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This one will be a short post, as I’ll simply take another quick stab at the popular yet erroneous notion that strategic due diligence is a synonym for “market study”.

A typical market study will provide you with high-level trends and forecasts regarding the demand side of a given sector. While this provides you with useful contextual information about an industry,  it provides you with nowhere near the decisional intelligence you need to assess the competitive positioning, capabilities and strategic outlook of a specific target company.

If you understand that investing in ETFs (exchange-traded funds) and investing in actual securities are two very different activities, then you already have a good intuitive grasp of what strategic due diligence aims to do: it aims to discriminate between players in a given industry.

The whole rationale of an ETF is to allow the investor to bet on the outlook of a given industry without having concentrated exposure to a specific company. The ETF investor takes a market risk, not a company risk. On the other hand, the individual stock picker goes beyond market risk and specifically takes a company-level risk, with the implicit assumption that his chosen stock will outperform peers in the same market. The decision-making methodologies have to be quite different.

In this regard, private equity investors are stockpickers (with the added component that they usually have significant influence on portfolio companies’ strategies). Furthermore, their typical deal size and the resulting portfolio concentration often makes them poorly-diversified stockpickers. It is therefore crucial for them to use the specialized set of tools and techniques to discriminate between players in a given sector. This is what strategic due diligence is all about. These are the very practices this blog aims to document, discuss and share. Hope you enjoy reading!

One of the reasons for which strategic due diligence (SDD) is misunderstood and under-utilized is probably its association with the overall “due diligence” umbrella term. For starters, “due diligence” conjures images of accounting and other data audits. Unfortunately, most of what SDD aims to achieve has nothing to do with an “audit”, and everything to do with “anticipating and strategizing”. In this sense, perhaps “strategic due diligence” is a misnomer. Perhaps it should have a different name. Like “pre-investment value mapping” or something.  I will certainly revisit this idea in the near future.

Nevertheless, this association with the “due diligence” umbrella term probably explains why strategic due diligence is often perceived as just another “risk mitigation” tool. The analyst wants to ensure that the “absence of future demand for the company’s products” is a risk that can reasonably be ruled out.

Viewed from this angle, a strategic due diligence can have two outcomes:

1. I have found reasons not to go ahead with this deal
2. I have found no reasons not to go ahead with this deal

In a sense, you have mitigated your risk if you have reached either of these conclusions. But if you stop there, you have missed out on half the story! You have used the “risk mitigation” potential of SDD, but you have failed to use its “value creation” potential. Indeed, SDD is only a two-sided coin if you bother to flip it!

Worded differently, SDD doesn’t have to limit itself to deciding whether you should put on the brakes (or not) for a given transaction. It can actually help you identify the direction in which you should accelerate the target’s development, post-transaction. The reason is that most of the data collection and analyses conducted during SDD provide you with sufficient material to start mapping out value-creating initiatives in the target company. It allows you to identify growth areas, assess competitive intensity in these growth areas, and even map out and quantify the payoff of specific initiatives to be launched post-transaction. To put it simply, if you want to rapidly unleash value-creating activities in the acquired company, you will certainly gain by having pre-discovered and pre-mapped these sources of value prior to completing the transaction.

This approach also has the obvious benefit of helping you properly value the target. In clearly mapping out what you think will be your active value-creation levers post-transaction, your valuation exercise will be a lot more useful (and accurate) than if you limit yourself to  quantifying the “premium-justifying” synergies. With SDD, you will be able to identify not only the value you will be “taking”, but that which you will be “making” (or creating).

To sum up: as soon as you plan to have some active role in a target company post-transaction, your actions will likely be creating (or destroying!) value. By identifying your value-creation plan prior to the transaction, you will be in a much better position to put the right price tag on the company. And you’ll be in a position to swiftly yet strategically move during the oh-so-critical “first 100 days” that follow a transaction.

I’ve recently had an epiphany. For a decade and a half, I’ve been assessing investment opportunities in just about every industry and at every step of the corporate life-cycle (from seed investments to buy-outs). Along the way, I’ve repeatedly educated multiple stakeholders on the different disciplines involved in developing fact-based and informed opinions on these opportunities (business valuation, commercial due diligence, financial due diligence, quality or earnings, management team assessment, market forecasts, digital competencies assessment, etc).

