Commercial Due Diligence

The Key to Understanding Value in an Acquisition

Peter Howson

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317163800
• Edition: 1
• Topic: Business
• Subtopic: Business Strategy
• Index: Business

Commercial Due Diligence (CDD) is about telling the difference between superior businesses and poor businesses, which is why this book is a mixture of business strategy, marketing analysis and market research. However CDD is not about the bland application of analytical techniques, it's about understanding how businesses and markets work and what is really important for profits and growth. Commercial Due Diligence is written by someone with over 25 years' experience of practical strategic analysis who nonetheless has a strong academic grounding. For the first time here is a book that deals with the essentials of strategic analysis with the practitioner's eye. If you are in the business of formulating company strategy, and you want to see how to apply the theories and understand in practical terms what works, when, and what can go wrong, this is the book for you.

Part I The Basics

Introduction

Commercial due diligence (CDD) is the poor relation of financial and legal due diligence and although now widely used, it is still misunderstood by many acquirers and professional advisers who frequently regard it as a bit of customer referencing combined with some market data gleaned from a published report. This first part of this book shows why CDD has to go much further than its financial and legal counterparts and discusses how to organize and structure a due diligence programme to get the maximum value from it.

What's It All About?

DOI: 10.4324/9781315572840-1

CDD is all about understanding customers and markets. The idea that acquirers should investigate the customers and markets of the companies they were buying did not really take off until the early 1990s. Strange this when the value of any business is its future profits and profits depend on the strength of its market and its ability to sell to its customers.

Key to the development of CDD in the UK was the Ferranti story. Ferranti was a sizeable, publicly quoted, defence electronics company with sales of about £800 million. In 1987, it purchased a US defence electronics company called ISC. Not long after the deal was done, it became obvious that ISC had boosted its profits by creating $1 billion worth of fictitious contracts and transactions through offshore companies. Eventually Ferranti was dragged down by the weight of the $700 million it paid for a company that had little real sales, and had existed primarily on illegal arms dealings. The company declared bankruptcy in 1991 and sued ISC’s CEO, James Guerin. Guerin claimed he had been working for the US government, but was disowned, and was eventually convicted and sentenced to 15 years for defrauding Ferranti of $1.1 billion, money laundering and illegal arms exports. Ferranti sued ISC’s auditors for negligence. An out of court settlement of £40 million was reached, but that was scant comfort to shareholders who had owned a company with a market capitalization of £800 million before the ISC deal.

Although it is still scary how little some acquirers know about the businesses they are buying, CDD has evolved over the last decade and a half or so from the sort of customer referencing that Ferranti could have done with to more of a mini strategy review. As the market for companies tightened during the 1990s, so the need for CDD became increasingly recognized as an essential part of the deal-making process. Case Study 1 illustrates why. No longer were acquirers content to listen only to management’s assessment of the target company’s market prospects. With more and more of the deal value resting on growth and synergies they had to understand the target in depth.

Case Study 1 Using Cdd to Run Rings Around the Industry Giants

How did a small company manage to beat the giants of the software industry in an auction for a software provider? This was not a big deal as these things go, but nonetheless there was an impressive list of acquirers competing to acquire a small British payroll software company. Names included some of the biggest and most powerful in the industry, some of them household names, most of whom could have bought the target with their loose change. The winner was a tiny outfit. It outbid the others simply because it understood the target’s market best. It took the trouble to work out the target’s value proposition and how the target’s software fitted in. The target’s customers were providing a payroll bureau service. Its software was vital to their service but its cost was only a fraction of their overall cost base (this is a theme examined in more detail in Chapter 8). The winning acquirer knew the target could increase prices without damaging the business first because price was not that important to its customers and second because they were locked into using the target’s software. It factored this into its valuation and won the auction.

At the same time a new breed of acquirers, private equity houses, have become significant players in the market for companies. Private equity returns come from buying established businesses and selling them at a higher price three to five years later.¹ In order to sell at a higher price, investors must either buy well or improve the business while it is under their stewardship. The days of picking up a misunderstood subsidiary of a distressed plc at a bargain price are long gone. Nor does the modern-day private equity investor put too much faith in price/earnings (P/E) arbitrage – buying in unfashionable sectors at low multiples and selling on at higher P/Es when they come back in fashion. Figure 1.1 shows how private equity investors typically make companies worth more when they sell them than when they bought them. Something like 70 per cent comes from improvements in the trading position of their investments, of which half comes from operational improvements and half from market and sector improvements. The remaining 30 per cent comes from their deal-making abilities.

