CHAPTER 3
Does It Makes Sense?
Financial, Commercial, and Operational Due Diligence
Sellers—unsurprisingly—present buyers with rosy pictures of their future revenues and margins, and for good reason: A significant portion of most companies’ shareholder value is based on future growth expectations. Acquirers must take on the fact the future is filled with uncertainty for both the stability of the current business and profitable revenue growth.
As a consequence, acquirers must perform due diligence on both the current business and its stand-alone future growth potential because they will pay for both—plus a premium. Remember, when acquirers play this game, they pay an up-front premium for some distribution of potential outcomes—the synergies that will make the newly merged entity more efficient internally and grow faster and more profitably in the marketplace as a result of the deal (“if but for the deal”). In addition, to satisfy investors, acquirers must earn a cost-of-capital return on all of that luxurious capital that they’re investing.
The analyses performed during the diligence process are intended to get under the hood of the target and identify financial, commercial, and operational issues, as well as critical red flags. Proper diligence helps develop reasonable assumptions and inputs used in the valuation model as well as an early view of integration issues that will need to be managed to realize the value of the deal. Ultimately, diligence tests the investment thesis of the deal—its value creation logic and how that value will be captured. It should help make the case that you will present to your board, and ultimately to your investors.
In our experience, while successful acquirers rarely lament deals they walk away from that would have resulted in paying too much, they hate to lose a deal to someone else because they missed valuable opportunities that could have been illuminated during diligence. Our approach is intended to improve the sensibility of the offer price, increase confidence in the maximum bid, and minimize downside risk.
Prepared acquirers benefit as they perform diligence regularly on their watch list deals, because they are able to learn a lot, over time, about the landscape of players, executive talent, market trends, and changing customer demands—beyond a particular deal at hand—and incorporate those findings in improving their overall businesses and ongoing corporate development efforts. Reactors, by contrast, force themselves into compressed time frames as a target emerges for a bid, so they are under even more pressure to get this right. This chapter will be helpful for both.
Often, the diligence process is described as useful in making the acquirer “comfortable.” A truly thorough strategic due diligence process helps acquirers develop the confidence they need to proceed with the deal—or to walk away. It will help determine whether a potential deal offers the profitable growth and value worth paying for and avoid the trap of confusing existing revenue or cost improvement trajectories in stand-alone valuations with would-be synergies. Diligence provides support for the strategic vision, and for the operating model and integration design of the new combined company. It challenges the assumptions coming from acquirer and target executives and those of their advisers pushing the deal, and forces an explicit view of what must be true to defend why the deal is indeed strategic and why and how it is worth the capital that will be required.
While financial due diligence (FDD) looks backward to gain a more accurate view of the baseline of the state of the business by removing accounting distortions, commercial due diligence (CDD) and operational due diligence (ODD) look forward and examine the stability of the current business and the likelihood of growth in revenues or improvements in the cost profile, respectively. The three meet in the present to create a three-dimensional picture of the target—a picture of how the target has performed in the past, its ability to maintain today’s business performance in the future, its potential for future growth, and possible cost and revenue synergies under new ownership.
There are, of course, important technical and operational tax issues that should also be explored—and could be the subject of several chapters on their own. Tax diligence for strategic buyers will attempt to uncover skeletons in the closet such as potential legacy tax risks that the buyer might be inheriting and how that would need to be priced in the deal.1 Pre-closing tax diligence also focuses on structuring to capture value in the post-closing combined enterprise, which could include opportunities for tax efficiencies from certain legal entity rationalization, integrating and realigning supply chains, or establishing a more favorable intellectual property footprint.
In short, FDD, CDD, and ODD serve to test the business case required to support the price of the deal. The upshot: Post-merger meetings are the wrong time and place to build that case.
Financial Due Diligence: Looking Harder at the Numbers
FDD focuses on providing an alternative view of the target’s business than what may be reflected in audited financials. That may require peeling back the onion and unwinding some accounting rules—rules that may be perfectly reasonable to use in service of the target’s day-to-day business but that don’t represent actual business trends (e.g., one-time events, changes in accounting policies, and out-of-period adjustments). Recognizing items that are non-recurring or non-cash, or not core to the business, can help an acquirer assess the quality of earnings (QoE), typically earnings before interest, taxes, depreciation, and amortization (EBITDA), for an indicative and normalized business-focused picture of the target.
Undistorting historical sales, operating expense trends, and working capital and capital expenditures (CAPEX) needs will establish a more accurate starting point, or baseline, and allow an acquirer to clearly evaluate key assumptions used in target management’s forecast, which in turn can be used to build more reliable and testable forecasts of revenue and EBITDA.
Without proper FDD, the nuances of financial accounting can be missed, limiting an acquirer from developing a normalized operational understanding of the business and a consistent and credible starting point for other diligence workstreams. For example, if an acquirer were to overstate the stand-alone EBITDA baseline of the target, it could deliver an overvalued win from a deal multiple applied to the wrong base case and a new, combined firm that’s unable to meet the growth and synergy forecasts of the deal thesis.
Although company financials are audited and certified, landmines may hide below the surface. Financial accounting contains judgments, including estimation of reserves and when and how revenue is recognized, creating a significant impact on reported profits. An audit’s purpose is to provide assurance that management has presented a view of a company’s financial performance consistent with generally accepted accounting principles (GAAP), but audited financials don’t identify significant issues likely to be of interest to an acquirer. While the audit is about certifying numbers, an FDD says why the numbers are what they are. Audits verify results, while FDD explains results.
Think of it this way: The process of buying a company is not unlike buying a house. You can walk away, attempt to adjust your price, or identify issues where you might want to make contractual adjustments.
FDD can also help to inform acquirers what exposures they are signing up for that they might not otherwise know—because it’s not the seller’s job to reveal everything they know (and sellers may not know everything regardless). Potential exposures may be triggered by a transaction and include the upcoming renewal of a collective bargaining agreement, change in control provisions in employment or lease agreements, or higher levels of required funding for regulated pension schemes, and acquirers had better know about those before they become a sad surprise.
Because FDD can uncover some irregularities and a greater understanding of the financial performance of the target, it may also provide ammunition for negotiations after the initial offer. For example, trends in historical financial performance may be inconsistent with the target’s rosy projections. That also sets the proper stage for the forward-looking tests of future revenues and costs in CDD and ODD, respectively.
