Adding Deal Value through Commercial Due Diligence (CDD)

ADDING SUBSTANTIAL DEAL VALUE

The Success or Failure of an acquisition lies above all other things in the combination of (A) the price paid and (B) the possibilities to create value post-deal.

The primary focus of Commercial Due Diligence (‘CDD’) is identifying the ‘unsaid’ in the Target’s information provided and to challenge the ‘said’. Findings from CDD could uncover significant and deal-breaking risks and/or issues to the prospective buyer but also point to unnoticed product or market opportunities, cost savings or synergies.

According to various researchers many deals still fail to deliver the expected returns of the investment case and they try to find underlying root-causes in order to understand why.

Figure 1; About half of deals fail to deliver expected returns

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Source: Analyses based on European Acquisition Success Study and Bain

Answering this question, research findings point to the middle of the deal process. More unambiguous, it points to the unfortunate lack of having CDD activities performed on top of the almost indispensable Financial Due Diligence scope, while these activities appear to add substantial deal value.

As Harvard Business Review (2011) puts it, diligent review of the business model prior to making the deal is key to deliver expected returns. As the scope of Commercial Due Diligence is focused on providing an independent review of crucial elements which create or diminish deal value, Commercial Due Diligence should be regarded the ‘bulls-eye’ or focal point in deal making (or deal breaking for that matter) passed the non-binding-offer stage in the deal.

MID MARKET DEALS

Especially in the mid-market environment there is less room to absorb a bad deal, supporting the argument that in mid-market deals even more diligence should be taken before a deal is made. According to a study by Deloitte (2012), mid-market corporates evaluating potential M&A targets should carefully consider 4 key factors in order to decide to close the deal or walk away;

  • Strategic fit when it comes to products, markets and culture
  • Root cause of depressed or bloated earnings
  • Probability of improved financial performance
  • Identification and attainability of potential synergies

Typically, all these 4 factors are elements of the scope of Commercial Due Diligence.

THE DEVIL’S ADVOCATE

The core added values of Commercial Due Diligence are significant; (A) findings could identify potential deal-breaking risks or issues which could entice you to walk away from the deal, (B) with the evidenced argumentation you have a potentially larger ‘deck of cards’ to  negotiate a better price, (C)  the identified profitability improvements, synergies and/or upsides will support your valuation (and potentially provides you with insides other buyers might not have, improving the ‘odds’ you can close the deal) and lastly, (D) having CDD activities performed by an independent advisory firm allows your team to move faster and quickly develop a solid understanding of your target and its market.

Figure 2; Key Sources of Value Add through Strategic Due Diligence

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Source: De Strategie Compagnie

An often overlooked but valuable argument is the ‘second opinion’ nature CDD findings provide to the acquirer’s investment team. Not rarely, investment teams find themselves trapped in argumentation to rationalise the deal internally, while a third-party performed CDD supports internal decision making and argumentation.

In addition hereto, it is often easier for a third party (due diligence provider) to find direct customer feedback and competitor insights whilst remaining below the radar.

METHODOLOGY

The approach of CDD is a focused search for argumentation supporting (or undermining) the investment case. By means of a hypothesis-based methodology and existing sector experience it is possible to quickly deliver sound and quantitative presented findings through (financial) data analyses, expert interviews, research/press, customer feedback and interviews with key competitors.

Figure 3; Common Questions Asked in the Investment Decision Process

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Source: De Strategie Compagnie

We  believe rigorous Commercial Due Diligence is pivotal in determining if you should make a deal on the investment case at hand and if yes, for what price. Also, we believe the advantages of having due diligence performed by an independent advisory firm are significant.

ABOUT DE STRATEGIE COMPAGNIE

De Strategie Compagnie is a small scale, high-end consultancy firm based in Amsterdam, the Netherlands. Our team consists of highly experienced, top-tier (Big4) consultants. We distinguish ourselves primarily by our pragmatic, no-nonsense approach and high quality of service.