I always felt there ought to be a “catch all”, simple and direct formula to capture and explain the entire diligence process in a few words. Such a formula would be helpful to orient new recruits and colleagues, as well as to brief target companies ahead of the process.  I find that the term “fundamental analysis” is a decent proxy borrowed from the public markets’ value-investing folks. However, the term does not seem to resonate with the private market crowd.

Well inspiration finally struck. Here’s my three-word formula to capture the process:

Assets and Assumptions.

Yep, when investing, you buy assets and your buy assumptions. If it’s not an asset, it’s an assumption. Simple as that.

The asset is arguably the easy part. Tangible assets can be touched, seen, visited. They are quantified through financial statements. Intangible assets (such as brands and IP) are trickier, but can still be dealt with through the proper valuation methodologies. For the sake of this post, I will also include the target company’s key personnel as an asset. Accounting standards obviously don’t agree with me on this, but I definitely feel justified in classyfying humans as intangible, verifiable assets during the due diligence process. You can see folks, you can interview them, you can purchase key-person insurance for them…so, you know what, I say they’re assets!

Enough with the assets. What about the assumptions ? Well they pretty much cover the rest  of your investment decision variables. Everything related to your perceived outlook of the target company is an assumption. Your PESTL analysis and outlook (political, environmental, social, technological and legal components) ? A set of assumptions. Your assessment of your key competitors and suppliers’ next strategic move ? An assumption. Your assessment of potential new entrants disrupting your industry ? An assumption. And on and on.

As i’ve written about in the past, a major challenge is that some assumptions are made consciously while others are not. The investor might strive to make the best assumptions regarding his « known unknowns » without realizing the key assumptions he’s unconciously making in the « unknown unknowns » category. This can be lethal because an unidentified, unconscious assumption will go unscrutinized. Business graveyards are filled with those kinds of unscrutinized, unconscious yet very real assumptions. That’s what’s called a blind spot.

That’s it for now. Now go work on solidifying your assumptions.   Because no strong thesis can rest on weak assumptions!

You’re putting the final touches on your financial model. You’re practically done valuing the company. Following are a few questions that will ensure that your valuation assumptions are robust. Because let’s not forget, valuation is merely a tool. Its ultimate value essentially rests on the quality of the assumptions which it is fed. So here we go:

• Have you mostly relied on the target company (or worse, on its advisors) to inform your assessment of the target’s risk and opportunities? Or have you built your own, proprietary view of the target’s potential by conducting your own extensive strategic analysis and by tapping into your own, unbiased information sources (such as suppliers, competitors, ex-employees, expert networks, clients, ex-clients, etc.)?
• Have you limited yourself to a “market and industry outlook”  analysis? Or have you conducted a thorough competitive analysis in which you’ve gone much deeper and clearly compared and ranked all the relevant players using the relevant criteria ?
• Along the same lines, have you identified the likely predictors of future market success, based on demand trends and likely shifts in the competitive landscape?
• Are you sure that you are avoiding “confirmation bias”, which is  the tendency to ignore any information that does not support the investment decision that you’ve already made (whether consciously or not) ? To make sure that you’ve avoided this bias, have you played the “bulls and bears” game ? That is, have you made sure that someone on the investment team has purposefully taken opposite sides of the deal champion and has identified at least 5 good reasons to NOT pursue an opportunity? Has the team been able to satisfactorily defuse each of these reasons to NOT proceed?
• Have you done a minimum amount of “war gaming” or competitive simulation? Have you assessed the robustness of your investment thesis under different scenarios that could unfold after the transaction (especially consolidation amongst customers, suppliers or competitors)? Of course, this assumes that you have a well-researched profile on each competitor, its management style, its shareholding structure, its most likely strategic direction, etc. You do have such information, right ?
• Finally, have you taken a step back to honestly ask yourself if you were forgetting any crucial question in your analysis ?

There is nothing static in the investment game. Like in most competitive endeavors, your chances of winning are based on your ability to properly read all players and anticipate their likely actions and reactions. Avoid the common traps. Describing a situation does not mean that you understand it. And without a reasonable understanding of that situation, you will be unable to intelligently anticipate likely developments. And if you can’t reasonably anticipate, you should not invest.