FDD may mean different things to different people. But at its core, FDD focuses on answering three major questions:
- Do we have conviction in the numbers—are they correct?
- What is the “normalized” profit and loss (P&L) and balance sheet?
- What do those diligence-adjusted numbers tell us?
Are the numbers correct?
While the scope of FDD will never provide assurance on the operating results and financial position like an audit, acquirers often take comfort in the fact that another set of skilled eyes have been through the detailed financials. It is not uncommon for experienced diligence teams to uncover accounting errors or management estimates that push the boundaries. Additionally, audits often operate with a materiality threshold where known or likely misstatements are not corrected because they are below that threshold. While the management team and auditor have determined these errors to be immaterial, in a transaction context an acquirer might take a different view.
What is the “normalized” profit and loss and balance sheet?
It’s one thing to have confidence that the numbers are accurate but another to know what they say about the current state of the business. The key insight behind FDD is to “normalize” earnings—to take out extraordinary earnings (revenues or expenses), sometimes unwind accounting rules, and better represent the baseline of the business for forecasting. FDD provides a perspective on “core” recurring operations of the target and ultimately informs your confidence in recurring revenues (believability and repeatability) and the forecast for growth.
For example, are earnings impacted by the target’s revenue recognition practices versus their peers, their estimates with regard to recorded reserves, or expense capitalization policies? Has management been overly aggressive or taken an alternate approach compared to the industry?
Understanding the trends and what is happening in the core business is important, but acquirers may have to cut through a lot of accounting noise. As one active acquirer told us, “We spend a lot of time unwinding the accounting rules. Accounting rules can get you further away from cash, and sometimes it’s best to bring earnings closer to cash to give us a sense of what’s happening in the underlying operations.”
Although there are many types of adjustments, acquirers must be aware of the following major adjustments that make up the vast majority of FDD.
Out-of-period adjustments. These might include true-ups or changes in estimates to reserves from one year to the next that can distort the P&L when you make the subsequent adjustment. In that way, FDD provides you the ability to present the financial statements with the benefit of hindsight and apply a consistent accounting approach, removing the potentially lumpy impact for changes in estimates or policies from prior periods.2
For example, suppose the target had to record a large bad debt reserve in 2016 but it turns out the receivable was collected in 2018. In this situation 2016 would be overburdened with a bad debt expense and 2018 earnings would benefit from the reversal of that reserve simply by the collection of a receivable. FDD gives you the ability to look through the impact of these out-of-period changes.
Or suppose you have a potential patent litigation exposure that requires you to record an expense on your P&L and a $10M liability on the balance sheet. If you win the case in a subsequent year, you’ll reverse that liability and will have a positive impact on the P&L of $10M just because you won the case. If you don’t take these out-of-period adjustments into account, you’ll likely misunderstand the trends.
One-time revenues and one-time expenses. These might include one-time customer sales where, for example, the company “won” a new large customer because a competitor had a fire and the target was able to sell products to them at an artificially high price—but such revenue is not recurring once the competitor’s production comes back online. Even worse, after adjusting for the one-time sale, a closer look might reveal that the target’s backlog is weak: actual customer renewals are down, and the target doesn’t have a backlog to fill growth projections or replace key customer losses—and the trend is actually negative rather than positive.
On the other hand, companies can incur one-time expenses that are either not core to their operations or abnormal. If a company undergoes a restructuring, they will record expenses to establish restructuring reserves, so an acquirer needs to strip those out if they want to evaluate the normalized expense profile. Other typical one-time expenses are large litigation expenses, unusual losses, transaction costs related to debt or equity raises, M&A transaction costs, or one-time bonuses.
Including those one-time expenses might artificially depress the bid price, just as including the one-time revenues might result in a higher valuation and the bid being too high.
Non-cash adjustments. This category of adjustments is used to put certain P&L line items on a cash basis. There are two general reasons you may want to evaluate certain P&L items on a cash basis. First, as you determine your free cash flows (FCFs) for debt service there may be meaningful differences between GAAP-reported operating results and cash flows that you want to understand. Certain non-cash adjustments are allowed in debt covenants, and an acquirer would want to make sure those are understood early to optimize available leverage. Second, the cash flows from operations may be a better indicator of growth trends.
Common non-cash adjustments include stock-based compensation, goodwill impairments, unrealized gains and losses, recorded booked versus cash rent expense or differences due to the deferral of revenue recognition. By removing these non-cash items, you not only have a clearer picture of the cash flows, you may also have a better picture for operating ratios or growth trends. For example, by evaluating revenue on a cash basis as if it were paid up front, where accounting rules require you to defer its recognition, you may have a better sense for sales growth and momentum, particularly in high-growth companies.
In situations where EPS dilution might be important (for public companies), non-cash charges may burden EPS, often called “EPS drag.” Suppose you were going to pay $100M for a business where the fair value of net tangible assets is $75M and the $25M left over gets recorded as $15M to goodwill (that will ultimately go through an impairment test) and $10M to intangibles with a 10-year life. Over a 10-year life, $1M per year would hit the P&L as amortization expense and result in an EPS drag that has nothing to do with the baseline of business operations, which might drive a lower bid than justified. That would also be the case for a target that had done deals and was amortizing items from those deals—an acquirer would want to look at the state of the target’s business without those accounting charges, like a business that had not done deals.
Pro-forma and run-rate adjustments. Pro-forma and run-rate adjustments attempt to adjust the earnings (i.e., EBITDA) to better represent the target’s earning potential given significant material changes going on in the business.
For instance, a pro-forma adjustment might include adjusting EBITDA for the impact from a recent acquisition. Suppose a target had done a bolt-on acquisition only five months ago; an acquirer would want to present the target as if they owned the bolt-on all along. If the EBITDA of that recent acquisition were $25M during the seven months prior to the acquisition, an acquirer would add this to the target’s reported numbers so that they were evaluating a full year of earning potential.
Run-rate adjustments are sometimes more controversial but can be effective tools to evaluate the earning potential of an enterprise. Let’s say the target is in the business of operating physician clinics. On average, each clinic earns $500,000 in EBITDA after three years of operations. Newer clinics take time to mature, and a greenfield clinic that opened one year ago is only earning $150,000 in EBITDA. A run-rate adjustment will present the difference between the $150,000 and the run rate of $500,000. So, embedded in reported EBITDA is $150,000, but we could give credit as if the clinic has reached its ultimate run rate of $500,000. This is a judgment call; if we were to do that, we would want to be sure we are not applying a valuation multiple that would double count the expected growth.
