More Than You Wanted to Know About Commercial Due Diligence

If you are new to mergers and acquisitions (M&A), contemplating a career in Commercial Due Diligence (CDD), or if you are an owner trying to understand what your investment banker is trying to convince you to spend money on before taking your company to market, you have come to the right place. In this post, we are going to cover:

• What is Commercial Due Diligence?
• Why is an industry study useful, and how is it used?

• When is a CDD report typically commissioned?
• How is the market defined in an industry study?
• What is typically covered in a CDD report?
• Is your CDD report Canned or Custom Made / Fitted?
• What is TAM, SAM, and SOM?
• What is market penetration?
• What is VOC?
• Supply Side Builds vs. Demand Side Builds and Triangulation
• Why is segmentation important?
• Why is the standard forecast period five years?
• Remember it is a map, not reality
• Why do some consider CDD one of the harder M&A fields in which to work?

What is Commercial Due Diligence?

Commercial Due Diligence  is one of the common third-party studies commissioned during M&A transactions. It is also referred to as Industry Due Diligence. Broadly speaking, commercial due diligence helps map the market in terms of market size, penetration or adoption rates, growth rates, customer segmentation, purchasing behaviors, and competitive dynamics. From these studies, investors seek to understand the overall industry dynamics, nuances on how the industry functions, the size of the potential opportunity, and the competitive landscape and level of market differentiation. Investors want to understand both (i) the overall industry and (ii) how a specific target company is positioned in that market. In other words, good commercial due diligence is performed through a specific, rather than general, lens.

Why is it useful, and how is it used?

Reviewing commercial due diligence studies can test and inform the underlying tenants of an investment thesis.  Market size, penetration rates, growth rates, competition, and differentiation are common areas of focus in market studies.

In addition to testing and informing underlying tenants of an investment thesis, these reports are used by investors in preparing investment committee memos and in post-close strategic planning. CDD reports are frequently shared with other parties involved in completing transactions, such as prospective lending partners, other co-investors, and rep and warranty insurance providers, among others. When commissioned on the sell side, CDD reports are used by sellers and their investment banking advisors to educate prospective buyers and to highlight and position investment highlights.

When is a Commercial Due Diligence report typically commissioned?

Commercial due diligence  reports can be commissioned by prospective buyers or the seller. On the sell side, investment banks regularly encourage their clients to commission a CDD report or market study. This serves to educate and inform prospective buyers, which allows them to move faster in getting up to speed and hopefully making them more confident in their bid for the company. A good CDD report also provides the seller’s investment banking advisor with more information to highlight and position in packaging the business for sale by including some of the findings in key offering documents like the teaser, confidential information memorandum (CIM) or confidential information presentation (CIP), and the management presentation. Much like any other sell side due diligence activity—e.g., financial due diligence (FDD)—commissioning a sell side CDD report has the potential to identify issues that buyers are likely to uncover, providing the seller and their advisors with the ability to preemptively address, reevaluate, remedy, or otherwise position before going to market. It makes it less likely there is an unpleasant surprise issue that gets surfaced by a buyer, which could stall the process, impair valuation, or result in an unsuccessful or busted sale process.

Sell side CDD reports are usually commissioned a few months before the investment bank is planning to take the company to market. The scope of a sell side report can be significantly different than that of a buy side report. The seller wants to highlight the attractive qualities of their industry and the target’s performance within it. Areas known to be less attractive or might detour prospective buyers may be thin or non-existent in the report.

Sometimes rather than commissioning a fuller scoped CDD report, a seller may commission a targeted report, where providing a third-party published view of a particular issue may alleviate concerns or highlight a key investment consideration. For example, in a physician practice roll-up where the business being sold has a particularly unique physician partnership model, surveying and interviewing the target’s physicians vs. a control group of other physicians serves to highlight this investment consideration in a way that is more impactful than the target company merely touting it themselves.