Commercial Due Diligence Experience

Our team proudly represents a solid experience in Commercial Due Diligence trajectories, with over 40 engagements performed. Focus lies predominantly on the mid-market in Western Europe. We have built specific and in-depth knowledge of various sectors, such as in Media and Telco (TMT), Healthcare, Retail, Aviation, Industrial/Manufacturing and Technology (ICT).

Other areas of experience

Strategy, Forecasting, Feasibility Studies, Market Entry Studies, Business Plan Reviews, Financial Modelling, Cost Reduction, Benchmarking, Business Acquisition, Acquisition Guidance.

We would be glad to assist you in your specific requirements and would welcome the opportunity to introduce ourselves and assist you with our services.

Website: www.destrategiecompagnie.nl

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Primary contact:

Drs./MsC Reinier Huisman, Managing Partner

Mail: r.huisman@destrategiecompagnie.nl

 

 

Competitive Analysis and Intelligence Gathering

Competitive Analysis within Commercial Due Diligence

Competitor Analysis and Commercial Due DiligenceSource: Depositphotos.com/@lightsource

Background

One of the key and most requested elements of Commercial Due Diligence is understanding the competitive environment. Just who exactly is the target company competing against and what are the relative market shares both now and expected in the future?

Plus are there likely to be any new entrants or technologies into the market which could affect things further?

The Challenge – Finding Relevant Competition

The main issue with competitive analysis and intelligence work I have seen is in finding general versus specific or relevant competition for the target company. This means that in many market reports and even analyst reports, competition is mentioned and sometimes there are even industry level market share diagrams.

However, the reality is a lot more complicated than this. One company can be present in many different markets within a country. Plus they can be involved in multiple countries and regions, each of which has their own competitive structure which can differ substantially based upon things such as legislation, cultural norms, historical relationships etc.

So it could be that one competitor dominates one market but is not present in another market. E.g. in the paper market, you might have competitors in commercial v consumer paper. Then there can be competitors in different segments whether that be by size of product, type of customer, price points etc. So you can already see that there could be a whole matrix of competitors which need to be analysed.

And, as Ralph Niederdrenk and Matthias Mueller in their German language Commercial Due Diligence book point out, there are also direct, indirect and potential competitors to be considered. Direct are those already in competition and who can take direct share, i.e. I as a customer buy their paper instead of yours. Indirect can be substitute products e.g. a law firm switching to iPad only material thereby cutting out paper and printing for their legal documentation. And potential competitors in this scenario are those companies which may be considering entering the market. E.g. a foreign competitor considering entering a new market.

The Aim of Competitive Analysis

The aim therefore of competitive analysis within Commercial Due Diligence, is to actually work out what is the ‘real’ position of the company in its various markets and sectors. Who are the main competitors and what are their shares, again within the specific sectors. How is each company perceived and positioned both in terms of financial results, margins and profitability and more importantly what is the future likely to hold for competition. What are competitors’ stated and likely goals in the future?

This sounds like a lot and it can be quite complicated work getting there. However, the clarity you will receive by doing this will help you in working out if this is a market and indeed a company you want to invest in.

The ideal aim is the so-called Warren Buffet style ‘moat’ whereby the target company has a strong position against competitors and a clear offer versus them. As well as a clear pricing and growth strategy. You want to see that your target understands the reality of their competitive environment and is taking action and steps to meet future customer need to protect themselves against competition in the future.

This can include e.g. mergers and acquisitions between major competitors to things like Clayton Christensen’s Innovator’s Dilemma where new competitors focus on the so-called ‘lower’ end’ of the market and thereby innovate to the point where the target’s customers are willing to ‘trade down’ to the cheaper offer.  There could be also future acquisitions and strategic alliances highlighted as part of this work.

How To Conduct Competitive Analysis

This is without doubt one of the most difficult aspects of Commercial Due Diligence. To get to the real heart of competition in some industries can be tough. It can involve collecting as many data points as possible and then doing some clear, logical analysis to ‘fill in the blanks’ where published market research does not provide the answer.

And that is in fact the approach – start from top down, published and sometimes more general research and work your down into the more specific focused research. There are various ways of doing this but the more specific the work, the more that primary research, i.e. speaking directly with customers, competitors, market experts and professionals is key. You need to get the ‘feeling on the ground’ so to speak.