Technology companies have trended toward subscription revenue models over the past decade. As a result, there has been a greater emphasis on analyzing the recurring revenue of these subscription-based businesses to understand their current monthly recurring revenue (MRR). During diligence significant effort should be put into analyzing customer churn and retention to assess the stability of MRR for these types of businesses. Properly evaluating MRR, the amount of predictable revenue a company expects to earn each month, allows acquirers to understand monthly trends and growth momentum. Additionally, acquirers may choose to make a run-rate adjustment for fast-growing businesses where the recent MRR would indicate a higher revenue base than the recorded revenue during the last 12 months.
CAPEX and working capital adjustments. Companies require CAPEX for maintenance, just to keep the lights on, and for growth, to build the new factories. The target may have had a one-time capital project that is not ongoing or has deferred CAPEX, and their factories may be in bad shape. Evaluating the historic CAPEX for either non-recurring or deferred maintenance is important as you consider FCFs, so you only include those required cash investments in your forecasts.
Examining and adjusting working capital will allow an acquirer a better understanding of trends in net working capital (NWC) such as seasonality and cyclicality driven by customer and vendor trends (faster payments demands, customers taking longer to pay, or higher inventory levels to facilitate on-time delivery) or develop a plan to reduce NWC and extract cash during the acquirer’s ownership, and effectively improve balance sheet performance.
The evaluation of optimized NWC is a frequent component of FDD. Suppose a high-performing benchmark for NWC balance would say the company could operate with $90M of NWC and the target currently has $100M. If you can reduce NWC by $10M through better inventory management or improving cash collection on receivables, you now have $10M in cash you can either take out of the business and pay as a dividend or reinvest in new capital projects, reducing new investment—effectively reducing the total cost of the deal. Alternatively, because you believe you can decrease invested capital (lower NWC), then you will have increased FCF and economic profit (because you have the same operating profit at a lower capital charge; more on this in chapter 4)—effectively allowing you to pay more, if necessary.
The evaluation of NWC also allows an acquirer to define and quantify a normalized NWC “target” when there is a purchase price adjustment mechanism for NWC. That represents an acquirer’s point of view on the amount of NWC required to be delivered with the transaction by the seller. Should the NWC delivered at the closing be an amount higher or lower, the adjustment mechanism would lead to an adjustment in the purchase price.
What do the numbers tell us?
The diligence-adjusted numbers allow a business-oriented view of current operations. Acquirers must make sure they are starting in a good place before they attempt to forecast the future. With properly normalized numbers, they reduce the chance they compound mistakes in their valuation model.
For example, suppose the non-normalized numbers suggest margins of 40 percent and historic annual revenue growth of 6 percent, but the normalized numbers suggest margins of 47 percent, because of non-recurring one-time expenses, but growth of only 3 percent. Both of those adjustments will have significant impact on the valuation and forecasts of the future. And if both the revenue growth and margins are overly rosy, the acquirer will likely miss the forecast it paid for in all subsequent years and will have overvalued the target’s stand-alone value right from the beginning.
Pulling all of this together, FDD informs a go or no-go decision, the ultimate value you’d be willing to pay, how you mark up a purchase agreement with the types of protections you want to incorporate, the lender package for underwriting the debt, and the underwriting process for insurance protections.3
This is the key point: You must understand that you are buying the future. The reason that you want to strip out one-time or out-of-the-ordinary events and recast earnings is because you need a true picture of the business today to help forecast the future. Without proper FDD, you can miss the nuances of financial accounting, limiting an acquirer from developing the operational understanding needed to create accurate forecasts of future revenues and profits. FDD allows you to start with accurate numbers. You want the trend to be your friend.
Commercial Due Diligence: All the Answers Are in the Market
CDD is the natural follow-on to M&A strategy—using market intelligence and analytics to test the investment thesis of a deal. It answers the question of whether the deal’s growth strategy will likely create value. CDD tests the validity of the acquirer’s beliefs of the target’s revenue line (price × quantity) as a stand-alone business (recurring revenue and future growth), and the revenue enhancement opportunities the acquirer imagines through synergy. Proper CDD serves to validate the major assumptions around the market opportunity, the target’s position in the market, and the likelihood the acquirer can deliver all that it is assuming in the valuation.
Done carefully, CDD yields defendable inputs for the valuation model as well as early inputs to integration planning for the improved go-to-market strategy and potential revenue synergies. It may also slow down the “Wow! Grab it! acquisition locomotive” if the acquirer learns the target’s prospects are not as favorable as initially imagined.4 It’s here that acquirers test the elements of the investment thesis over which they may have little control: changing customer preferences, competitors, and headwinds and tailwinds from market trends. Since all valuations begin with the revenue line, ignoring diligence on the commercial opportunity can spell disaster for a valuation. Acquirers who rush or forgo a careful CDD because they fully believe they know their business miss the last chance to stress test the strategy they are about to pay for.
CDD forces acquirers to face the realities of the market, customers, and the target’s capabilities and position relative to competitors, and how those realities will influence the revenue line in their valuation assumptions. An acquirer may not want to face those realities, but they have to test their assumptions to protect against bias—bias that can creep in from the target’s numbers and assumptions, optimistic new go-to-market strategies, or from internal pressure to get the deal done. As we like to say, All the answers are in the market.
Testing claims and beliefs lie at the heart of CDD—claims made by the target’s management reflected in a management presentation, or what they have guided investors to believe about the stability of their business and prospects for growth. Moreover, CDD tests the acquirer’s beliefs about how they will create additional value in the market in combination with the target. Does the acquirer fully understand the market and the target’s ability to capture more of the market or to produce better margins (through pricing and product offering) than they have today? Are they defining the market or estimating its size correctly? Are the target’s growth projections plausible? How is the target positioned for growth relative to its closest peers? And, ultimately, can the acquirer and target create more value together than apart because they can serve customers in ways they couldn’t before, and in ways not easily replicated?
