Five fundamental topics in Commercial Due Diligence
Commercial Due Diligence (CDD) is a vital aspect of the pre-investment process for private equity firms and investors. CDD is typically conducted before buying negotiations begin, in order to allow the potential buyer to assess the risks and potential of the target company before proposing an offer. CDD is often performed alongside Financial Due Diligence and Legal Due Diligence.
The purpose of CDD is to provide a holistic and comprehensive picture of the internal and external environment of the target company.
Acquiring a business is complex and challenging. A solid CDD process is always necessary in order to support a buying decision. It is desirable to get a clear view of the targets’ commercial attractiveness, it is even more of interest to conduct solid CDD when investors are not familiar with the market their potential target is operating in. Markets have their own dynamics and characteristics and can easily appear attractive on the outside. CDD should warn investors from targeting a company that appears attractive (based on its prior financial results and historic growth) but is actually active in a market threatened by competitive innovation, new regulations, shift in demand or other disruptive events.
The specific structure of a CDD report depends on the party responsible for delivery, the target company, scope of the research, timeline and available budget. Still, some fundamental topics are (almost) always present in the report:
Off course, intelligence needs to be collected about the target company. It is essential to make an assessment of the achievability of their business plan; is it realistic taken into account the internal and external environment? What does the current cost structure look like? Additionally, it is vital to learn more about the company’s historic and future strategy.
Also, recent developments within the company need to be considered. Was there a recent change in management team, restructuring, capacity expansion or lawsuit? The portfolio of the target company also needs to be assessed. How is their portfolio diversified and what are makes their products or services unique?This will provide a first indication of the competitive edge of the target company. In a further stage of the analysis this information is used to create a solid understanding of the ability to compete of the target company.
In order to provide a decent assessment of the market the target is operating in; it is of utmost importance to get insight in where the market is heading. Is the market mature? Which growth drivers and key developments do we see? Is the market susceptible for disruption? Can we identify a regulatory framework? Which substitute markets are evolving?
Sometimes, data about a certain market is not available. In that case it is necessary to estimate or model the actual and obtainable market value to get reliable insights in market shares and market growth. All the insights combined give a clear understanding about how market developments affect the (future) value of the target company.
Competition plays a major role in assessing the commercial attractiveness of the target company. Creating a better understanding of the competitive playing field is crucial. How are market shares divided among competitors? What is the intensity of the rivalry? Can the market be seen as consolidated or fragmented? Part of this is creating competitor profiles of the key competitors and identify how the target company is positioned in the value chain.
Next, it is necessary to estimate future competitive threats. Think about companies competing in a related market, or companies from other geographical markets with expansion drift. Depending on the level of competitive intensity within a market, new competitors will enter the playing stage. The entrance of new competitors in a market is more likely when there are high profit margins, no major entry barriers and when there is still a high future growth potential.
In analysis of customers of the target company, it is imperative to first define who we see as a (potential) customer. This demarcation helps to keep focus and reduce the scope. Next, customer profiles can be made with the right segmentation. Are the customers other companies or consumers? What is their purchasing behaviour? Are customers easily switching between different brands?What are they willing to spend? Also, conducting an order analysis and get understanding of the distribution channel is essential.
A crucial element are the key buying criteria; are customers making their purchase decision based on price, quality or service, and how is the target company performing on those criteria?
Relevant buying criteria provide context for solid competitor analysis, it enables to draw a framework in which the competitors and their products can be valued or scored. It also supports in assessing whether the target company has a strong and defendable position with respect to customers. Pinpointing the right buying criteria is a tough task, but when done right, the information is invaluable.
Revenue and pricing
Last but not least it is useful to take a deeper look into the balance sheet,P&L and cash flow of the target company. Where is the main revenue deriving from? Are cost and revenue projections reasonable? How much can the target company be expected to make over a set period of time? Prices can fluctuate over time; what is the forecast for prices in the future and what factors affect the price? Examining revenue and pricing structures can also be shared with activities performed in Financial Due Diligence.
Of course this list is not complete. The exact content of a CDD report truly depends on the profile of the target company and the specific characteristics of the business environment. However, these five topics are always present and absolutely essential as building blocks for a solid CDD report.