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By Chris Fay, Greenwich Strategy

Investors who are doing commercial due diligence the way they’ve always done it are almost certainly missing opportunities to own great companies.

Commercial due diligence used to be a confirmatory step at the end of the acquisition process. In today’s tough market it’s got to be front-loaded. It serves not so much to steel the buyer’s resolve as to test whether any real resolve should be built.

But it can and must do much more than that. If conditions are there to allow it (if there is an edge to be found), commercial due diligence done right will deliver insights that justify paying a price that looks too high to the uninformed. That’s pretty much the definition of a buyer’s edge.

From our front-row seat to roughly 500 middle-market PE investments over the past about 20 years we see four characteristics of edge-delivering commercial due diligence. Each is briefly explained below, with a case in point.

Be blind. The richest insights often arise when an investor seeks out and speaks with informed parties without the involvement of the seller.

Case in Point: Aircraft Repair

Inexplicably high target-company growth in the past few years was an obvious due-diligence priority. Customer interviews did a fine job of revealing that the service provider was capable, responsive, and delivered good value for the price. But decision-makers in the maintenance department, while well-placed to speak to the target company’s performance, were unable to shed light on their very high rate of spend growth on the target company. It took “blind” conversations with managers outside the maintenance area to piece together a case-cracking insight: The level of the kind of repairs the target company does rises disproportionately with the age of planes. Moreover, a nationwide rise in average plane age (with its roots in order cancellations going as far back as 2001) resulted in unusually high market growth for the target company. And since average plane age would not/could not fall anytime soon, the target company’s top-line growth could be predicted with strong confidence to stay high for years to come. In fact, the buyer’s base case called for growth in excess of selling material estimates.

Interview competitors’ customers. Conducting research on target-company customers is the core of commercial due diligence, but it’s almost never sufficient. It is almost always essential to conduct research among competitors’ customers.

Case in Point: Pro-Grade Trailers

Another case study in which target-company growth seemed too good to be true was in the pro-grade trailer industry. While a cyclical recovery was undoubtedly to blame for high market growth, the target company’s recent growth had been off the charts. Customer interviews were glowing, but again fell short when it came to explaining very high sales growth at the target company. The explanation was found through interviews with dealers of competing trailer brands. It became clear that the target company’s impressive growth was due much more to share gain than market growth. In turn, two driving factors were at work: 1) the target company’s website and e-commerce transaction support were so much better than any other in the industry that the target company was virtually the sole beneficiary of sales “migrating” to online, and 2) the target company’s product was, in technical terms, the coolest. Not only did the investor gain an edge from confidence in continued strong top-line growth due to share gain, but the risk of cyclical downturn – which at the start of due diligence was thought to be the key investment risk – was understood to be a veritable non-factor.

Interview competitors. The customer perspective almost always must be supplemented with rich learning from competitors.

Case in Point: Commercial HVAC Maintenance

Who wouldn’t want to hear what a target company’s competitors have to say? The trick is being able to pull it off with integrity, not luring people into conversations on a false or misleading basis. How to do so is not formulaic but it’s often possible. One way is to make it a collaborative process whereby competitors participating in the research can also participate in research findings. A great number of commercial HVAC contractors recently shared data and information in exchange for participating in study learnings. This critical stream of due diligence showed something no number of customer interviews could have: There is a distinct and significant range in customer profitability across end-market verticals. For example, data centers and hospitals are far more profitable, less price sensitive, more loyal customers than are retail establishments and many kinds of public-sector buildings. The variation in profitability that results from variation in competitors’ end-customer vertical mix was huge. As was the investor’s edge.

Do interviews before doing (certain) math. Some math, no matter how seemingly straightforward, should not be done until rich learning from customers and competitors has taken place.

Case in Point: Specialty Food Distribution

When Amazon said it would buy Whole Foods, it generated lots of talk about the demise of grocery stores, especially independent, regional chains, as well as the distributors that feed them. The math seems pretty straightforward: Grocer margins are razor-thin and if a given grocer loses as little as 2% of its sales volume to Amazon/the online channel, they’ll be out of business. But by resisting the temptation to do this math in the abstract, and first interview people in the know, a savvy investor learned that online grocery sales are no threat to specialty grocery distributors. On the contrary, it’s an opportunity. Better distributors will have the chance to gain share much more quickly than they otherwise could, to the extent online grocery distribution gains traction. The reason is simple: Such distributors are today and will in the future be the most efficient way for AmazonFresh and other online players to source specialty product.

After probing interviews revealed this simple truth, the right math to do became clear. An audit of product brands offered by AmazonFresh in different markets revealed that the greater their market share (which is directly related to how long Amazon’s been in a given market), the greater the amount of regional/niche brands offered. For example, Amazon offers virtually no meaningful level of regional/niche brands in its very new Chicago market, but in its very mature Seattle market nearly half the brands offered are regional/niche brands. And interviews showed that the way such brands are sourced is via the same specialty food distributors that carried those brands before Amazon entered the market. Rather than missing an opportunity by doing the “obvious,” but incorrect, math, the investor gained an edge, by first interviewing people in the know, then doing the right math.

Chris Fay is president of Greenwich Strategy, which he started in 1997. The firm does commercial due diligence for a select clientele of middle-market PE investors. Reach him at  [email protected]. Photo courtesy of the firm.