The common case: The target asset (i.e., the target company) has a demonstrated track record of running a good business, enjoys healthy margins and some nice growth. The research indicates that drivers of demand are strong and sustainable. But the diligence also surfaces the fact that none of the providers, including the target company, have a materially differentiated solution – and the market is fragmented.

The service itself may not demand all that much differentiation (e.g., like dentistry may not), or the customers may be ill-equipped to discern genuine differences in service or product quality (again, like dentistry). There are plenty of healthy businesses where a majority of customers have insufficient expertise to pass great judgement, and feel more comfortable trusting the expertise of the “professionals.” Customers view outcomes in binary terms: Did it work? Was it easy? Example industries: dentistry; auto repair; dry cleaning; insurance; plumbing repairs; and many more.

When faced with what looks like a healthy business – e.g., healthy margins, strong ongoing demand, less than sophisticated operators – it is all tempting to buy into a management plan based on market share growth and an early track record of the same. But too many times, the promised economies of scale fail to materialize, differentiation proves insufficiently noticeable or valuable with too small a segment (of the market).

A potentially greater view: However, these fragmented markets may present a greater opportunity – if you take a different angle.

When these attributes exist - i.e., fragmentation, largely undifferentiated players enjoying distributed share and reasonably strong profit margins -– a greater opportunity often exists in a strategy (and a potentially a fantastic platform strategy) centered on becoming a supplier to this healthy market.

When your diligence uncovers one of these situations, take a look at the value-chain, as well as the supply-chain, associated with providing the good or service. Typically, operators share a common vendor-base with their competitors. The operators do not have sufficient scale to invest in proprietary and differentiating solutions, yet they benefit from products and services that create operational effectiveness. Given that they serve a strong end-market they represent a great customer base with a robust willingness to pay.

We suggest taking these five steps:

1. Interview Operations, and ask about how key operating activities get done. Dig in and discover what requires too much effort, too many dollars, what is subject to insufficient quality or reliability and causes a bit too much frustration. Now move on to the other functions. Ask what they would love to do or have, but don’t have the know-how or the resources. Remember that these may be customers who can afford to spend to make things better (given the end-market)
2. Examine the expenses (including labor) to see where time and dollars are being spent – even the smallest of categories can open up clues as to the customer search for solutions
3. Ask functional leaders the names of vendors that have been making life better (and how)
4. Determine whether any supply categories are over-served by horizontal players – and if there is room for a greater vertical play that emphasizes the unique specialization of the market
5. Take your same ideas to competitors of the target company, and see where they have common responses

In most cases you will find an ecosystem serving this healthy, but fragmented, customer base. This can make for an outline of a strong platform play - and one with customers who lack strong purchasing power (due to the fragmentation) serving a strong end-market. Given the narrow (and common) definition of businesses being served, you will also likely see that many of the services and products in the value chain inherently get integrated by the operators to produce an end product or service – although in a non-optimized fashion - furthering your prospect for a platform that exploits economies of scope.

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