Figure 1.1 The sources of value added to portfolio companies in private equity transactions

Note: The numbers refer to the per cent of total value added

Typically, private equity houses want to make a minimum internal rate of return (IRR)² on their investments of 25 per cent. This is roughly equivalent to doubling their money over 3 years. To achieve this and to make sure they make full use of their limited equity resources, the capital structure in private equity deals must contain as much debt as is sensible. The reason for this is shown by the charts in Figure 1.2, which set out the mechanics of private

Figure 1.2 Achieving 25 per cent IRR with 50 per cent debt and 75 per cent debt

equity. Both charts show how much the value of a company bought for £20 million and held for 3 years must appreciate to give a compound return of 25 per cent per annum to shareholders.

If the deal is funded 50:50 debt:equity (the chart on the left-hand side), the business has to be worth £29.5 million at the end of year 3. The £10 million debt can be repaid leaving £19.5 million for the shareholders. If the deal is funded with 75 per cent debt the business only has to be worth £24.8 million at the end of year 3 for the investors to make their annual 25 per cent return. Once the £15 million debt is paid off, shareholders are left with £9.8 million, just under double their original £5 million stake.

What level of debt is ‘sensible’ depends on the size of the target’s cash flows and their variability or, more crudely put, it depends on the chances that the target will not be able to meet its interest bill, because if it does not it will go bust. The more the variability of earnings, the higher the perceived risk. Figure 1.3 shows two companies with the same average, or expected, cash flows.

Figure 1.3 Two very different commercial risks

The cash flows for Company A are much less variable (and hence much more predictable) than they are for Company B. Moreover, if both have to meet interest payments of Z, there is no chance of Company A going broke, but there is a chance that Company B will. This variability in cash flows is called ‘commercial risk’.

Looking at Figure 1.3, it does not take a financial genius to see that the higher the level of the annual interest bill (Z), the higher is the risk of failure too. Just where Z is depends on the level of debt (and the interest rate). This is called ‘financial risk’. It is the amount of fixed obligations – that is, debt – in the capital structure.

So, going back to Figure 1.1 for the moment, investors can take on debt to improve their own returns, but they are also taking on more risk because they are adding financial risk (in the form of debt) to commercial risk (the variability in cash flow stemming from market and competitive forces). For a given level of risk, there are any number of combinations of financial and commercial risk.

The lower the commercial risk, the higher the financial risk can be. For the private equity investor, this means the lower the commercial risk, the more debt can be taken on, less equity is needed and, if all goes to plan, a higher return. Private equity investors, therefore, need to understand commercial risk so that they can value the business and, as important, so that they can sell the desired financial structure to the lending banks. This is what makes CDD so important. It provides private equity investors with an independent assessment of a company’s prospects, which helps them secure the debt funding they need to make their deals work.

If you thought banks only look at the books, you would be wrong. Lending banks look at any proposal brought to them in terms of risk and reward.

Ideally what they want is strong, stable cash flows and just like the private equity investor, they are well aware that financial risk magnifies the underlying commercial risk (and reward), as illustrated in Figure 1.4

Figure 1.4 The variability of un-geared and geared cash flows

Note: Illustrative only

This means that the lending banks need to understand the commercial risk in detail in order to structure debt packages so that they receive an acceptable risk/reward profile across their portfolios. In turn, this means understanding how the future cash flows of the business will perform and repay the debt, reinforcing the importance of CDD. A well-established business with a good track record of profitability helps the ‘story’ immensely, but lending banks will focus as much on the commercial prospects of the business as they will on past financial performance because, just like the private equity investors, they need to understand the relative financial and business risks under different capital structures. Low commercial risk makes the banks more relaxed about high levels of debt funding, high commercial risk means funding must be more skewed towards equity.

What is CDD?

As already mentioned, CDD is all about understanding customers and markets. In its simplest form, it is customer referencing. What do customers think of the company you are thinking of buying? Are they all about to take their business elsewhere or are they about to double their orders because it does such a great job? ...