Strategic M&A Due Diligence Should Look to the Future
The business world has changed dramatically over the last two years. While some changes brought on by the COVID-19 pandemic are expected to be only temporary, others are expected to last indefinitely. When buying a business, it’s imperative to evaluate its expected future performance, rather than focus on its historical results. While the future can’t be predicted with complete accuracy, analysis of historical trends and other information that is known or knowable about the company at the present time may be helpful in projecting future cash flows. Strategic due diligence can help vet an acquisition’s potential success or failure.
Adding a Layer of Assurance
Legal, financial and operational due diligence help determine value, uncover risks and establish a fair purchase price. But strategic due diligence specifically addresses whether a deal is realistic and not simply overly optimistic on the buyer’s part. It should be considered additional to the usual screening processes.
Strategic due diligence evaluates a deal and explores its rationale from the following four angles:
1. The market. The success of a merger or acquisition will depend largely on the health of the target company’s market. For example, is the market expected to continue growing at its current rate or is it maturing? And how will technological advancements affect market activity?
During the market investigation, it’s important to determine current market size and its competitive characteristics and drivers. Then segment growth must be forecast. Rather than relying solely on data from the target company’s management, consider talking to customers, competitors, industry observers, suppliers and regulators for an unbiased perspective.
2. Customers. If the target company has an up-to-date customer database, a five-year study can help clarify trends and potential risks. This analysis starts by identifying major customers and analyzing their key purchase criteria. Is their business based on personal relationships with key personnel? Also consider negative indicators, such as service or product complaints, low loyalty rates, or delinquent payments. This data is essential to determining how well the company is currently meeting its customers’ needs — and how well it will sustain growth and revenues in the future.
3. Competitive positioning. It’s important to evaluate whether the target company has successfully differentiated itself from others in the market. Does it have adequate resources and capabilities to stave off the competition? What is the competitive edge of new market entrants? What type of consolidation or divesting activity has recently occurred in the industry? Sometimes sellers’ motivations stem from impending competitive threats that won’t be obvious from your due diligence.
4. Management. Ideal market conditions and a differentiated competitive position will be all but lost on an ineffective management team. Assess the capabilities of individuals and groups to determine what — and who — is working.
It’s particularly important to ask whether the current management team will be able to deliver on the deal’s anticipated value. Regular management due diligence, such as background checks, is a necessity. But consider conducting competency-based interviews, too. Look for managers who can adapt to change and implement decisions quickly. These characteristics will be crucial during the integration period.
Buyers who dig deeper into a target company’s strategic operations may be able anticipate post-acquisition risks and opportunities, helping them maximize their returns on investment. Unfortunately, most buyers have limited M&A experience.
But there’s a silver lining: You don’t have to conduct strategic due diligence alone. Consider hiring an experienced outside financial expert to help vet a deal. The right expert can perform extensive research that considers not just the past, but also the future.