Answering those questions means identifying and testing key assumptions in the target management’s business case and the plausibility of the acquirer’s forecasts—often in a frightfully short period of time, especially for acquirers stuck in auctions. CDD also can unearth and evaluate previously unrecognized issues and risks to deal success that will have to be mitigated.
Elements of commercial due diligence
Performing CDD requires three major baskets of work that provide a view of the commercial prospects of the target and opportunities for the merged entity:
- Market analysis of size, growth, and trends
- Competitive positioning of the target and customer behavior and preferences
- Revenue enhancement opportunities
Market analysis offers insights on the addressable versus true serviceable market size and growth potential, emerging technologies and competitors, new strategies and business models evolving in the market, changing government regulations, and stability of margins.
Positioning and customer analysis, largely through primary research, unveils customer and non-customer key purchase criteria and behaviors, how the target is positioned relative to its peers across relevant competitive dimensions and how that has changed over time, switching dynamics, willingness to pay, the value of brands, channel strength and evolution, and the stickiness of its customer relationships. (See the sidebar, “How to Get All the Answers: Primary Research.”)
How to Get All the Answers: Primary Research
While secondary research—that is, buying reports—is an obvious way of getting some commercial information, those same generic reports of varied quality are available to everyone else, so they’re unlikely to be a source of advantage. The key to unlocking the market’s secrets is primary research—the secret sauce for CDD. Talking with a diverse group of market participants will reveal important insights about the target’s business. Effective primary research yields insights for the analytical work on serviceable and addressable market size, competitive positioning, switching dynamics, recurring revenues, market share, go-to-market strategy, and growth prospects.
In our experience, a primary research program involves three parts: hypothesis development, interview and survey design, and execution and synthesis.
Hypothesis Development
Because there is tremendous ground to cover, developing testable hypotheses helps provide direction on to whom you will speak, what groups you may need to survey, and the questions you need to ask. Some acquirers may be acquiring in their core markets and may have a strong command of the market dynamics. For them, the scope of their CDD may be understanding the stability of the target’s customer base. Some acquirers may be entering into new markets, geographies, or other adjacencies that require a more thorough evaluation of the market and the target’s positioning. Hypotheses should not be a laundry list of items, but rather items that are material to the presumed valuation of the company. For example, typical hypotheses to be tested are “The target believes it will outpace market growth by X percent over
the next five years” or “The target believes its leadership position is defendable for product Y.”
Interview and Survey Design
Interview questions are designed to test your hypotheses—and are refined throughout the program. Surveys are designed to quickly reach much larger, targeted populations, and obtain quantitative and more granular insights.
It is important to determine the types of people who can meaningfully answer the questions relevant to the deal. These will typically include current customers (the actual decision-makers), customers who switched or decided not to purchase from the target, future potential customers, channel partners, competitors, the target’s current and past employees, and industry experts. As interviews continue and you learn more, you’ll be able to refine your questions and focus on the most important issues that need validation and make the best use of your time.
Execution and Synthesis
Execution begins with sourcing and reaching the most important potential candidates. Options for sourcing candidates include the acquirer’s network of contacts, direct facilitation by the target’s management team to arrange interviews with key customers, third-party meeting organizers, and targeted blinded outreach by third-party diligence advisers. Acquirers use surveys (or shopper intercept techniques for consumers) to reach much larger customer and non-customer audiences to get statistically significant insights on the hypotheses being tested.
It’s important to get hard numbers or validation of existing numbers (estimates of market size and trends) from the interviews and quotable commentary on market dynamics, competitive differentiation, and customer perception of the target’s products. Without being misleading, you are trying to learn information you otherwise couldn’t get through secondary resources. Skilled interviewers will build a rapport and ebb and flow with the conversation versus rigidly reading off an interview guide.
Primary research interviews should create a platform for customers, non-customers, and other market participants to voice their thoughts as opposed to simple answers to pre-set questions. Deal teams should leverage the customer outreach the company has already done in the brand management of their products and services and avoid the “no one ever asked me” problem. Interviews and surveys should provide enough information to either confirm or refine the original thesis or to strongly raise red flags of a problem.
Done well, the first two baskets of analysis will yield significant data and insights so relevant to assessing whether the acquirer can generate revenue enhancement opportunities (the third basket) and create new value for customers with the target. Are there opportunities to improve the go-to-market strategy of the target? Are there potential revenue synergies because the integration will yield better geographic coverage, cross sells, or new offerings that address unmet customer needs that competitors can’t easily replicate and for which customers are willing to pay?
One final point: No matter how well you know the market as part of your business-as-usual, many companies don’t actively reassess their markets through ongoing research. Even if they do, if they are not fully reaching out to all relevant parts of the market for answers (current customers, lost customers, potential customers, and competitors), their research can actually reinforce biases they have about their customers, products, and markets, and their own advantage.
Re-evaluating the market and how things have changed is a great opportunity to understand changing customer preferences, technology evolution, and emerging players who can serve customers better or differently. Smart acquirers test their understanding of the pace of change of the commercial aspects of the opportunity even if they’ve been operating in the industry for a long period of time. Technological changes, for example, might be on the horizon that could reshape the marketplace. Amazon’s disruption of incumbent retail giants through strong digital, direct-to-customer, and customer intimacy and analytics capabilities is a classic warning for companies not keeping abreast of the market and their presumed advantages.
Major insights from commercial due diligence
The market in which the target operates is—like all markets—often rapidly changing and evolving. CDD is focused on revealing the realities of those markets and insights on how the target operates and competes within them: market size and growth, product satisfaction and distribution capability, competitive positioning, and the stickiness of customer relationships. Taken together, they provide an assessment of the stand-alone value of the target, and a better sense of how you might go to market differently with existing or new offerings. We’ll examine these each in turn.
Market size and growth. Accurate sizing of the market—the total size for sure, but, more important, the parts of the market the target can actually serve today with current capabilities and how fast it is growing—uncovers important inputs to strategy and value.
The only way to understand the target’s trend in market share is to first understand the size of the market the target can serve today—its serviceable market. While that might seem self-evident, targets often stress the total addressable market—the one that might be served with new (or better) capabilities or market access, rather than the actual serviceable market. In other words, sellers will typically promote a larger market size than the company can service through existing products and geographical distribution. They may very often promote a compound annual growth rate (CAGR) of their total addressable market that may be far higher than the CAGR of the market segments they can serve today.
