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Commercial due diligence

What is commercial due diligence?

What is commercial due diligence?

Commercial due diligence processes evaluate a company's growth potential, competitive landscape, customer relationships and overall operational capabilities. It's a critical step in mergers and acquisitions (M&A) and provides insights into whether the future business plan is realistic.

It's about developing a deeper understanding of the following key questions: What's the target's growth potential? How does it stack up against competitors? Is the target company's market position as strong as it seems? How loyal is the customer base?

The process aims to generate valuable insights regarding the target's growth potential and overall market trends. This diligence process enables investors to understand the market dynamics and make informed decisions.

Benefits of a buy-side commercial due diligence

Benefits of a buy-side Commercial Due Diligence

When investors engage in the commercial due diligence process on the buy side, they focus on several critical areas to ensure their investment is sound. Private equity firms, for instance, often have a diligence checklist that guides their analysis. Here are the key points they typically address:

Validating the growth potential of the business plan

The primary benefit of commercial due diligence for a private equity firm is the rigorous validation of the target company's business plan. This validation process encompasses assessing market dynamics, competitive positioning, and growth projections, ensuring that the assumptions in the business plan are realistic and achievable. This is crucial because the success of the LBO model hinges significantly on the accuracy and feasibility of the business plan's growth forecasts.

Confidence in LBO calculations

A validated business plan directly impacts the confidence level in the LBO calculations. For an LBO to be successful, the top-line growth (revenue growth) needs to align with the projections. When due diligence confirms the viability and robustness of these projections, it provides private equity firms with a firmer foundation for their financial models. It reduces the uncertainty around future cash flows and the company's ability to service debt, which are critical components in structuring and executing a successful leveraged buyout.

Benefits of a sell-side commercial due diligence

Benefits of a sell-side Commercial Due Diligence

Sell-side commercial due diligence, primarily aimed at private equity firms, serves specific purposes in business transactions. These potential investors may not have an in-depth knowledge of the market like a strategic investor might. Here are some reasons why a seller might proactively conduct a commercial due diligence:

Mainly targeted at private equity investors

Sell-side due diligence is particularly valuable for private equity investors needing more detailed market knowledge. Unlike strategic investors, who are expected to be familiar with the market, private equity investors benefit significantly from the comprehensive market insights provided in these reports.

These sell-side due diligence reports are typically accessible only to financial investors, not strategic ones. A strategic investor should already know the market dynamics of their industry. Furthermore, providing such detailed insights to strategic competitors could give them a competitive advantage, something that sellers want to avoid.

The seller can include more private equity firms in the M&A process

The seller reduces the diligence burden for potential buyers. Once a prospective buyer is seriously committed, there will be a standardized market due diligence report for every financial investor. This streamlined approach makes it possible to include more private equity investors in a sell-side M&A process. This will help foster a more competitive environment for the sale.

Accelerating the deal process

For a prospective buyer, a sell-side due diligence offers a quick deep dive into the market, significantly speeding up their decision-making process. Since the provided information is comprehensive, their management consultants only need to verify the details instead of starting from scratch, accelerating the overall deal process.

Who conducts commercial due diligence?

When conducting commercial due diligence, the approach often varies based on the type of investor. Two common types of investors in business transactions are private equity firms and strategic investors, each with distinct methods.

Private equity firms

Private equity firms frequently turn to management consulting companies for commercial due diligence. Since private equity clients deal with a wide range of industries and need a thorough, objective analysis to validate their clients' investment theses for each potential investment, management consultants are their go-to experts.

These consultants offer a deep dive into various aspects of the target company, including market position, competition and growth potential. Their broad experience across industries and expertise in detailed market analysis makes them invaluable for private equity firms looking to ensure a good investment decision. Their input is critical in assessing whether the target aligns with the strategic and financial goals outlined in their clients' investment theses.

Strategic investors

On the flip side, strategic investors, who are often direct competitors or operate within the same industry as the target company, may opt to conduct commercial due diligence internally. These investors already deeply understand the industry's nuances, competitive landscape, and customer base.

