Month: January 2016

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.

Strategic due diligence (SDD)  requires you to integrate multiple disciplines in order to craft a reasonable set of expectations about the target’s likely future. In this post, I wish to map out these core disciplines, as they will be referred to in many future posts.

• SDD requires microeconomic analysis to understand an industry-level set of supply and demand curves, to understand the industry-wide equilibrium pricing, and to understand the industry’s cyclicality and its correlation to the national and global economies
• It requires marketing research to have a better understanding of the current and future demand curve, and to understand how the underlying goods and services’ features will likely evolve. It requires you to have a clear understanding of the differences between TAM, SAM and SOM (total addressable market, served available market and share of market). These distinctions are critical for market sizing.
• It requires competitive analysis to have a better grasp of the different market participants making up the supply curve (as these collectively represent the target’s competitors!) Such rigorous analysis is also required if you want to better assess the depth and sustainability of the target’s “competitive advantage” (or competitive moat, has it’s often called in the fundamental analysis community).
• It requires strategic analysis. This is where business strategy and industry analysis tools come into play (the traditional strategy consultants’ matrices, Michael Porter’s 5-forces model, SWOT analysis, and many more which will be explored in future posts).

While the above list is not exhaustive, it provides an introductory look at the different “thinking hats” that must be worn during the strategic due diligence process.

I hope you have taken away from my last entry that strategic due diligence (SDD)  is more than a mere market study. The following simulated Q&A will reinforce the point and provide additional examples.

Q: So, this is a glorified, deluxe market study ?

A: Not exactly. That would be too restrictive of a definition. You do need to look at the overall market trends in an SDD, but you have to specifically understand how and why your specific target might fare in your envisioned future. You must therefore make correct assumptions regarding 1) the market’s future and 2) the target’s ability to stay competitively positioned in that market.

Q: I get it. It simply means you have to specifically understand the target’s product line and how it compares to competitors’?

A: Well not quite. You still have to go deeper. You must determine how good the target’s products are in delivering the attributes that matter to its target customers. In other words, you have to understand why your target is not merely “good”, but “good where it matters”.

Q: Right. All you’re saying is that you have to understand how good your target is, compared to its competitors, at delivering product features that matter to customers…

A: Well, that would be relatively straightforward. Unfortunately, the challenging part is yet to come. Strategic due diligence requires you to read into the future. Its forces you to make a judgment call regarding how good the target will likely be at delivering current and future product attributes that its customers will likely want in the future. This is where the crystal ball part comes in. This is where you have to understand your target’s pipeline and R&D programs and product development capacities, and assess whether those will meet tomorrow’s needs as well as it has yesterday. All this while keeping in mind that

• in a profitable industry, somebody somewhere wants you dead
• abnormal profits generally get competed away

As you see, the “market study” part of strategic due diligence is an important one, but it does not in and of itself constitute a complete exercice. If you want to bet on the right racing team, you need to understand the race track, but you also need to understand what all your key competitors have under the hood (litteraly). That knowledge is not gained through market study. It is gained through applied competitive analysis.

 

I believe the most important question to ask oneself in order to activate one’s diligent, investigative thinking is the following: what is it which I don’t know that I don’t know? In other words, what are my zones of ignorance 1) of which I’m not even aware of, but 2) which are potentially critical in this situation?

The investment research process often tends to revolve around finding answers to the rather obvious questions (ie. it focuses on the known unknowns). For instance, an investor will receive a confidential information memorandum and quickly get to work on validating the information provided by the seller. This is incomplete, if not wrong, as it brings the investor to work within someone else’s framework (and with the biases, mistakes and omissions generally contained therein).

In order to address the challenge of identifying the “unknown unknowns”, the following two investor attributes are crucial: intense curiosity and humility.

Intense curiosity is the part of you that will ask question after probing question until you feel that core issues have been discovered. It is the part which recognizes that real issues are usually several questions deep, but that there usually is an Achille’s heel in any situation. It is the part of you which probably likes to conduct RCA (root cause analysis) when faced with a problem. And finally, it is the part of you which genuinely enjoys open-ended thinking, researching and continuous learning.

