Visions of Opportunity and Language of Risk

In our experience, financial backers assessing a potential transaction are typically interested in five key questions:

• How realistic are the ambitions of the current management team and is thinking aligned with demand and the direction of the developing market?
• Can organic growth from the underlying business in the immediate market segue to other segments, thereby expanding the addressable market?
• Does management have the requisite experience and capability to drive growth in new market segments?
• How scalable are the business operations to support rapid expansion without compromising quality or performance?
• What are the key competitive advantages that can be sustained over the long term?

To answer these questions, due diligence should assess the investee’s competitive standing within its supply chain, particularly its buyer power relative to upstream supplier, downstream consumers, and other participants such as agents or distributors.

If company income relies on a concentration of customers or purchasing costs depend on a few suppliers, incoming backers will seek confirmation that these critical relationships are sufficiently robust and can withstand independent scrutiny. Would independently obtained references mitigate an observed dependence on key customers, suppliers or distributors? Could the factors driving the sales team’s expectations of a strong customer pipeline be verified through referencing discussions with senior customer personnel, such as purchasing directors or technical specification managers? More fundamentally, is the company’s sales team targeting the customers who provide the optimal sales volumes, values and margins, or are resources wasted due to poor sales enquiry conversions and disproportionate selling costs?

SME’s fulfilling an unmet customer demand in a defined market segment are attractive to backers. However, they risk being “niche today, gone tomorrow” due to factors such as technological redundancy, pricing commoditisation and market consolidation. Consequently, the scope of a due diligence project should address how business direction and strategy are set and by what processes. What inputs are provided by which functional managers, and how do these combine to contribute to the preparation of the business plan and sales forecast? How consensual is the process involving both senior company directors and tier-II operational management? Who wrote the numbers, and by how much have they been ‘polished’ for presentation in a vendor’s information memorandum?

More in-depth diligence will analyse the robustness of the business plan and evaluate management’s understanding of the addressable market. This may include an assessment of the extent of the company’s geographical sales reach and channels to market in addition to the complexity of its supply chain and the degree to which its operational footprint is differentiated from alternative market suppliers and competitors. Do the compound average growth rates for historical and forecast sales align with marketplace developments and sector growth trends? What levels of sensitivity, probability and confidence underpin the revenue and margin growth figures in the business plan?

The design of the due diligence project scope should align with the deal’s anticipated size and complexity in addition to the period of exclusivity agreed between the transacting parties. Where the industry faces structural change or the financial backer is unfamiliar with the sector, a more broad-based risk and opportunity analysis may be necessary. Alternatively, a reduced or early-stage scope may suffice where an investment opportunity seems promising, but a few questions remain for the investor’s final understanding.

If a business is in a ‘special situation’, where it is trading at a level of distress and at risk of breaching banking covenants or repayment dates – but the difficulties are believed short-term – the due diligence project can focus on specific and critical operational, commercial or strategic issues in an urgent turnaround scenario.

The language spoken by business owner/managers and backers may never be quite the same, but independent diligence can bring transparency and perspective to the deal process, enlightening the transaction’s value-creation opportunities to the benefit of both parties.

CSA’s strategy and commercial due diligence advisory services sit alongside and complement the day-to-day activities of company management. We provide independent and objective evaluations of strategic direction and customer value creation, providing a road map for business performance improvement and long-term financial investment.

For information about how we can help you to assess business and market attractiveness please call: 0208 947 5108.