Buy side CDD engagements are typically commissioned post signing of the letter of intent (LOI). Based on this, one may conclude that little to no work is done before this point on understanding the industry, but they would be mistaken. When diligencing a Target, most investors perform their own desktop research and they will often speak with experts—typically sourced via expert networks like GLG, Guidepoint, and Alpha Insights. Keep in mind, many prospective buyers are industry specialists or invest heavily in specific sectors, providing them with a base of knowledge and limiting the need for in-depth third-party research. Established investors also have libraries of CIMs/CIPs, sell side reports, and other data sources that can provide information on overlapping spaces.

Not all buy side reports are commissioned post-LOI. Investors wanting to win a deal in a competitive space may commission a CDD report earlier in the process—before LOIs are due. Some may have an industry or sector driven thesis and may have even commissioned work in advance to understand the attractiveness of the space and then run a search to acquire a platform asset.

Sometimes prospective buyers will attempt to run a phased approach for their third-party CDD work. They may engage a CDD provider to focus on specific, more critical industry related issues to their investment thesis. For example, if there is concern about the market size, a phase one engagement may focus just on establishing a baseline for the market size. This may be done earlier in the sale process, and other topics like the competitive landscape and voice of the customer may only be added as a phase two engagement if diligence checks out and the prospective buyer moves into the later stages of the sale process.

How is the market defined in industry studies?

Commercial due diligence reports are customized to a particular buyer’s needs and wishes, and this starts with defining the market to be studied. While this seems like it would be an obvious exercise, it is often far from obvious. Companies may offer more or fewer products or services than their competitive set, so it must be determined which products and services will be studied. It is common for companies to operate in multiple niches and/or end markets, so is the CDD study to cover one or multiple industry segments? Investors may be interested in adjacent spaces as well, to help assess other growth opportunities.

What about geographic considerations? Which geographies does the target company currently serve? Is the investor interested in just the target company’s geographic footprint today, or are they interested in a broader geography to assess for expansion potential? Is it enough to understand the U.S. vs. ex-U.S. / rest of world market delineation, or is it necessary to understand the size of specific countries or regions that comprise the ex-U.S. market?

Many private companies operate in industry niches or segments that are subcategories of larger industry verticals. For example, if the target company provides accounting software for small and medium sized businesses, like Intuit’s QuickBooks, should the market definition include or exclude accounting software providers that focus on larger enterprises, such as those serviced by SAP, Oracle, and NetSuite? There is not a right or wrong answer here, it depends on what is important to the investor, their investment thesis, and what growth avenues they envision or want to better understand.

Not all companies in an industry niche necessarily have the same revenue model. For example, if we are studying the market for fitness trackers or fitness wearables, some of them have a recurring revenue subscription model, others only sell the device as a one-time sale, and an increasing number have the device sale coupled with a smaller subscription component. Determining how the market size will be measured—in this example recurring subscription revenue vs. one-time device sales—needs to be considered and agreed upon with the investor to make sure they are getting the information they seek.

Being able to thoughtfully articulate the market definition to diligence requires a fundamental understanding of the target company, its value proposition, and the end markets it serves. Foundational Questions^TM are a useful tool to do just that.

What is typically in a commercial due diligence report?

While the scope and contents of a commercial due diligence  reports are custom and vary considerably, the most common topics addressed include those items listed in the table below.

Is Your Commercial Due Diligence Report Canned, Custom Made, or Custom Fitted?

There are numerous off-the-shelf, canned industry reports from such sources as Freedonia, IBIS, MarketsandMakets, among others. Many investors and investment banks have subscriptions to these resources and others. However, these off-the-shelf reports are often not specific or tailored enough to the needs of buyers and sellers in an M&A process. These reports often do not provide the assumptions or key metrics that go into assessing the market size, nor do they differentiate between addressable and penetrated market sizes. They often lack specific voice of the customer feedback and are largely devoid of non-public competitor information. Since they are off-the-shelf, they are unlikely to address idiosyncratic company- or deal-specific issues important to an investor’s investment thesis and underwriting criteria.