Humility is quite simply recognizing that you are not omniscient, and that arrogance can lead to costly mistakes. It is about recognizing that ego and good decision-making don’t always go hand in hand. I really like this quote which I’ve often heard in a stock market setting: do you want to be right, or do you want to make money ? It means that you should always be open to the possibility of your thesis being wrong. You should consequently pay close attention to all the available information rather than focus on that which confirms your pre-established thesis. When faced with information that conflicts with your thesis, don’t just speak louder…start listening !

Interested readers can do some research on confirmation bias and illusion of explanatory depth to further explore these issues.

Thanks for reading.

Being a big fan of analogies,  I like to compare financial/accounting due diligence to a jigsaw puzzle and strategic due diligence to a crime scene investigation.

In a jigsaw puzzle, the problem is well defined from the beginning. You have a box full of pieces to assemble right in front of you (the dataroom). The entire task is contained within this one clearly-defined jigsaw box. You simply have to

• go through the motions of auditing the data provided
• build a financial model which reflects the behavior and interrelations of revenues/costs/expenses/capital expenditures
• extrapolate the past and feed the financial model with some best case/worst case scenarios.

A crime scene investigation is different. To solve the mystery at hand, you start with little or no guidance. The problem-solving task is not clearly defined. (The world is your dataroom!) By closely observing the crime scene, you can pick up certain pieces of information that may (or may not) be clues to the mystery. There are multiple red herrings along the way. Once you feel you’ve gathered enough clues and observations, and once you’ve proactively linked your different observations and your data points, you can now build your forecast (thesis) of where the criminal will strike next. And you can start validating your thesis.  That’s the only way you can hope to catch your criminal…

The point is that strategic due diligence is a much more open-ended exercise. It requires assumption-making and thesis-building. Whereas financial and accounting due diligence present you with a clear cut set of information to analyze, strategic due diligence presents you with the unique challenge of correctly framing the problem before you even attempt to solve it. It requires creativity. It requires decision-making, as you are time-constrained and cannot follow every possible lead. You have to prioritize the leads to follow, by using your intuition (acumen) and probabilistic thinking. Commercial due diligence is the part of the diligence process that requires you to make an educated and substantiated guess about the future. It requires a different kind of reasoning and a different kind of questioning.

Financial analysis is obviously central in assessing a target’s real value. However, it is not sufficient. It must be backed by an equal (if not superior) amount of strategic analysis. These two fields of expertise are complementary, not substitutes !

I personally believe that private equity (and most M&A) belongs to the realm of strategy as much as it does to the realm of finance. And  in this regard, true transactional insight comes from rigorously intersecting them.

Let’s take the fictitious case of an investment professional who’s part of the corporate M&A team at a generic industrial company. The aim of his work should not be to close deals for the sake of closing deals. His task is first and foremost to gain a deep understanding of his employer’s strategic plan and use that understanding as a compass for deal screening. Indeed, in a corporate context, M&A is not an end itself but rather a means to achieve an organization’s strategic plan. In this context, M&A will be sometimes be used

• to acquire technical competencies missing in the company
• to accelerate product development
• to acquire a customer base in a different geography and expand footprint
• to consolidate the market and reduce number of competitors

While the above might seem obvious, it aims to illustrate that corporate M&A does not live in a vacuum. Its purpose is to accelerate or enhance strategic corporate development. It is a tool to deploy corporate strategy, just like in-house product development or corporate alliances.

Now let’s take the case of a pure-play private equity investment fund looking at each opportunity as a standalone opportunity. The fund’s goal is to deploy capital to achieve targeted returns. In this case, the need to quickly develop a strong and insightful strategic understanding of the target is even more crucial, as the fund generally does not benefit from massive in-house strategic expertise/insight about the target’s specific sector. Sure there are lessons that can be applied from adjacent sectors that the fund is familiar with, but that will only go so far. The challenge is this case is for the investor to rapidly develop a strategic understanding of the industry’s attractiveness and of the target’s competitive positioning. Not a “high-level” understanding. A subtle understanding that gets as close as possible to that generally possessed by the seller. This is easier said than done. This is the challenge that strategic due diligence aims to meet. It aims to reduce, as much and as fast as possible, the massive information asymmetry existing between a buyer and a seller. It aims to close the knowledge gap. Its aims to help you see what the seller is not saying. And sometimes, it even helps you see what the seller is not seeing.