Let’s consider two examples: First, we were engaged to evaluate a Hispanic foods company with a solid revenue base, but the target trumpeted the $90B Hispanic foods market and unlimited opportunities for growth. We peeled away the layers of the market they actually served: the 15 US states they actually operated in, the specific ethnicities they viewed as their customers (Dominican, Puerto Rican, and Cuban), and the food categories where they were most advantaged (e.g., frozen food varieties). The target loved to say that the overall market was a $90B opportunity. But our analysis revealed that it was really a $5B–$6B opportunity, a far smaller serviceable market than the target claimed.
Second, we worked on behalf of a large industrial client, evaluating size and growth of the global backup power generation set (genset) market. Based on initial reports the client believed a market opportunity of $15B+ existed. However, refining the market specifics by fuel type (e.g., diesel), commercial end markets, and power output revealed the addressable market was under $7B, or roughly 55 percent less than original estimates. Further, regional specific analysis revealed different expected growth profiles by region and end market with, for example, data center and telecom customers driving the most significant growth within Asia Pacific.
Why is any of that important? Market sizing estimates are used to determine what share of the target’s current serviceable market it really has—its market share. The market share of its serviceable market will typically be larger than the market share of the target’s addressable market (with additional capabilities or market access). Do you think that targets are more likely to overstate or understate their market share? It turns out that targets will often understate their share or overstate the size of the market, so it appears like there is more headroom for growth. These types of discoveries expose a potentially inflated view of the target’s growth potential, resulting in a higher valuation than is justified.
Understanding the actual serviceable market also offers a view of the target’s market share dynamics overtime—how has it been changing? If the target has been gaining or losing share, you need to understand why. And if the target’s projected growth rate is greater than that of its serviceable market, you need to understand from whom they expect to take share. That will help drive both the strategy and integration hypotheses and valuation of the deal. That also leads to considerations regarding whether or not the new combination of capabilities and market access will yield a larger serviceable market or expand the size of the market that can be addressed.
Product satisfaction and distribution capability. Evaluating whether the target has products that customers value and why, and their ability to scale distribution is fundamental. Almost anything else can be fixed, but if customers perceive their products as inferior or don’t value the brand, it’s a real problem. Do the target’s products or services deliver on customers preferences and specific purchasing criteria better than competitor offerings, and are they willing to continue paying for them? Does the target have sufficient current distribution capability to serve the growth in its markets? Customer satisfaction and distribution capability may sound obvious, but they are phenomenally important and often overshadowed by other issues like marketing, advertising, or lack of qualified sales reps that can be more easily remedied.
Improving product advantage or attractiveness and demand in the face of competition and creating and building distribution capability is costly, takes a lot of time, and carries huge execution risk. That said, the acquirer may have strong distribution capabilities that could be a source of significant synergies when paired with the target’s products.
Competitive position and the evolving landscape. Examining the target’s competitive position reveals the customer segments and geographies it serves successfully (and those it doesn’t) and its customer value propositions relative to its competitors—where does it play and why does it win? That means also understanding the positioning of target’s peers—how they contrast with the target and how the target differentiates its offerings. The target’s positioning, as well as the acquirer’s, directly influences an acquirer’s ability to defend and take share and achieve potential revenue growth from the combination.
Competitive position is dynamic. Position can be deliberately chosen and where the target has worked to build advantage, delighting customers with more of what they want (better than competitors) at prices they are willing to pay. Or, it can be where the target finds itself because of competitive forces, technology changes, and changing customer needs and preferences over time that it didn’t anticipate or address. In other words, the target can have strong growing positions in certain segments or geographies, and yet weakening positions in others. Done correctly, this analysis will create an animated view of positioning changes over time.
We were engaged by a client investigating the world’s largest global manufacturer of an industrial product with a variety of uses, from household and personal care to pharmaceutical applications. In recent years, the target exited the lowest-margin segments but did not innovate in the highest-margin segments such as pharmaceuticals. Over time they found themselves stuck in the middle. And it was getting worse: They were being attacked by the lower-end competitors in the US market and from Chinese competitors in Europe and Asia, and were constrained from the high-growth, high-margin segments globally because of a lack of R&D investments. In short, they had become horribly positioned, attacked on all fronts. Most acquirers would have walked away from an impending disaster. Although the target was poorly positioned, through extensive primary research, we learned that many of its more than 1,000 industrial customers had long-standing relationships and, more important, they wanted the target to survive to maintain price competition in the market. Without that primary research the acquirer would not have fully understood what additional role they played for customers.
Acquirers may find that the target is addressing the needs of customers better than competitors at more attractive price points, which means it’s reasonable that they can continue to execute on their current commercial strategy. On the other hand, acquirers may discover that the target is not positioned to address key customer segments, which means the target’s ability to achieve projected growth requires some serious investment and attention, or complementary capabilities and market access from the acquirer.
Acquirers should be prepared to debate prospects for the target with respect to its global peers—and how that context may change over the next several years under the acquirer’s ownership. It’s important to recognize that some elements may be largely out of the acquirer’s control but are crucial to understand for evaluating the current position and the growth potential of the target.
Stickiness of target’s customer relationships. An important part of evaluating recurring revenues and the target’s growth potential is assessing the tenure and growth it has had with its major customers. Even if a target is poorly positioned and will likely struggle with growth, it may have a saving grace. It may have strong “sticky” relationships with its customers that took years to develop. And those customers may want to make sure the target survives to maintain price discipline in the market, as was the case for our industrial goods target we just described. Customer stickiness—the stability and growth of customer relationships—is the lifeblood of recurring revenues and the platform for future growth, and for cross-selling new offerings after the deal has closed.
There are several drivers of stickiness. Customers may value the brand, service levels or quality, or their relationships with the sales force, and may be price inelastic. Then again, even if they might consider switching, the process of switching might be lengthy and costly, especially for industrial customers, and the benefits of switching unclear. Understanding switching dynamics, especially the cost to switch, ease of switching, and under what conditions customers would switch—is a vital part of assessing the stability of the business and the platform for growth.
