Following record levels of M&A in the last few years, the market experienced a significant decline in 2022. The war in Ukraine, the high level of inflation and the resulting rise in interest rates have caused the private equity sector to rethink their own processes and investment propositions. More than ever before, today’s investors are facing the challenge of making the “right” deals and of already giving some thought, in the early stages of the process, to the future direction of the entity to be acquired and also to the planned exit several years later. Private equity investors will need to focus more strongly on “fit for exit” in future. The formerly dominant modus operandi of “buy, hold, sell” must be transformed into “buy, optimize, transform, sell” so that assets can be sold successfully in the years ahead, particularly in very volatile times.
Whereas, in the past, commercial due diligence (CDD) primarily dealt with the question of how sustainable the existing business model was, the last few months have seen a distinct increase in forward-looking due diligence analyses. Although these still follow the established structure of CDD reports and use tried-and-tested analyses such as the net promoter score (NPS) and key purchasing criteria (KPC) to validate customer feedback and strategic differentiation, today’s reports make a substantial contribution to the strategic orientation of the acquired entity. Below, we take an in-depth look at the contribution made by CDD towards increasing corporate value and optimizing the portfolio company.
What findings are generated by commercial due diligence reports?
The CDD report can serve in shaping the full potential plan and achieving portfolio optimization. On the one hand, CDD provides an outward-looking view of the market and business environment, the shape of competition and customer dynamics; on the other hand, it provides an inward-looking analysis of past and future forecast (financial) performance and is able to pinpoint the capabilities required for implementing the declared corporate strategy, as well as identifying and assessing overlooked opportunities and challenges inherent in growth areas.
Due diligence reports can help to considerably improve the quality of the goals and measures for fulfilling full potential plans that form the basis for operational portfolio optimization. While full potential plans are notably prepared on the sell-side, these are frequently lacking in terms of the derivation, precision and feasibility of the defined goals. The following sections explain how the findings from due diligence reports are utilized.
Market insight
To achieve portfolio optimization, it is imperative to have a thorough understanding of the market and business environment, as analyzed in the context of CDD. The business environment must be explained in the CDD with respect to trends, disrupting factors and the regulatory framework. Particularly in times of ever greater market volatility and complexity, a high degree of reflectivity is called for, as well as a willingness for contextual analysis, in order to interpret dynamic new developments as they emerge and take account of their impact on the portfolio company.
The initial challenge lies in identifying the actual competitors and grouping them into clusters, in order to have a better understanding of the company’s own market position. In this context, as part of a CDD, risks posed by possible disruptors are also analyzed where they have the potential to alter not only the business model of the portfolio company but also the market itself.
Another fundamental component of a CDD is to discern the key criteria underlying customers’ purchase decision-making and to assess the company’s market position in terms of potential end-customers. Established tools such as KPC and NPS analyses are used to acquire an in-depth understanding of these aspects.
By performing a KPC analysis it is possible, for example through interviews, to get a reliable picture of the situation which reveals not only the relevance of the purchase decision-making criteria but also shows the portfolio company’s performance in direct comparison with competitors. A KPC analysis helps to uncover weaknesses such as an insufficient range of services or a lack of market differentiation.
The net promoter score (NPS) analysis is a reliable tool for assessing a company’s market position in terms of end-customers. Customers are asked in interviews how likely it is that they would recommend the company to others. Moreover, it is possible to establish a company’s USP and those of its competitors, to identify weaknesses in positioning and to gain a better understanding of the customer base with regard to cross-selling and up-selling.
The scope of a CDD should also include analyzing the go-to-market strategy, selling processes and sales-relevant KPIs, to identify weaknesses and synergy potential for standardizing sales approaches.
Internal environment
Analysis of the internal circumstances of the portfolio company and its financial situation constitutes a key component of a CDD. It is vital to get a fundamental understanding of its organizational structure, business segments, production capacities and other aspects in order to understand the extent to which the portfolio company supplements what your own enterprise has to offer. In this context, financial analysis makes it simpler to identify growth opportunities and areas that are potentially to be shed.
Business plan analysis plays a key part in dependable investment decision-making. It involves assessing the entity’s past performance on the one hand and, on the other, validating the entity’s growth prospects. The assessment of a business plan can range from “ambitious” or “feasible” all the way through to “conservative”, and can provide an insight into the portfolio company’s future sustainability.