The stakes are too high to rely merely on these off-the-shelf reports. For public companies operating in large end markets, there may be sufficient coverage in these general market reports or other similar avenues; however, this is often the exception. Private companies often operate in markets that are too small or niche to have the visibility and detailed coverage required by investors and the questions they are trying to answer in a detailed fashion. Understanding the make-up and size of an industry is useful but only in context and comparison to the target company. As such, a custom approach to commercial due diligence is often necessary.

What is TAM?

TAM stands for Total Addressable Market, and it represents the total market or revenue opportunity if every potential customer purchased the product or service in question, i.e., if 100% adoption or penetration were to occur. TAM is usually enumerated as a revenue figure, but it can also be quantified as the number of customers, organizations, seats, users, units, or whatever other unit of measure that might be relevant or informative in a particular situation.

An example of this is the number of oil changes for vehicles in the U.S. There are approximately 280 million registered vehicles in the U.S. (using registered vehicles as a proxy for vehicles in operation), and the recommendation is that vehicles should have their oil changed twice per year. That means the TAM in terms of oil changes is approximately 560 million oil changes (i.e., number of vehicles times the frequency of oil changes). If the average oil change costs $50 to $100, then we might take the midpoint to arrive at an implied TAM of $42 billion (i.e., $75 times 560 million oil changes).

As evidenced by the above example TAM calculation, these are often estimates. After all, the TAM is a theoretical quantification assuming 100% of potential customers purchase the good or service. Oil changes are often bundled with other services, which can skew the pricing assumption, to say nothing of geographical differences. What about segmentation? Fleet vehicles that are commercially owned may negotiate a lower average price for oil changes compared to individuals. New cars often use synthetic oil, which costs more, but the frequency of required or recommended oil changes is less frequent. Even if it is recommended to change your oil twice per year, not everyone maintains their vehicle up to the recommended standards. Furthermore, not everyone goes to a third-party to change their oil. Some people change their vehicle’s oil themselves, but as we noted, a TAM provides the market opportunity as if everyone used a third-party for oil change services at the recommended frequency.

What is SAM?

SAM stands for Serviceable Addressable Market, and it represents the portion of the market that is readily addressable or can be credibly serviceable by a business. SAMs are important because not all segments of a market, particular geographies, or potential customers are readily addressable for a particular company.

Sticking with our vehicle oil change service example, if the business in question is a chain of oil change service centers with a geographic footprint in five Midwest states, then the SAM should be based on just the number of vehicles in those five states. To be even more precise, we might want to limit the SAM to those vehicles within a certain credible distance likely to be driven by consumers to one of the company’s oil change service centers. However, this more refined view gets closer to our next topic—the SOM.

What is SOM?

SOM stands for Serviceable Obtainable Market, and it represents the specific portion of the SAM that a company can realistically capture with its current strategy and resources.

As noted above, consumers are only likely going to drive so far from where they live and/or work to get their oil changed, so the obtainable part of the market might be the number of vehicle owners within a certain radius of existing locations. This does not mean that more of the SAM or TAM might not be able to be captured by opening more locations either within the existing five state region or outside of it. In our example, other adjustments to arrive at the SOM may be necessary. For example, those potential customers who change their own oil may not be obtainable in the near term (or at all). Or maybe the chain does not have sales personnel and/or relationships who can pursue commercial contracts with owners of vehicle fleets, thus the SOM might need to be decreased by the estimated number of vehicles that are part of a commercial fleet.

What is the penetrated market?The penetrated market refers to the actual size of the market today. Conceptually, it can be thought of as the portion of the TAM that has adopted a solution for the good or service in question. The penetrated market can be quantified on a dollar or unit basis, and it can be discussed as a penetration percentage rate (as compared to the TAM).