That said, customer stickiness can cut both ways: Sticky relationships may help you maintain share but at the same time make it hard to take share from competitors. On one hand, customer relationships that are less sticky may yield opportunities to take share given the right market offerings or raise red flags for vulnerabilities that need to be addressed. On the other hand, if customers won’t leave a competitor, for example, your serviceable and addressable markets may be even harder to capture than you thought.5
Understanding non-customers (those who have switched and those who have never been customers) is just as important because it helps the acquirer understand segments of the market the target has not addressed, or at least not successfully. That will inform the size of the actual serviceable market, offer a deeper assessment of stickiness, indicate why customers shop for alternatives, and uncover why and how certain competitors are doing better. (On how technology can support CDD, see the sidebar, “The Role of Data Analytics in Commercial Due Diligence.”)
Insights gathered from those four areas—sizing the market and growth potential, understanding product satisfaction and distribution capability, evaluating competitive positioning and the evolving landscape, and testing customer stickiness and switching dynamics—are all inputs into how you might go to market differently post-merger, yielding a 360-degree fact base that allows for considering improvements in the target’s go-to-market strategy and an initial integration strategy. Further, with that fact base discovered in the market by CDD, acquirers can identify revenue enhancement opportunities from combining with the assets of the target.
The Role of Data Analytics in Commercial Due Diligence
Data analytics can offer benefits for CDD from the enormous amounts of data that exist across customer purchasing behavior, price and volume trends, social media sentiment, geospatial mapping, and other data. AI tools and approaches such as natural language processing (NLP) and machine learning enable better and faster insights and predictions in ways that were not possible before.
The initial use of data analytics involved trying to get to an answer faster. It is now focused on generating a deeper understanding of customer behavior and demand drivers impacting current and future product revenues by finding connections and statistical correlations that otherwise might have gone unnoticed.
For example, analysis of social media postings and product reviews using NLP can help articulate what users are saying publicly. That can help explain customer behavior and key purchasing criteria and their impact on past sales of specific products or services, along with providing insights on future behavior and demand faster and with a broader lens than customer surveys alone.
Machine learning can predict future price and volume trends of a given product or service based on statistical analysis of anonymized credit card data with concurrent external factors or events. Geospatial analysis can help construct a localized picture of market penetration and competitive pressures, in retail or healthcare for instance, by using customer concentration, provider locations, and local socioeconomic data from the US Census Bureau.
When robust analytics enables us to find proxies for customer behavior and competitive positioning to develop informed commercial hypotheses up front, acquirers can use more targeted primary research to test those hypotheses that matter.
Potential revenue synergies from merging the two companies are ultimately the result of a change in go-to-market strategies. Revenue synergies can be evaluated from several potential sources: cross-selling, leveraging sales infrastructures across geographies, offering customers on both sides new integrated bundles they couldn’t buy before, or innovating new products or services. In the pre-deal phase, clean rooms can be essential to share information deemed competitively sensitive (more on clean rooms in chapter 6). Each source of synergy will have associated costs, so the analysis must be linked to ODD and cost to achieve.
Acquirers should consider the answers to the following important questions: How does the target’s product portfolio complement current offerings of the acquirer? Can the acquirer or target now penetrate customer segments or geographies either has struggled with? Are there untapped opportunities in core and adjacent markets from different applications of existing products? What ongoing problems can we solve for customers because of the combination that will enhance stickiness? How can the acquirer better address changing or unmet customer needs through new or more compelling offerings?
CDD paints a dynamic picture of the target, how it’s perceived by customers, the size of its serviceable and potentially addressable markets, its current positioning, and opportunities for growth and revenue synergies. In summary, CDD validates the stability of target’s current business and its growth potential based on what’s known today and reveals what challenges or opportunities are on the horizon.
Operational Due Diligence: Are the Cost Synergies Real?
ODD is an overall holistic inspection of the target’s operations, and the first layer of testing the potential transformation—from current state to future state—required to realize value from the transaction and help “pay for the deal.”
Why bother? Because acquirers not only purchase the target’s cash flow, products or services, market presence, and customer relationships; they also acquire the target’s operating model and upstream and downstream inputs to production and distribution that drive the cost structure. They also inherit any already planned cost-reduction programs the target says it has in place—yeah, you could just take their word for it.
ODD spans the problems of the efficiency and scalability of the current operating model, cost-synergy capture (size, timing, and complexities of achieving cost synergies), and an assessment of the effectiveness of the target’s ongoing operational programs. That includes assessing the current efficiency of a target’s selling, general, and administrative (SG&A) expenses, cost of goods sold (COGS), and operations strategy. ODD can also uncover operational issues that might threaten the business case and challenge the valuation of the deal.
But here, we’re going to focus on capturing cost synergies. Acquirers typically rely on high-level, top-down assumptions, from benchmarks or their advisers, to identify the cost synergies that are then built into valuations. The target’s bankers will regularly present a “magic 10 percent” as a top-down cost-synergy target. They’ll have limited support for the assertion. It is especially important to differentiate whether potential cost reductions are from synergies as a result of the deal or from the target’s claims of an ongoing cost transformation process that has yet to be realized.
Yet those same acquirers are often surprised when assumed post-deal operational improvements aren’t as significant as planned, or take longer and are costlier than expected to realize. Further, failing to realize expected cost synergies can easily cause delayed attention to customers and revenue-enhancement programs, opening the door to competitor actions and derailing revenue synergies.
ODD also includes areas like HR and IT. While these are important because the acquirer will want to fully understand the costs and complexity of issues such as the transformation related to payroll and other information systems changes or harmonizing benefits plans, we won’t go into detail here because of their technical complexity.
Practical elements of operational due diligence
ODD focused on cost synergies involves three major analyses that allow a view of the go-forward cost structure of the target and opportunities for the merged entity:
- Cost and headcount baselining and benchmarking of acquirer’s and target’s core operations (and true stand-alone costs for divisional carve-outs)
- Plausibility of target’s stated ongoing cost-reduction programs
- Bottom-up synergy analysis including one-time costs, potential interdependencies, and timing of synergies
ODD requires a high degree of cooperation and interaction between the acquirer and the target. Access to data—the target’s as well as the acquirer’s internal data—is at the heart of ODD. Acquirers often assume that gaining access to their own internal data will be easier than it actually is, which can slow analyses that require information from both companies. Procurement data, product prices, detailed functional cost and headcount breakdowns, and other internal data are typically required to build the functional baselines central to performing thorough ODD and assessing potential synergies.