Their in-house teams are well-equipped to evaluate the target company's market position and synergies. By leveraging their industry-specific knowledge and expertise, strategic investors can efficiently assess how well the target company aligns with their strategic goals and operational frameworks.

What does a commercial due diligence involve?

What does a commercial due diligence involve?

A commercial diligence process has multiple parts. The main goal is to understand the target company's business environment. This process is critical in mergers and acquisitions. All necessary aspects of the target's market, competitive landscape, customer base and operational capabilities need to be assessed and understood - almost like a commercial due diligence checklist.

Product or service evaluation

Evaluating a company's products or services is vital to commercial due diligence. This step involves a detailed analysis of the quality, uniqueness and demand for the company's offerings in the current market. Understanding how these products or services stand out from competitors and how customers perceive them is crucial.

This evaluation also includes examining the product lifecycle stages—introduction, growth, maturity, and decline—to gauge where the company's offerings currently sit and predict future performance.

Additionally, the company's capacity for innovation is scrutinized, assessing the robustness of its pipeline for new products or services and its ability to adapt to changing market needs and technological advancements.

This comprehensive product or service evaluation helps determine the target's competitive position.

Market and demand analysis

Market and demand analysis is fundamental in a commercial due diligence as it lays the groundwork for understanding the business landscape. This analysis dives into the market size, growth trends, adjacent markets and maturity of the company's market. By evaluating these factors, investors can gauge not just the current status but also the future growth opportunities.

A large and growing market signifies ample opportunities for a business to expand and increase its market share. Conversely, a stagnant or shrinking total addressable market might suggest limited growth potential.

Competitive landscape

The competitive landscape is about where a company stands among its peers. This analysis involves identifying key competitors, their market share and unique selling propositions.

It's not just about who the competitors are but how they operate, innovate and adapt in the market. This analysis also covers the competitive dynamics, such as new market entrants, potential substitutes for the company's products or services, and the intensity of competitive rivalry.

It also examines how external factors like technological changes or regulatory updates might shift the competitive balance.

Ideally, the target business is a market leader with a defendable market position with low competitive threats. You don't want to invest in one of the weaker companies in the industry.

Customer base

Understanding the customers is a critical part of a commercial due diligence. This involves segmenting the customer base by target groups and geographic locations to know where and to whom the company successfully markets its products or services. Such segmentation helps identify which customer groups are the most profitable or have the most growth potential.

Equally important is assessing customer loyalty and retention rates. High customer loyalty often indicates satisfaction with the product or service, suggesting a stable revenue stream. Conversely, issues with customer retention can signal underlying problems in product quality, customer service, or market position.

Understanding these aspects of the customer base provides crucial insights into the company's current performance and potential for future success.

Sales and marketing efficiency

This part of the diligence process assesses the effectiveness of the company's sales and marketing strategies.

A critical area of focus is understanding the methods and channels through which the company sells its products and services. This encompasses analyzing direct and indirect sales channels, online platforms, and the effectiveness of various marketing tactics in reaching the target audience.

A key metric in this assessment is the time taken to convert a lead into a customer. Sales conversion rates are also analyzed to gauge how well potential leads are transformed into actual sales.

How is commercial due diligence different from financial due diligence?

How is commercial due diligence different from financial due diligence?

Financial due diligence

This diligence process is all about numbers and financials. Financial due diligence dives into the financial health of a target company. It involves scrutinizing financial statements, cash flow, debts, assets and liabilities. The goal here is to validate the seller's financial information and ensure there are no hidden financial risks.

A prospective buyer will look at things like revenue and EBITDA splits, quality of earnings, net debt and working capital management to get a detailed financial view of the target company's financial performance.

Commercial due diligence

On the other hand, a commercial due diligence is about validating a company's business plan with its growth potential.

It's about understanding the business's overall demand, place in the market, competitive landscape and customer loyalty. This involves analyzing market trends, customer base, product or service viability, and competitive positioning. The focus is on the potential for future success and growth.

While financial due diligence looks at the present and past financial health, commercial due diligence is forward-looking. It's about the business's potential and ability to navigate and capitalize on current and future market conditions. Both forms of due diligence complement each other to give a holistic view of the target company's overall health and potential for success.


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