Low penetration rates or an underpenetrated market implies a large “whitespace” or “greenfield” sopportunity for companies to acquire more customers who are “unvended” or have yet to adopt a solution. For many markets, it tends to be easier to win new clients who have yet to adopt a solution than it is to displace an incumbent vendor. However, an underpenetrated market does not automatically signal a high growth market opportunity, as there could be viable substitutes or a marginal value proposition for the good or service.

A further note of caution for young, underpenetrated markets is warranted. Too often, management teams and investors claim there is no or limited competition in young or maturing markets. Monopolies are rare—valuable, but rare. Substitutes are broad and the status quo bias of not purchasing the good or service is competition unto itself. For example, some factories still have punch card systems. Habits and the status quo are persistent competitors. 

What is VOC?

VOC stands for Voice of the Customer, which is feedback, survey results, reviews, and interviews from customers, prospective customers, and sometimes industry subject matter experts in the market. VOC sections detail why demand exists, why customers buy what from who, how often, and at what price. VOC often provides valuable insights into the areas noted in the table below.

VOC can be a fundamental differentiator in the quality of a commercial due diligence  report. Not all CDD reports are the same. If the survey design is not well constructed and this is the source of pricing data or frequency of purchasing used in the market build, then the market size is going to be skewed. This is one reason to scrutinize a CDD report that only uses the target company’s pricing data to forecast the market, especially where there may be significant market segmentation among the customer base. Good data analysis often starts with understanding the variance of the metrics.

Poor survey design and/or improper use of industry terminology can also lead to fundamentally misstating penetration rates or similar important metrics. Like with anything, garbage in, garbage out.

When done well, VOC gives critical insight into the target company. It can give insight into how well the company’s sales team performs, if there are opportunities for price increases or upsells, or if the company has underinvested in areas like customer support. Insights such as these are immensely valuable not only in informing the investment decision but also in strategic planning, execution, managing the business, and helping generate a return all in the post-close period.

As the title suggests, VOC is technically focused on the Voice of the Customer.  However, soliciting feedback from other key market constituencies can shed light on key issues facing the industry and the target company. Thus, CDD often includes interviews and surveys with other constituencies, such as competitors, labor / employees, company partners, regulators, among others. 

Supply Side Builds vs. Demand Side Market Builds and Triangulation

There are multiple ways to estimate a market size, and it is often useful and instructive to use several methodologies to help triangulate on the likely value or range. You can use bottoms-up methodologies, and you can also take a more top-down approach. The earlier example of the vehicle oil change business where we took the number of vehicles times the frequency of oil changes times an average sale price is a bottoms up methodology.

More of a top-down approach might include a revenue walk or build up by competitor, where you add up the revenue for the competitors where you have the data then estimate the revenue for the rest of the competitors where you do not know their revenue. This tends to be an easier exercise in industries that are more consolidated with larger competitors who are publicly traded or otherwise have published revenue figures. However, even where the critical mass of competitors is not known, this methodology can be effective in at least establishing some bookends to the market size.

Like all methods, there are trade-offs, shortcomings, and challenges. Many businesses in the competitive set may offer ancillary services that are not part of the market you are trying to size. In one scenario, a commercial due diligence provider shared a rough cut of a TAM to a private equity client for a niche staffing business they were pursuing. The CDD provider’s TAM was one-third the size of what the private equity firm thought it was when they first bid on the deal. The PE firm cited the revenue of the three largest competitors equaling the CDD provider’s estimated TAM as evidence that the CDD provider was grossly understating the market size. However, the private equity firm conflated the core market with all the other revenue sources outside of the core market that these larger staffing companies offered. They were comparing apples and oranges. The competitors’ revenue included lines of revenue the target company did not offer. While the revenue walk was instructive, because it highlighted potential service line expansion opportunities, which could increase the overall potential TAM, the core market TAM of the target company was much smaller.

