Month: January 2020

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.