This will need another post to go into the details of how to collect and analyse this data – and indeed what kind of questions to ask and look to answer. The key thing is to work out upfront what your likely concerns are, based on the management presentation and materials you have already received. As well as your own research.

This work will then be in doing a few things:

  • Validating the competitive assessment from Management and the Vendor – if they are not either honest or aware of their competitive position, what about the rest of their work
  • Understanding where the competitive strengths and weaknesses of all players in the market lie. So you know what you can do upon acquisition. E.g. there might be some relatively straightforward deficiencies you could deal with to instantly increase market share
  • Understand the future strength and viability of the company. Is it going to collapse with the launch of a new technology within the next three years for example?

These are some of the questions to ask yourself as well as then putting together some specific questions based on the information you have already received.

There are then many ways of analysing and presenting this data which we can go into at a later stage. You can hopefully see just how involved now the competitive analysis. And if you need to speak to competitors to get their input that makes it even more difficult.

Analysing The Target Company’s Offer

One of the absolute basic requirements of Commercial Due Diligence (CDD) is an assessment of the target company’s business model. This has two aims, one to understand how it currently works and is competitively positioned and how this model is likely to allow the business to meet its sales and business forecasts.

As stated in the Commercial Due Diligence book by Ralph Niederdrenk and Matthias Mueller, a simple way of understanding a business model of a company is to understand the structure and process of how the company goes about making a profit.

In their book, the authors state four main methods, which they call the basic infrastructure for understanding a company’s business model:

Profit Model

Value Creation Model

The Target Company’s Offer

Customer Model

 

The Target Company’s Offer

The Offer is simply the range of products and services offered by the company in question. What is the combination of products and services that the company offers its customers? Bearing in mind that some of the products and services may be combined such as with the consultancy or systems integration needed for certain software solutions.

For this, you will need to understand each product, service or product/service mix being offered. Obviously a company could have thousands of SKUs or different offers, so in this case, it is important to understand the over-arching categories. This will assist later with the market analysis by understanding the structure of the market, which could be segmented according to these product/service categories.

There are four main types of offer:

Individual Products or Services

This is the very basic offer, which is an individual or independent product or service meaning that customers may not need additional products or services to consume these products.

Additionally, these categories can be split between commodities and specialised products. So one company could offer the same basic type of products with different features according to the requirements of their customers.

Product Bundle

A combination of two or more products and/or services.

These combinations could be directly manufactured or be provided by the target company or by third parties. Generally these offers are standardised rather than specialised.

System

A group of individual products and services which have been specially combined for an individual customer. The aim here is the combination made specifically for an individual customer but with all of the products and services being standardly offered products, i.e. the products and services have not been altered merely the combination.

Customer Solution

This is an integrated and individually created solution developed for one individual customer, focused on their individual specific problems. So, for example, a customer in the nuclear power industry might have very specific requirements when compared to a customer of components in the renewable energy sector.

These can be viewed in a matrix with on one axis, the level of integration and on the other axis, the level of bundling.

Price and Condition

The price and condition of the offer is an important element to be considered in the Commercial Due Diligence against the competitive products and services. It is important to understand where the target company fits into the market with its offers. This can get complicated depending upon to what level of complexity the market breaks down into.

The aim is to understand whether the target is a commodity or specialised/premium service provider. Obviously one caution with pricing is to understand discounting, warranties, other services and products added into an offer etc.

Customer Value Proposition

Once you have understood what the target company offers in terms of its product and service offering, the next step is to understand its value to its customers, as to why the customer uses this and what problems they are trying to solve or which needs are being met with these products.

As the Commercial Due Diligence book states, this is different to a segmentation of the end customer industries. We are specifically trying to understand in more detail:

Product/Service Performance

Understanding the difference between the qualities of the product and service the target company offers in comparison to competitor offers. This can include better quality, functionality etc.

Price Performance

This is usually valid where the target company is able to offer a product at a lower price point to its competitors because of its lower price structure.

