Commercial due diligence (CDD) is often important to conduct in an M&A process when evaluating the commercial viability and attractiveness of a target company or acquisition.
I liken it to looking out of the window of an airplane before you land.
This becomes especially important in the context of
New market entry – when the acquirer is unfamiliar with the attractiveness and competitiveness of the target company’s sector. CDD can help identify the target company’s competitive strengths and weaknesses, customer preferences, and regulatory or legal risks.
Private equity buyers: Often corporate acquirers have been studying the acquisition landscape and may have operations adjacent to the target company – and therefore have the benefit of knowing the macro trends and the value chain in the market. PE buyers may have a sharper learning curve if their attention is spread across different sectors, and since the teams making the acquisition decision are often as close to the industry as portfolio company management teams.
WHAT ISSUES CAN AN ACQUIRER EXPECT TO SURFACE IN COMMERCIAL DUE DILIGENCE:
Customer and supplier relationships: CDD may identify issues with customer and supplier relationships, such as customer concentration or supplier dependence.
Market size and growth potential: CDD may identify issues with the market size or growth potential of a company’s products or services e.g. if the market is small or declining, the growth projections may not be achievable.
Competitive landscape: CDD may highlight issues with the competitive landscape, such as the presence of well-established competitors, or the emergence of new and disruptive technologies or business models. These factors may impact the company’s ability to gain market share or maintain profitability.
Specific product or service offerings: CDD may highlight issues with a company’s product or service offering, such as lack of product differentiation or limited product portfolio, impacting the company’s ability to attract and retain customers.
Sales and marketing strategy: CDD may identify issues with a company’s GTM, sales, and marketing strategy, such as a lack of a clear value proposition or ineffective sales channels – impacting the company’s ability to achieve growth targets.
Regulatory and legal issues: CDD may uncover regulatory or legal issues that could impact the company’s operations or financial performance. For example, if a company operates in a heavily regulated industry, it may face compliance risks or legal challenges.
HOW DOES COMMERCIAL DUE DILIGENCE FACTOR INTO VALUATION?
Advisors (like Athena Consulting Partners) or corporate development teams find a well-done CDD report invaluable to value the business.
Here are some ways to factor in the results of CDD in a valuation:
Adjustments to financial projections: Based on the findings of CDD, adjustments may need to be made to the company’s financial projections, such as revenue growth rates, margins, or capital expenditures. These adjustments can help reflect any risks or opportunities identified, and provide a more accurate estimate of the company’s future cash flows.
Factoring in risk: CDD can help identify risks associated with the target company’s operations, market, competition, or regulatory environment. These risks can be factored into the valuation by adjusting the discount rate used in the discounted cash flow (DCF) analysis. A higher discount rate may be appropriate if the target company is exposed to significant risks that could impact its future cash flows.
Synergies: CDD can help identify potential synergies between the target company and the acquiring company, such as cost savings, revenue growth, or market expansion opportunities. These synergies can be factored into the valuation by adjusting the cash flows.
Market comparables: CDD can help identify how the target company compares to other companies in the same industry or market. This information can be used to select appropriate market comparables to use in a relative valuation analysis.
WHEN IS CDD NOT PARTICULARLY USEFUL?
A CDD report is almost always useful but it’s not without expense and effort invested. Here are a couple of scenarios where it might not be helpful.
Distressed assets: In the case of distressed assets, such as bankruptcies or liquidations, the focus of the acquisition may be on acquiring assets or intellectual property rather than the commercial viability of the business. In such cases, the acquirer may not need to conduct CDD, but may instead focus on other types of due diligence, such as legal, financial, or operational due diligence.
Small acquisitions: For really small acquisitions, the cost and complexity of conducting a broad CDD may outweigh the benefits. In such cases, the acquirer may rely on publicly available information, such as financial statements or industry reports, or internal subject matter experience to evaluate the target company’s commercial viability.
As an acquirer, a CDD effort is worthwhile to consider – but use the specific circumstances of each transaction to determine the appropriate scope and level.