Moreover, as part of the business plan analysis, it is possible to draw up the initial break-out measures for exit. There are various possibilities in relation to this, depending on the type of company and market, ranging from autonomous value creation and resale to a financial investor, all the way through to a transaction with a strategic purchaser with aspirations in the portfolio company’s core market.
To conclude the CDD evaluations, the entity’s business capabilities are analyzed and assessed. Depending on the portfolio company’s branch of industry, business sector and type of business, this analysis is carried out along the entire value-added chain. Essentially, the analysis answers the question of how important such internal capabilities are for the company’s success.
Results-based portfolio optimization
The findings from the CDD should form the basis for portfolio optimization, should gauge how well the business portfolio transposes the corporate strategy and should identify any strategic vulnerabilities. It is important that management is included and involved in the evaluation process. By reviewing a company’s portfolio on the basis of its corporate strategy, it is possible to categorize the company and its respective components as “future business”, “core business” and “non-core business”.
Future business is not part of the company portfolio, but is instead part of the corporate strategy and a reflection of future business aspirations. The focus here is on developing and expanding business capabilities. Establishing business partnerships, acquiring additional companies, and strengthening existing areas of competence through the addition of new capabilities all represent scope for action.
Case study: Recycling
- A vendor due diligence report for a packaging manufacturer shows the future business as not yet being a part of the company portfolio, but instead as part of the corporate strategy and reflecting future business aspirations.
- A differentiated KPC analysis shows high potential for differentiation vis-à-vis competitors for recycled packaging, limited by raw material restrictions.
- Implementing a break-out move to establish a recycling business unit resulted in a significant increase in the valuation of the company.
Core business is part of the portfolio, is in harmony with the corporate strategy and, in the optimum instance, comprises the largest portion of business. It generates strong cash flows and adequate profitability. We can see that the core business is strengthened by focusing on research and development, digitalization and optimizing the value-added chain or organization. The investment propositions of private equity firms increasingly include the CDD elements of the value-added risk profile – primarily in the context of hedging the supply side of the business. The use of benchmarking tools makes it possible not only to analyze existing capacity but also, at the same time, to uncover optimization potential for reducing manufacturing or service costs.
Non-core business is part of the portfolio but does not sit with the corporate strategy. These areas of business frequently take center stage in the portfolio optimization process because they have a direct positive impact on the valuation of the company, particularly in cases where the specified level of profitability is not being achieved. Many investors often opt for divestment for that reason. However, deeper analyses can present a differentiated picture of the situation within the business segment to be sold. It often turns out that the business segment contains niches with adequate profitability levels– and which should therefore be retained. Other customer groups or value-added areas may perhaps not show the required level of profitability, but nevertheless have capabilities that may be useful in terms of future strategy – and these should therefore be put to further use. That is why various exit options should be investigated, in order to free up capital that can then be used where it will generate better returns. The residual part ultimately represents what the company should part with.
Case study: Automation technology
- A vendor CDD report shows the economic benefit of spinning off a business segment. However, within that segment there are profitable business areas and customer groups.
- By making a structural adjustment, it was possible to keep serving these business areas and customer groups successfully. Production licensing was implemented for the remaining customer groups and business areas.
- Factories that were no longer needed were analyzed and divided into categories: 1) continued use for other products, and 2) closure or divestment.
- Closure or divestment of the remaining factories, depending on the size and geo-graphical location
Exit readiness
Prior to initializing the selling process, the company must be examined for its “exit readiness”. Critical issues arising from the due diligence reports are to be focused on in this context, and it must be ensured that these weaknesses have been eliminated or minimized within the holding period. Furthermore, the “equity story” must also be developed and validated. This involves questions such as “Can the company benefit from current trends?” but also “What is the next step for the new owner?” A sound “equity story” forms the basis of the investment propositions for interested parties and should be reflected in the vendor and buy-side CDD.
Regardless of the specific questions addressed to the due diligence report, the findings can be utilized in the portfolio optimization and value creation processes. Using due diligence reports as a basis, the main strategic thrusts can be derived effortlessly, the catalog of measures developed easily and transfer to the full potential plan performed simply, enabling shareholders to exert a decisive positive influence on business developments. In particular, using them in combination with other (operational or financial) due diligence reports, for example, makes it possible to identify options for action along all parts of the value bridge. It is important to regularly compare the optimization process with the investment proposition, the full potential plan and the due diligence reports. It means that due diligence is – and will remain – “the gift that keeps on giving”.
Nils Altfeld and Freia Lorenz co-authored this article.
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