Customer Relationship Performance

This has to do with how the offer helps the structure of the relationship with the customer. If the target company is taking on some o the customer’s key requirements, such as reducing their risk or integrating with their financial systems, then this is aiding the customer and potentially reducing their costs above just the price being offered.

Differentiation

The key driver in determining how valuable the product and service offer is, is how differentiated it is from the competitors. Too similar and the target will be susceptible to price competition and potential replacement due to economic factors. Too specialised and they may be dropped if their service is to too advanced for their users’ requirements.

“Me Too” – undifferentiated offers – identical to competitors i.e. commodity products

Innovative Imitations – same as competitors with unique elements attached

Differentiation – through performance or price structure

Unique Business Model – ‘Revolutionary’ offer or meeting customer needs in a way no competitor can currently do.

For more information on this, please contact info@commercialduediligence.net

(Sources: Commercial Due Diligence – Die Strategische Logik Erfolgreicher Transaktionen- by Ralph Niederdrenk and Matthias Mueller, Octavia Life Ltd Research and Analysis)

The Advantages Of Vendor Due Diligence

If you are considering selling a company or one of your divisions or even brands, then you will most likely put together an Information Memorandum outlining basic details of the entity up for sale and some information on its market and customers and competitive environment.

Some vendors believe this is sufficient for buyers to get an initial overview and they can then commission more detailed research or even a Full Scope Commercial Due Diligence. You may be of the belief that this is their responsibility and their burden in terms of cost and time required to conduct such detailed research. After all, you may know your market and customers inside out.

The Advantages Of Vendor Due Diligence

There are however, some specific advantages or benefits of you as a vendor, commissioning an independent Commercial Due Diligence (CDD) provider to conduct a detailed and impartial vendor due diligence report. This would be in the form of a comprehensive and quality suitable to support banks and other financial institutions which may become investors.

As stated in the 2012 book Commercial Due Diligence by Dr. Ralph Niederdrenk and Matthias Mueller, there are a number of advantages in you proactively conducting such research:

  • As a vendor, your control of the sales process will be increased. This is because if the buyer conducts their own due diligence and highlights risk factors you weren’t aware of, they would have both a negotiating and also time advantage over you. They could use the points identified to negotiate down the value and hence sales price.
    • Also, you would not have sufficient time to really react and get to the bottom of those issues. By you identifying any risks upfront, you can factor these into both negotiations and the sales process itself. And indeed make alterations to company strategy or postpone sale until such time as any risk factors have been mitigated.
  • Reducing the duration of the sales process by covering off the requirements of the potential bidders so they need to do less research and investigation and hence can get to a decision and into the negotiation process quicker.
    • Additionally, the providers of the vendor due diligence report can offer Questions and Answer (Q&A) sessions with individual buyers to address their specific issues. In this way, everyone’s needs can be addressed relatively inexpensively and quickly.
  • Freeing up management and executive time to actually run the business. During the sale process, significant time and attention is needed by management to work with the various advisors and answer relevant questions. If this process is drawn out or concentrated in specific time windows, it can make senior management unavailable to actually run their companies.
    • Vendor Due Diligence can therefore be set up so as to factor in management’s time as effectively as possible and with more control over as and when to engage with them. There might also be the possibility to do this work over a longer time period than if it was conducted by the buy side teams.

Overview

In summary, a vendor due diligence conducted in as detailed and thorough a manner as possible will put you as the potential seller of your company or division into a stronger position to negotiate a higher price as you will be in control of the information and aware of any risks – and upside when talking with the various parties during the total sales process.

If you are interested in finding out more about vendor due diligence services, please contact us at info@commercialduediligence.net

Red Flag Commercial Due Diligence

What Is Red Flag Commercial Due Diligence?

This is a Commercial Due Diligence (CDD) project which is conducted on the buy-side by either investors or trade buyers when in the very early stages of considering a potential acquisition.

The idea is to do a brief amount of work, usually around a week to a week and a half in duration, in order to find any ‘red flags’ or issues or criteria which could scupper a deal.

The main focus is on the positioning of the target company within its market as well as any inherent risks in the coming years in the market – e.g. new competitors or new technologies which could replace demand for the target’s products and services. At the same time, if any huge risks with major customers that is a bonus although it ma not be apparent at such an early stage.