Going back to our oil change example, another way to triangulate the market size is to identify the number of firms or establishments providing vehicle oil change services. We might even be able to obtain other revenue driver variables, such as the corresponding average number of service bays per location and/or the number of oil change service technicians in the industry. From this, we could research and survey the average revenue per location, average revenue per service bay, and average revenue per employee.

The approaches we have discussed so far are all demand driven. It is often instructive to also look at a supply side market build where we estimate the market’s production capacity. Using select data from above, such as the number of service bays across the industry and/or service technicians (or FTEs), we can estimate the industry’s full capacity for oil changes. For example, a TAM for vehicle oil changes might look at the number of locations times the number of service bays multiplied by some input that approximates daily potential throughput. How many vehicles can a service technician service in a day? How many hours a week does a service technician work? What is the variance in both answers? Looking at just hours worked alone, taking the number of mechanics times say 37 – 40 hours a week would give you one estimate of potential labor capacity. However, industry dynamics and norms vary.  Maybe the industry’s labor model avoids paying benefits by capping hours worked per week. Or maybe there is a labor shortage, and the typical worker jumps on the overtime driving the average closer to 50 hours a week. Further surveying competitors could even identify the oil change utilization of available appointments to see how closely this estimate triangulates on the demand side penetrated market estimate.

Supply side estimates help identify how much capacity there is built in the market, and comparing it to the demand side estimates can often lead to interesting questions to further probe and/or insights. Often, people overlook supply side constraints to growth, such as the ability to hire skilled labor, time to build new manufacturing facilities, etc. Such calculations can help zero in on these potential constraints. Conversely, excess supply might signal a hypercompetitive pricing environment and margin pressure on market participants.

In the real world, data is messy, missing, and incomplete. This is even more true when you are working in compressed three-to-five-week periods to deliver a tailor-made report. Thus, a high quality CDD provider sizes the market in multiple ways, and when possible, from both the demand and supply sides, to triangulate a “true” market size. It is never as easy as just plug in a few numbers and bam, there is your market. 

Why is segmentation important in commercial due diligence?

Not all buyers pay the same price in a market and the purchasing frequency may vary as well. Assume for a second, you are selling software to city and county clerk’s offices. Large municipalities have larger budgets than small villages or less populated counties. The big ticket, high margin markets serving big municipalities have a pricing structure that is different from the smaller villages and counties. The larger municipality segment might represent 60% of the market on a dollar basis, yet only account for ~25% of the TAM on a unit basis (i.e., number of municipalities). 

Applying a single average price is likely to heavily skew the market size. Applying pricing based on segmentation will give a more accurate representation of the structure of the market. 

If the market for large municipalities is 95% penetrated, but the total market is 35% whitespace (i.e., unpenetrated), then the lion’s share of the unvended opportunity is in the mid- to small-size municipal markets. All growth (or other segment attributes) is not equal. 

Why is the standard market forecast period for commercial due diligence reports five years?

A typical private equity firm holds a portfolio company for three to seven years, with an average closer to five. It generally takes this long to drive sufficient operational and financial performance to drive the level of returns that these types of investors seek.

Before a private equity (PE) firm buys a company, they are already thinking about how and when they are likely to sell it to generate their sought-after return. The five-year forecast aligns with this average financial buyer hold period and helps inform the buyer’s perspective on what must be achieved within that window to hit certain financial performance metrics, which in turn is likely to drive certain investment return thresholds.

Any forecast is likely wrong. Going beyond five years is even more likely to be materially wrong.

Investors often get caught up on the accuracy of the market forecast. Obviously, a good commercial due diligence provider attempts to be as accurate as possible in their forecast. However, the utility is really in the exercise itself, as it challenges thinking about credible and likely achievable growth levers. A good market forecast decouples the growth drivers. In other words, how much is expected to come from unit growth, price increases, greater market adoption / penetration, or other levers? It should help the investor think more critically about each of these levers for the market, as a point of comparison to handicap each of those drivers for the target company. And it does so, over the average time horizon the investment is likely to be held. 