At the same time, because rapid access to target data is so critical before the deal, establishing a quick, simple, and trackable data request process will help the acquirer avoid delays. Prioritizing requested data enables the target’s management to focus their time on providing the most important data first. The diligence team should stay coordinated to avoid multiple data requests for the same data from the target.
Establishing a baseline and performing bottom-up analyses of cost (and revenue) synergies often involve accessing sensitive target company information such as supplier pricing for potential procurement savings or employee salaries, hire dates, and termination policies for possible labor savings; or pricing and customer information for potential cross-selling initiatives on the revenue side. Management teams can manage confidentiality concerns related to this information using clean rooms and avoid potential anti-trust issues (more on this in chapter 6). Because confidentiality is essential, the acquirer’s diligence team should be small with as few functional leads “under the tent” during initial negotiations as possible. Where it is not practical to have representatives from each function, external advisers can help fill expertise gaps. In any case, bringing leaders under the tent as diligence progresses must be coordinated so that their knowledge or inputs are obtained.
Experienced acquirers look not only for cost synergies from the integration of current-state businesses during diligence but also larger transformation opportunities that can impact value. “Transforming while you transact” might include offshoring non-core business operations, leveraging robotic process automation (RPA), using centers of excellence for high-volume, low-value transactions, or migrating to a digital cloud-based IT infrastructure.
Top-down and bottom-up
Without bottom-up ODD—which begins with assuming there are zero synergies and builds up from there—it will be unclear where or how synergies can be delivered, what the run rate of synergies is, and what the one-time and ongoing costs to achieve the synergies are. Acquirers will miss the opportunity to consider operational-fit risks with the target, along with the timing and complexities of realizing synergies, creating operational blind spots missed in a top-down view. This is especially true when buying a division. (See below, “Operational Due Diligence for Carve-Outs.”) Without understanding supplier relationships and contracts and the cost structure (labor and non-labor) of the overall operating model during ODD, acquirers push that work into the integration phases after promises to shareholders have been made and without testing hypotheses of what the acquirer will actually do with the business.
It’s not that top-down ODD is useless. In fact, it is the starting point. It’s important to develop initial synergy targets based on a review of the acquirer’s and target’s P&Ls against industry benchmarks and have a clear picture of the headcount, by function, on both sides. It also helps to validate estimates based on industry deal data or past experience. Although it is a useful starting point, it’s not enough.
Acquirers often gloss over cost reductions that are perceived as easy to achieve—the top-down magic 10 percent. But this oversight can have huge ramifications on realized value and management credibility if those synergies do not occur or are delayed. As a result, unexpected and needless delays in realizing synergies—so-called value leakage—can become costly to investors and cause confusion for employees who have to deliver them.
Why? The story is a familiar one. Post-signing, when an acquirer needs to quickly launch critical integration planning around geography, headcount, and functional alignment, the executive team belatedly realizes that projected cost reductions have not been fully tested and related decisions have not been made. What often happens next? Integration teams are forced to perform the bottom-up diligence that should have taken place pre-signing, and the resulting integration slowdown causes confusion and angst in the workforce. Questions then surface about the credibility of the deal’s true value or, even worse, the deal’s overall investment thesis.
Synergy-capture ODD offers something more. It’s a bottom-up approach that puts management’s skin in the game early on to identify where specific cost reductions may be achieved, or where there may be potential for dis-synergies that will need to be netted against the benefits. For example, closing one corporate HQ may generate substantial savings, but will require leasing some additional, more expensive floor space at the remaining HQ. Such diligence can help provide—or test—important inputs to valuations and drive early alignment around the new operating model for the combined businesses. You may arrive at the same magic 10 percent, but you’ll know why and how those savings will be achieved, and how much it will cost to deliver them.
Often, bottom-up cost-synergy diligence with sufficient data from both companies will yield different results from top-down analysis. Understanding what drives the variance by function between the two methods can yield important insights to help prioritize where to improve performance, achieve synergies, and build an initial integration roadmap, by function, with early identification of interdependencies.
Synergy-capture diligence by the numbers
Bottom-up synergy-capture diligence involves five major steps: create consistent cost and functional baselines; segment and prioritize synergy opportunities; quantify specific benefits, costs, and owners of each opportunity; develop the new financial model; and create a synergy-capture roadmap by function with initial identification of sequencing and interdependencies.
- Create consistent cost and functional baselines. The acquirer’s diligence team should begin by gathering P&L data from recent financial statements, and the data room, for both companies to view the total pie and normalize the statements by removing one-time, non-recurring costs. The team can use this information to create a consistent baseline that maps headcount and cost pools from the combined P&L to specific functional areas such as finance, HR, and marketing. This is where it is vital both to understand any target cost-reduction initiatives so they can be assessed and removed from the forward-looking baseline and to identify complexities and interdependencies created by the target’s ongoing programs (e.g., an ongoing ERP cloud migration effort).
- Segment and prioritize synergy opportunities. Team members should make initial hypotheses about synergies that can be realized quickly, such as full-time-equivalent (FTE) rationalization, corporate insurance, public company costs and audit fees, and management overhead. Also important are hypotheses about synergies that will require additional information, such as IT and customer relationship management (CRM) consolidation, supply chain and logistics efficiencies, and corporate facilities and customer service site rationalization.
- Quantify specific synergy opportunities and cost to achieve by functional area. Through detailed interviews with executives and functional leaders, the acquirer should next identify redundancies across all functional support areas for synergies. This helps to build the new organization from the ground up, identifying responsible parties who are signing up for the plan. Other parts of this step are determining the costs to achieve synergies, such as severance pay, lease termination and vendor sunsetting fees, and other one-time exit costs, as well as any potential increases in ongoing costs as a result of the merger. Clean rooms will be required for sharing competitively sensitive information. Acquirers will also seek to identify additional overhead cost pools that may have been missed in initial assumptions. (Of course, the more data the target reveals in the data room, the better.)
- Develop the new financial model and explain variances from initial assumptions. The acquirer team can use the bottom-up cost-reduction and cost-to-achieve estimates to develop a new financial model and resulting P&L to present to the board of directors as part of the deal package. The model should identify and explain all variances—both positive and negative—from the initial top-down analysis.