The main aim is to allow the potential buyer to quickly find out if there are any ‘obvious deal breakers’ which could cause the deal either to collapse or make it not even worthy of pursuing any further.

The advantage of doing a Red Flag Commercial Due Diligence project is so as to relatively inexpensively know whether to stop investigating an acquisition and thereby saving tens of thousands of pounds down the line,

If you are interested in finding out more about Red Flag CDD or would like to commission us as experienced Commercial Due Diligence providers, please contact us at info@commercialduediligence.net

Top Up Commercial Due Diligence

What Is Top Up Commercial Due Diligence?

This is another type of buy side due diligence – i.e. which is paid for and commissioned by the potential investor or acquirer.

This is the work which is done on top of the vendor due diligence, with the aim of addressing any additional questions the acquirer has, or to double-check some of the assumptions and also conclusions having been made in the analysis conducted in the vendor due diligence.

However, the Top Up Due Diligence uses the vendor due diligence as its foundation and benchmark rather than being a ‘brand new’ piece of work so to speak.

Main Focus

The main focus of the Top Up CDD will depend upon the strategic requirements of the acquirer. They may have questions which refer to post-merger integration issues or those relating to reaching their strategic goals as a company.

Because vendor due diligence is often conducted to produce one report which must meet the needs of many different kinds of investors, from banks, private equity houses to trade buyers and even conglomerates, it often cannot address all of the strategic issues, each entity has.

Therefore Top Up CDD may be needed in order to flesh out those sections with not enough detail for the Board of the Investor’s organisation to make a decision.

Costs And Time Needed For Top Up CDD

The level of research and time and therefore cost needed for Top Up CDD depends entirely on the quality of the Vendor Commercial Due Diligence document provided to the potential bidders. This will also include the thoroughness of the document and into how much detail it goes.

Assuming the quality and depth of content is strong enough to be used as a firm foundation, the advantage of Top Up CDD is that the speed of completion and hence cost should be substantially less than having to do a complete commercial due diligence report from scratch.

The Three Key Requirements Of Vendor Due Diligence

Overview

First of all, what is vendor due diligence?

According to the German language book ‘ Commercial Due Diligence’ by Dr. Ralph Niederdrenk and Matthias Müller, vendor due diligence can be identified as follows:

“Vendor Due Diligence concerns itself with the independent examination of the company or division up for sale prepared in relation to the requirements of the potential investors and their financial banking partners.”

The authors also point out that although the vendor due diligence work itself may be commissioned by the vendor, upon completion of the deal, costs and any liabilities relating from the commissioning of the work will be transferred to the purchaser.

They also make the distinction between Vendor Due Diligence and Vendor Assistance:

“Vendor Assistance is where the target company commits an external service provider to help ensure an optimal sales process. The target company will be examined to check whether the transaction related information is available in the required quality and necessary level of detail.

Three Key Requirements Of Vendor Due Diligence

1. Independence Of The Report

This is critical for the potential investor or purchaser of the target to take the report and hence the vendors seriously. As long as the independence of the vendor due diligence provider has been clearly established in the market place, then investors will have more confidence in the report and the findings.

The other thing of benefit is for the purchasers to be able to have a ‘closed door’ session with the report writers, in order to get into the detail of any points which the vendors might be trying to sweeten or gloss over.

And that is the next point

2. Addressing of risk factors

The purchaser will be on high alert when examining vendor due diligence and in fact the target in general, that potential risks and issues which could cause the success of the merger to be called into question, will be either downplayed or glossed over.

If this is a serious concern, it could even cause them to commission their own research which will lead to both unnecessary time delay whilst further research is conducted as well as this then causing a potential dispute as to who will ultimately pay for the vendor due diligence report. The purchaser or acquirer may refuse to pay on the grounds that they had to conduct their own research.

All in all, clearly stating potential risks is needed in order to avoid any wariness in negotiations and in ensuring a smooth transaction.

3.  Comprehensiveness And Detail Of The Report

The more detailed and clearly logically structured report you can provide for potential investors, the more time both will be saved upfront and the more confidence the investor will have in you in terms of your attention to detail.