Remember your industry study is a map, not reality

A commercial due diligence report is a map, and like all maps, it is a representation of reality—not reality itself. Be skeptical. Understand assumptions, especially when those assumptions impact key areas of the investment thesis.

Let us look at two separate mobile phone-related examples to remind ourselves how difficult it can be to forecast market sizes and trends, even with rigorous diligence, especially in emergent and high-growth situations.

Our first example goes back to the 1980’s, when AT&T hired McKinsey to forecast the number of U.S. cell phone subscribers by 2000. McKinsey’s estimate of 900,000 fell short of 109 million actual cell phone subscribers in that year. While this was a longer-term forecast, longer than the customary five-year view, it was off by a factor of more than 100-times. It influenced AT&T to not invest in cell phone technology at that time.

Our second example places us in 2009, trying to size the market for iPhone protective cases. In 2009, the iPhone was relatively new, and a global recession was underfoot. The app store was relatively small. A sizable number of survey respondents said they would never pay $600+ for a phone to browse the internet, which would have resulted in a small serviceable addressable market (SAM) estimate. Fast forward five years, by 2014, the actual penetrated market size would have eclipsed any “reasonable” survey and data-driven 2014 forecasted SAM. Understanding inclusions, exclusions, and changes in market trends heavily influences market size forecasts. 

Why do some consider Commercial Due Diligence one of the harder M&A fields in which to work?

Like numerous other mergers and acquisitions (M&A) professions, the hours are often long; the deadlines are tight; demands are high; and speed, accuracy, and precision matter. Being in a client service role, client responsiveness requirements are high.

Unlike in financial due diligence (FDD) work, when the information is not readily available or supplied by the target company, it is not sufficient or acceptable to insert “non-quantifiable” into the report’s table. Commercial Due Diligence providers are expected to be resourceful and figure out the credible metrics to quantify and answer the critical questions. Since there is a degree of estimating and forecasting involved, it is also fraught with challenges and push-back from clients and other reviewers of the CDD report. Many of these challenges come from those who have not invested enough time to understand the nuances of the industry and/or target company, so adequately defending the points can be difficult.

CDD work usually requires gathering information from a wide variety of qualitative and quantitative sources in a brief period and synthesizing it into key takeaways. In a full scoped CDD engagement, the volume of information is often vast, so ensuring there is sufficient information sharing between and across functional areas within the CDD project / deal team is critical. It can be easy for information to not make its way into the final report because it was not fully shared across the team or with the right team members. Furthermore, sometimes the data points just do not seem to jive with what you think to be the answer. Thus, it requires real judgment of when to go with the qualitative vs. quantitative feedback when there is conflict between information sources.

If there is survey work involved in the project, it usually must be drafted and put into the field before enough information on the industry and the company has truly been shared and/or learned. These timing dynamics can negatively impact the quality and completeness of the survey design and question phrasing. This in turn can lead to critical information gaps or outlier data points.

Given the breadth of market participants who are interviewed or surveyed in a typical CDD engagement, the quality of the questions and how they are phrased is often paramount to the quality and accuracy of the responses. The research of behavioral economics pioneers—Daniel Kahneman and Amos Tversky—has demonstrated that people will often answer the same question phrased differently in a different manner. Thus, how questions are phrased can be critical to the information received.

Like many diligence workflows, early CDD efforts often identify other potential questions and areas of inquiry, which are not part of the original scope. This can lead to scope creep and sometimes tense conversations with clients about how to balance scope, project timing, expense, and accuracy.

Many people stay in the CDD field as they enjoy the problem solving, the client work, and combining quantitative and qualitative analysis. Some use it as a steppingstone to gain relevant skills to join investment banks, corporate development groups, or enter product management and market research roles.