As discussed in my previous entry, strategic due diligence is essentially a process of “question discovery”. Real issues tend to dwell several questions deep. Your analytical and creative energy must therefore primarily be applied towards discovering those key questions, the questions that will lead to breakthrough insights regarding a target’s potential. To paraphrase Claude Levi Strauss, “The wise man does not provide answers, he rather asks the right questions”.

For these very reasons, I disagree with the practice of fully outsourcing strategic due diligence to an outside consultant. While I do believe that external help can assist with research, analysis and sector-specific data (this is especially true in an era in which information has become commoditized), I also believe that such help should only be utilized once the deal team has developed a solid thesis and has made a serious effort to identify all the assumptions contained in said thesis, whether these assumptions be explicit or implicit. Otherwise, the deal team is keeping itself out of a critical component of deal analysis, and it is in my opinion handing over too critical of a task to an outside party. The obvious risk is for the deal team to end up with great answers to average questions, whereas it is arguably preferable in an investment setting to have average answers to great questions. Would you rather be approximately right or precisely wrong ?

For these very reasons, you can outsource the answers, but you really shouldn’t outsource the questions.

As I’ve written about in a previous post, strategic due diligence is quite different from financial due diligence. While the latter focuses on finding answers to questions you already have (your “known unknowns”), strategic due diligence aims to identify the blind spots which you are not aware of (your “unknown unknowns”) prior to investing.

In a sense, strategic due diligence is about rapidly discovering the right questions to ask in a specific business situation. It is truly an investigative challenge. When performing strategic due diligence, you are not assembling a puzzle whose pieces are clearly and exhaustively contained in a defined box.  You’re looking for clues in a wide-open and ambiguous environment where the signal-to-noise ratio is quite low. To further increase the challenge, this investigation has to be performed under two significant constraints, those of intense time pressure and massive information asymmetry between buyer and seller.

I’ve often heard that due diligence is about “connecting the dots”. I don’t believe that this adequately reflects the challenges of performing a high-quality and truly actionable strategic due-diligence. Such a due diligence requires a prior step: before connecting the dots, you need to uncover and expose multiple hidden dots that weren’t in the data provided by the seller and/or his broker. And you need to figure out which of these dots are relevant. And you need to rank them in order of importance and decide which ones you will focus on. Only then can you start to connect the dots and figure out what the deal narrative really looks like. In my opinion, a strategic due diligence should definitely lead to the discovery of at least two or three significant questions which were not on your radar when initially walking into the data room with your initial thesis. Otherwise, you’d be justified in feeling that you’ve probably missed something important regarding the deal you’re analysing.

As you’ve probably realized from previous posts, this blog is neither about startup investment nor unicorn chasing. As explained here, I am rather aiming to share and document best practices as they relate to the strategic and fundamental analysis of later-stage, cash-flow positive companies with an already-established business model.

However, I believe the PE and VC worlds are increasingly converging (at least in the mindset and skillset they require from participants). Failing to recognize that you need to incorporate some VC-type thinking in your non-tech private equity transactions will wreak havoc on your returns. Indeed, even if you are not seeking to invest in the next great disruptor and would rather comfort yourself in the solace of stable, proven and profitable business models from the past, you now have to go through the mind-stretching task of envisioning new, unforeseen sources of competitive threats.

This is not new. Even the most basic of strategy tools (Porter’s  5 forces) reminds you to assess “new entrants” and “substitutes” when analyzing a specific company. But the general tendency I have seen in the industry is for PE investors to focus the analysis on the competitive positioning and capabilities of current competitors (as Porter puts it, “rivalry amongst existing firms”) and try to anticipate new players with a reasonably similar model.  What often lacks in PE deal analysis is the harder, more speculative work of trying to envision future, un-existing, disruptive threats. The very threats that can kill a business.  The threats that the VC investor is trained to detect and seeks to profit from…

As a PE investor, this is a part of your due diligence process where curiosity, expert consultations, a futuristic mindset and a healthy dose of paranoia are all warranted. The signals you are looking for at this stage are generally quite weak and can only be heard at the boundaries of the target’s current business model. You must also keep in mind that the seller 1) is either keeping these signals secret, hoping you won’t notice them or 2) is simply not perceiving them, as they are still too subtle for his level of attention. (An alternate explanation lies in denial. As per Upton sinclair’s famous quote, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.“)

As a private equity investor, you should also keep in mind that a target company might not necessarily be threatened by one single disruptor, but rather by a series of innovative players that are each chipping away at a specific part of the target’s value proposition enablers.  This is called unbundling, a concept which has been popularized by  CBInsights. Unbundling basically spells death by a thousand cuts for the incumbent’s business model.