To make a comprehensive report will mean spending time and money on really researching all of your major divisions including detailed interviews with all key customers as well as former and potential customers. The same goes for the market analysis with different potential forecasts for the business by segment and division as applicable.

And within each segment, this could require ‘drilling down’ to the level of meaningful detail which investors will both appreciate and is likely to pre-empt the questions they have.

To understand their questions you will need to understand their point of view – i.e. what kind of an organisation are they and what are their strategic goals. So a venture capital company might have different strategic requirements to a multi-national corporate looking to acquire your company in order to enter a new market.

Whilst you may not entirely know the acquirer’s strategic objectives, common sense and putting yourself in their shoes will give you a rough outline. It therefore may make sense to have slightly tailored versions of the vendor due diligence report to support the different types of potential purchasers of your company or division.

Addressing these three key issues – independence, clearly and honestly highlighting risk factors as well providing the necessary detail and completeness will give your vendor due diligence output a high level of credibility and security to potential investors, thereby saving time and money in the negotiation and sales phase.

Our Services

Octavia Life Ltd, the authors of this article are able to able to provide detailed vendor due diligence and vendor assistance services. Please contact them at info@octavialife.com

What is Commercial Due Diligence?

Overview

Even though I have almost 15 years experience in Commercial Due Diligence (CDD), I am finding it hard to give a clear definition as to what exactly CDD is.

This is because there is no standard definition of Commercial Due Diligence and also because it is a relatively young discipline. It really only became important or more prevalent in the mid-1990s as private equity houses started to use CDD as a key part of their due diligence process.

A definition of Commercial Due Diligence

Here is a definition of CDD loosely translated from the German language book Commercial Due Diligence by Dr. Ralph Niederdrenk and Matthias Mueller published in January 2012 by Wiley VCH Verlag.

“Commercial Due Diligence or CDD is the ‘careful’ examination of the target company’s market, customer and competitive environments in the scope of purchase of the company or division in question and working in close contact with the financial due diligence process. The ultimate aim of CDD is to quantitatively validate the business plan of the target company and its sales forecasts. “

Careful can also be translated in German as thorough.

Commercial Due Diligence and Financial Due Diligence

The authors make the point that Commercial Due Diligence and the Financial Due Diligence must work closely together. Financial Due Diligence according to the PWC UK website involves ‘analysing and validating all the financial, commercial, operational and strategic assumptions being made. It uses past trading experience to form a view of the future and confirms that there are no ‘black holes’

Financial due diligence needs CDD in order to capture the future prospects of the target company’s sales and assumptions about the market and likely future demand on future sales and cash flow prospects. Otherwise, the FDD could be simply projecting the past intothe future. This is of course not to downplay the critical role that FDD plays in any transaction.

Other Definitions of Commercial Due Diligence

Depending upon the scope, commercial due diligence can often be defined as market due diligence or strategic due diligence. And even elements of work such as market entry or acquisition screening and so on also play a part in commercial due diligence.

I have even heard the phrase do a ‘quick and dirty’ to describe the most basic of commercial due diligence work.

My View Of Commercial Due Diligence

Obviously I am hugely biased in my opinion but I believe that the Commercial Due Diligence work which as mentioned above is to understand the historic, current and future prospects of the target company, is the critical element in a potential transaction.

Why?

The reason is because without understanding the commercial benefits and risks of the prospects of the target company – both as a standalone investment or with integration into a portfolio or into a corporate structure, the deal could be like many mergers and acquisitions a waste of money in plain terms. Or at the very least well below the expected return on investment.

The key is what is your company’s strategic objective? Either as an investor or corporate entity. The Commercial Due Diligence can therefore be tailored not only to understand the prospect company’s potential and market situation but also whether it fits into your own company strategy.

Often, we have to help clients work out what their strategy is in order to make sure the investments they are interested in are likely to make the acquisition a success going forwards.

Your Views

I hope this gives you a view of a definition of commercial due diligence. Please could you give your comments and better yet, your definition of commercial due diligence.