- Create a synergy-capture integration roadmap. An integration roadmap is an initial view of how the new organization should operate to achieve the deal’s intended business results. Developing this roadmap—with milestones, dependencies, and potential bottlenecks—is a critical step that will guide the organization later in its pre-close planning. While the combined organization’s end-state vision likely will evolve as new information is assimilated during the transaction, an initial roadmap provides a valuable frame of reference for focusing the entire organization on results and prioritizing the areas that will require the most attention.
By following these steps, acquirers should be able to surpass mere top-down cost-reduction assumptions, whether they are provided by bankers or based on past industry experience. It forces the assessment of the plausibility of the target’s cost-reduction programs so that synergies are not double counted with reductions already expected, and that interdependencies with those programs are considered. This process also encourages relevant management involvement, input, and personal commitment from the outset. It stress tests inputs to the valuation according to size, timing, and investment required to achieve specific cost-reduction targets, and is designed to generate a flexible financial model to accommodate multiple scenarios and new information as it is revealed.
Because responsible functional parties are identified along with specific synergy initiatives, senior management can focus much earlier on the new end-state operating model, serving customers, and preserving and growing revenue—the lifeblood of any acquisition.
A robust bottom-up ODD cost-synergy process not only positions the acquirer to size cost-synergy opportunities, but also allows it to consider the relationship and tensions between cost and revenue synergies where improving margins through cost reductions might cut too deep to support revenue synergy expectations.
It also means that the acquirer’s functional leads will be invested, since they’ve voiced their inputs (even if they need to be prodded). They’ll also have a better sense of the time and resources that will be required and complexities they may need to manage in the combined organization. The objective is to minimize value leakage after the deal is signed.
Thorough ODD will also help you jump-start the development of an integration roadmap and avoid downstream confusion as you embark on structuring your integration strategy and sign-to-close planning, and your go-forward operating model (we discuss these in chapters 6 and 7). Finally, ODD is another great opportunity to glean insights that might benefit the current operations of the acquirer, even if you don’t do the deal.
Operational due diligence for carve-outs
Buying a division of a seller creates even more complex problems of understanding the true run-rate costs of the division, separation costs, and supporting structures that will or will not come along with the business: direct costs, allocated and unallocated costs, and the need for transition services agreements (TSAs) that will have to be negotiated with the seller before and after signing while integration planning for the division is progressing from sign to close. Consequently, carve-outs add another layer of risk and complexity to integration because acquirers must ensure the business continuity of the division while it is separated, and understand the total cost base before they can estimate opportunities for improvement through synergies.
Acquirers must understand what they are receiving from the parent—for example, customer-facing front office staff (sales force and customer service) and back office support (IT, finance, HR, legal). You might say, why do I care about all that if I’m going to integrate the division into my systems anyway? Well, say you are buying a division with 30,000 employees—do you have sufficient capacity to provide all the necessary HR support with your existing HR information system (HRIS) and your current executive talent? Or, if the division is in 17 global locations and with 17 different tax structures in 17 jurisdictions with 17 different currencies, you may need a far more robust financial planning and analysis (FP&A) and treasury system than you have today. Those considerations will matter as the acquirer considers how it will integrate and operate the business.
Once acquirers know what they are getting, they will need to determine the total cost required to support the division as a stand-alone—direct, allocated, and unallocated costs. Direct costs are those directly attributed to and embedded in the division (e.g., division finance, IT, legal, HR business partners, manufacturing, supply chain and logistics, sales and marketing) and captured in the division P&L. Allocated costs that hit the division P&L are charges for shared services provided by the parent such as corporate FP&A, treasury management, corporate IT and legal, audit, and regulatory compliance—but what is being allocated may include costs not required to run the business or, on the other hand, might be understated, resulting in a higher valuation than warranted. Acquirers need to make their own assessment. Unallocated costs, which are typically related to global brand support or corporate HQ, are costs for services that the division has received from the parent but may not be charged. Acquirers will need to understand that total cost picture along with the degree to which they will integrate the division before they can estimate potential synergies.
Acquirers also must estimate the one-time costs required to separate the target from the parent, which will include breaking existing contracts such as an Oracle enterprise resource planning (ERP) system with the parent, and data separation from the parent ERP (division customers, employees, financial, and regulatory filings) that has to be logically and physically separated and then moved to the new medium. All of these are in addition to the typical integration one-time costs—IT, rebranding, facilities buildout, signage, and severance payments.
The complexity and risks of the transaction will be driven by how entrenched the proposed carve-out is within its parent. In general, the higher the level of integration and dependence on parent corporate functions or other business units, the more complex the carve-out. We have found that the higher the dependency, the higher the risk of underestimating the costs and time required to separate and integrate to achieve the required functionality.
Hard dependencies will include intellectual property, co-mingled IT and ERP systems, facility colocation, and shared talent pools, but there can be softer dependencies such as master procurement terms with suppliers, sales contracts through the parent, and tax advantages or revenues from transfer pricing regimes based on existing legal entity structures. This is where TSAs may be required to maintain business continuity to enable the separation while it is being integrated into the acquirer. Acquirers will need to determine the cost and the time those TSAs are required, while the sellers providing those TSAs work to end them quickly because they are not in the business of providing service to another company to run their former business.
Once one-time and run-rate costs, complexities, and issues for business continuity have been addressed, acquirers can then assess how to integrate the assets they are buying and the opportunities for improvement and synergies with the acquirer’s business. That may involve changing the go-to-market strategy in subscale markets or scale benefits from being a much larger parent than the previous parent in areas such as purchasing, facility overlap, and duplicative supply chain components (e.g., transportation, warehouses).
We have also observed a strong “agency conflict” among leaders of the division being sold. Many of these individuals have a strong affinity and attachment to the parent enterprise and feel conflicted about their future role. Qualitative evaluations, including the assessment of talent, their cultural identity, and compatibility with the acquiring organization, also need to be considered because critical talent might be at risk.
Conclusion
When CDD, ODD, and FDD come together, they can generate truly better insights. Each piece helps paint a total picture—but only if you put those pieces together. Acquirers can use what they learn during diligence as feedback to their original investment thesis and valuation, and to the larger growth strategy. These diligence processes will also help with pre-close planning—informing the future integration and value capture plan.
We will see in chapter 4 that diligence maps neatly onto what we will call “current operations value” and “future growth value,” and onto the improvements in performance required to justify the premium and the total price of the deal.