So if you’re working on traditional buyout deals, please resist the temptation to categorize yourself as a “private equity” investor rather than a “venture capital” investor, please resist the urge to label yourself as an “old economy” vs “new economy” investor, and please resist the urge to stay in your comfort zone by avoiding a deep analysis of the technology and innovation zones of the target’s competitive landscape. There is a stage of your due diligence process at which you’ll want drop the financial and strategist’s hat to wear the innovator’s hat. Not so you can pick the next big disruptor…but so you can avoid investing in the next big disrupted!

If you are reading this, you’re probably involved on an ongoing basis with conducting due diligence on potential acquisitions, and you’re probably frequently defending your investment theses regarding these acquisitions.

As the crux of this blog is to discuss tools and techniques that facilitate and improve the quality of buy-side analyses, it is greatly time to introduce the concept of “expert networks”. As the economist put it in a 2011 article, expert networks are “the matchmakers for the information age”.   While their subscription and billing models vary, these networks offer the same basic service, that of matching an investor with an expert possessing information, knowledge or insights sought by the investor. These networks are a primary research tool in which the end-product is not a custom report but rather the set-up of a custom conversation with a targeted individual. These networks can indeed provide a useful input in your decision-making process, as long as you use them properly and have reasonable expectations.

First and foremost, these networks can be a valuable substitute for something that used to be prevalent in the industry: publicly-available quality research authored by equity analysts. The old trick used to be that by finding a few unbiased sources and going through a few reports on companies active in the same market space as your target, you could develop a generic, high-level understanding of industry trends, opportunities and threats. An expert consultation will help you construct such a general high-level mapping of the industry.

However, this is no substitute to a full strategic due diligence. Using an expert does not relieve you from the hard and essential work of analyzing an industry, understanding its key players’ market and value-chain positioning,  anticipating  both key and emerging players’ next strategic moves as they relate to the target, and assigning probabilities to these moves. The expert can not do this work for you as 1) he is (most probably) not a business strategist but rather an industry executive with an operating bias and 2) you have probably kept the target’s name confidential anyways, making such analysis impossible even to a strategist.

So, is the expert consultation’s value therefore limited to replacing a bunch of generic industry research reports ? No it is not. As we just saw, the expert will typically be an operating executive. This will allow him/her to provide “operating” and “tactical” industry views that will be more accurate and insightful than those provided by a typical strategist or market researcher.  The key is to build a well thought-out questionnaire will allow you to extract useful information from the expert and interpret it in light of your target’s context. You need to study the ground and mark the ground with your Xs, the expert will help you dig. Indeed, if asked the right questions, the expert will help you go past generic industry analysis and provide leads that will help you assess the extent of your target’s intrinsic product and competitive advantage.  But it should be obvious at this point that the quality of the expert consultation entirely rests on the quality of the questions you bring to the table. Mark the wrong spots and you will retrieve useless, un-strategic material. 

Now, will expert networks provide you with a contact which you could not have found by yourself through linkedin ? Probably not. But the expert network provides the following benefits:

• Speed to expertise (the networks live and die by their ability to rapidly provide you with leads that meet your criteria. As such, I consider them to be “research accelerators”)
• Clear terms of engagement (pricing and service features are standardized and understood upfront by both the expert and the investor, which again removes friction from the process)
• Trusted middleman with the incentive to ensure quality control (the expert network has the built-in incentive to connect you with a quality resource)

Final two tips before we part:

• resist the urge to go into the conversation with the sole agenda of validating your pre-existing thesis. This would be a blatant case of confirmation bias, which I’ve written about in the past. Rather, do try to open-up the discussion and have the expert provide his own views on what he would look for in an investment target in the space. Again, while the expert can’t and should not replace you as the ultimate analyst regarding the opportunity at hand, such open questions might bring interesting insights as to how you should assess the “quality” of your target.
• As with most market research, varying sources will provide you with various inputs, and your task is to determine a reasonable zone of overlap between all the information provided. Techniques such as triangulation and cross-verification will therefore be as useful with expert consultations as they are with other types of research. So if you like the expert network approach, get ready to talk with multiple experts during the same due diligence assignment. To help you along the way, I will provide a list and comparative chart of the main industry players in a future post.

