Last year was an unprecedented time for private equity. Assets under management soared to $6.3trn, total deals valued $2trn and fundraising surpassed $1.2trn. Multiples held near all-time highs, and private equity returns outperformed other private asset classes.

The pressure to deploy capital remains as strong as ever despite rapidly changing market conditions. Supply chain shortages, the war for talent, geopolitical uncertainty and rising inflation and interest rates all create great risk and uncertainty.

Throughout 2022, more than £500m will be spent on commercial due diligence in the UK. In this testing landscape, diligence providers that simply flag risks and dwell on the negatives are rarely helpful. The same is true of those who doggedly bless every deal, without appreciation for the nuances or dangers of an opportunity. Nobody has time to read lengthy reports that skirt around key questions, lack deep customer insight and apply “cookie-cutter” approaches to important topics. 

The art of commercial due diligence is to present a balanced view of risks that may be mitigated, weaknesses that may be overcome, and value creation opportunities that may afford upside above and beyond the plan. Excellent commercial work achieves this through quality of insight, depth of primary research and an acutely analytical point of view.

Therefore, how can we ensure commercial due diligence fulfills its full potential in the current market?

Phase-zero

We’re seeing a pronounced shift from clients in private equity towards conducting more, “pre-deal” work earlier. Involving diligence providers sooner, and phasing the work, ensures concerns are flagged quickly and allows buyers to drop out from processes early if necessary, freeing up resource for other opportunities.

It also supports the relationship-building effort, demonstrating commitment and arming clients with different viewpoints when meeting management, indicating the ability to be effective board members that maintain a focus on the most pressing issues.

Most of all, developing a clear value-gen strategy to support today’s multiples takes time, and starting sooner enables far better development and testing of well-developed and non-obvious investment ideas.

Crafted and targeted

Commercial due diligence is a rare opportunity to take a fresh look at a market and company. Fundamental topics should, of course, be covered (market size, growth prospects, competitor mapping, etc.), but so too should the acquirers’ most pressing questions.

Definition of scope ensures that every ounce of effort is directed towards the highest-value activities. Spending additional time on scoping helps to avoid the “cookie-cutter” approach – not every project should look alike.

Through investing extra time on scoping, private equity firms empower the diligence provider to investigate the topics that truly matter in depth. The additional insight this creates may uncover a different angle, new risks, or justify a higher bid price.

Fully involve management

Too often, management teams regard commercial due diligence as a “tax” to be paid on the deal process, and another hurdle to be jumped in a grueling race. To avoid this frustration, the diligence team should work hard to generate management buy-in, fully involve them in the exercise, and offer a chance to have their questions answered.

Ultimately, the insights that a commercial due diligence report generates (both quantitative and qualitative), should equip management with a unique view of opportunities and risks.

We often find that management teams have a much longer list of new ideas than could ever be properly executed in a private equity hold period. Prioritising the best ideas (and ending debates on others) can drive focus from day one of the investment, enabling businesses to move further and faster.

Future KPIs

However strong a business plan might be, its execution needs to be carefully monitored, measured and iterated, based on relevant and accurate data. Post deal, only tracking financial performance is insufficient, as those numbers often fail to illustrate the specific sources of performance gains (or losses) and how they relate to the execution of your plan. The data also needs to be put into context. For example, how company performance compares to sector performance.

Ideally, commercial due diligence should build consensus on the right metrics to track success (e.g. growth of specific customer segments; customer satisfaction; ability to achieve premium pricing), capture a snapshot of those metrics, create a baseline against which to launch the 100-day plan, and develop a yardstick to measure future growth.

Deep primary research

In private equity, recurring themes are commonplace. In a rapidly changing market, it is important that these themes are not “taken for granted” as being indicators of value and potential.

To gauge emerging market sentiment, commercial diligence should harness the “wisdom of the crowds” at scale to unpick the nuances of a market and question these assumptions. In practice, this means actively seeking sources who challenge an investment thesis and understanding why, rather than settling for a handful of cursory “tick box” customer reference calls.

In a market where yesterday’s “safe bet” may today be a risky option, the importance of this approach cannot be understated. It can also bear fruit; unloved themes from the past may prove to be more attractive than they once were.

Access the full piece published in Real Deals here.