, the target is well ahead of the 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 before the acquisition, providing the insight needed to better understand the changes and cost implications of growing the target’s share of customers.
The above insight is just one example of properly executed commercial due diligence’s critical role in the pre-purchase process.