Today’s going to be a short entry, as I’m trying out the concept of sharing in near real-time any relevant materials and quotes which I stumble upon in my day-to-day activities.

 

This one is from “Post Capitalist Society” by Peter Drucker, the great management thinker. It goes as follows: “In knowledge work…the task is not given; it has to be determined. What are the expected results from this work ? (…) And it is a question that demands risky decisions. There is usually no right answer, there are choices instead.”

 

This very quote dramatically applies to strategic due diligence. Especially the part about the risky decisions. Because a key component of due diligence is the proper selection of areas in which to “go deep” (hence my blog’s title, deep diligence). This is necessary because in a due diligence assignment, you neither have the time nor the resources to fully explore all potential areas of concern. A bit like an upstream oil company, exploratory drilling choices have to be made. And these choices are key to the outcome.

 

As I once heard a management consultant tell me during the fact-gathering phase of an assignment, “we don’t have time to boil the ocean”.

Market sizing is a key component of a  strategic due diligence. However, depending on how it is approached, its results can range from useless (or worse, misleading) to essential. How can this be?

The key lies in the granularity of the analysis and its ability to provide insight on the target’s competitive position. Indeed, under varying qualities of analysis , the same target company could potentially be perceived as either a small player with much upside potential or as a dominant player with little to no organic market growth potential. Let me illustrate with an example, that of a single target first examined through the lenses of the misleading analysis and then through the lenses of the useful analysis:

Misleading analysis: Airplane gear inc. is a player in the fast growing aerospace industry. It provides airplane manufacturers with landing system parts, a growing global market worth US$ 2,7 billion annually and expected to grow 2,4% annually over the next 3 to 5 years. With its US$ 40 million annual sales, the company has less than 2% of a fragmented market and can reasonably grow its share through acquisitions or organic growth.

Useful analysis: Airplane gear inc. is a player in the aerospace industry. It provides airplane manufacturers with landing system replacement parts. It is not an OEM to aircraft manufacturers and has a competitive edge in the aftermarket replacement part. It does not serve the military aviation industry. Its commercial strategy over the last 10 years has been to focus on landing system spare parts for midsized crafts. Through various research and triangulation techniques, we estimate its addressable market to range between US$ 125 and US$ 175 million. We also note that the replacement parts market is underperforming the overall market and is expected to grow at less than 1% annually for the next 5 years. With its US$ 40 million in sales, the company has between 31% and 43% of its target market. 

As you can see, the same set of basic facts leads to a very different strategic conclusion!

The misleading analysis implies nearly unlimited growth potential and suggests that the target has a natural ability to grow by simply “rising with the market tide”

The useful analysis demonstrates that the target is possibly the dominant player and suggests that the target’s main source of growth will likely come from stealing market share from its main rivals, a strategy which might very well require aggressive pricing and hurt margins.

A key step in this matter lies in the proper definition of the market under study. This requires the investor to move from studying the TAM (total addressable market) to SAM (served available market), the latter being a more granular definition that takes into account the target’s specific product and segment choices (in our example, key segmentation factors were factors such as civil aviation only, spare parts only, specialized in midsize crafts, etc.). Once this is done, a variety of research (primary and secondary sources) and analysis techniques will allow you to come up with a reasonable “market size range” for the target.

The importance of properly sizing the market cannot be overstated, as it informs your entire investment thesis. It tells you whether the addressable market is fragmented or not. It gives you the possibility to compute your target’s approximate market share. This informed market share estimate in turn leads you to factually assess the company’s competitive position and its evolution through time, allowing you to determine whether the target’s performance is improving or deteriorating compared to its peers. While it necessarily includes estimates and assumptions, a properly-designed market sizing exercise is key in assessing a target’s strategic position and outlook.