Performing Strategic Due Diligence in M&A

What is strategic due diligence

First of all, there's no bright line between strategic diligence and other diligence. I divide it between strategic diligence and confirmatory diligence. By confirmatory, I mean these are the type of activities you do once you have conviction that this is the right move to make.

Then I send an army of accountants, lawyers, tax experts to go check all the boxes to understand that we're not stepping into some risks, liabilities, and understand exactly what we are buying to be ready for integration. 

But there is a layer of work and thinking that happens before going all-in. That is fundamentally about articulating your thesis about that opportunity to place a bet, a capital bet, and make good risk-adjusted returns for whoever that capital comes from. 

We typically, all of us in M&A, rarely invest our own money. There are entrepreneurs, for sure, but if you think about private equity, family office, corporate CEO, corporate development, we're all investing somebody else's money. 

It's the process of building conviction about the opportunity to invest money productively and responsibly before placing the bet and diving into final diligence. 

Deal people get a tombstone for just doing a deal. I never celebrate a deal. I like to wait a couple of years to see how the thesis played out. I'll get a tombstone from a bank, but each deal has two components of value creation. 

It's making a good decision, placing a good strategic bet, and that's what strategic diligence is about. And second is deal execution. Ensure you know what exactly you're buying, and not stepping risk.

I haven't seen the data, what determines value creation and returns at the end of the day. I would speculate that probably two thirds is driven by placing the right bets, making the right strategic decisions, and the third is that confirmatory, deal execution frame.

If you are placing the wrong bet, the terms of a purchase contract are not going to really save you. You can execute badly, and it can sink the deal, but execution alone won't make the deal. So, it's more of table stakes. You have to do it right.

Now, there are examples where more of an execution deal structuring is a source of returns. Maybe you have structural multiple arbitrage opportunities and that's many roll-ups, going to buy smaller businesses cheaper and then trade them as a bigger enterprise for a higher multiple.

That's value creation and I would say it's more execution driven. A good example is Warren Buffett. A lot of his greatest deals from the past were these interesting structures with preferred coupons. It's not just a straight equity investment and it's more opportunistic.

Also, if I may add, there is a third component to value creation, which is integration and executing on your thesis. People may disagree with that. And I know there's, if you read literature and articles, a lot of people talk about integration as being the holy grail of value creation.

And yes, it's a must. Again, you can have a great thesis and do a deal. And then if you don't execute rigorously on that thesis, what good is that thesis? So it's another sort of table stakes, but in my mind, it all rests on making the sound decision in the first place that even positions you to execute against a good opportunity.

How to perform strategic due diligence in M&A

Okay, let's talk about the five W's of strategic diligence: what it is, why you do it, who does it, when, and how.

Let's start with what. Articulate the thesis and how it links to the strategy. What you're betting on, and why your business deserves that investment. It all starts with wanting to invest in a given space, ensuring it will be a productive and safe investment for the owners of the capital you're investing. 

Identifying that thesis involves acknowledging uncertainties in your thesis and pressure testing the least certain and most impactful ones. A lot of it is what people call market diligence or commercial diligence. 

The second W, why you do it, is foundational for making a good business decision. It also allows you as an M&A professional to look good, especially when pitching the acquisition to an investment committee, executive team, or board of directors. 

A well-supported strategic thesis makes you look good and ensures you're recommending good decisions.

Who does strategic diligence? Key participants include the business, corporate development, M&A professionals, and sometimes external resources. 

In a corporate context, you are typically adding to an existing business, but sometimes you are buying a new platform. In a private equity context, someone on the investment team will need to wear the hat of formulating a thesis.

When you do it starts way before the deal. If you start strategic diligence when a specific deal pops up, it's probably too late. It's grounded in your portfolio strategy and business strategy. Engage closely with the business to understand the competitive landscape and investable opportunities. Having M&A professionals involved in corporate and business strategy is very synergistic.

The best practice is what I call the 'ponds and fish' approach, thinking about investment opportunities. Once you've identified good markets or businesses, validate the specific target that either you cultivated or came onto your radar.

Lastly, how to perform strategic diligence well. It's a multidisciplinary endeavor. M&A professionals need to understand tax, accounting, basic legal concepts, and be credible in operations and the commercial side of the business. 

Think like a fox or a hedgehog, whichever is the expert in a broader set of things. You also want to operate like a hawk: understand the landscape and market at a high level but also be able to pivot to the level of detail.

It involves understanding customer stickiness, switching costs, and how your product fits into the customer's organization. You need to talk to people, use expert networks, and be rigorous. Understand market growth drivers beyond just the numbers. 

Articulate the total available market opportunity well. Understand both the flow of the market and the stock - how many potential customers or products are out there.

Entering the right market

At BCG, they use this concept of pond and fish. The basic premise is it's more important to pick the right pond to fish in first. In that analogy, pond means the market or the type of business in a business and M&A context, before you start throwing the line. 

If you pick a wrong pond, you could end up with too little fish, the wrong kind of fish, or not the taste your family likes. You can be the best fisherman with the best equipment, but your family will still be hungry. That's why it's important to pick the right pond first.

This may sound trivial, but you would be surprised how often I've seen people have a bit of tunnel vision and invest in a market just because they're already in it. Not a good argument. Everybody wants to fish in good ponds and generally, people agree on what good ponds are. 

For instance, everybody wants to be in the software business. It's a great business, objectively. So there is some art, skill, and luck in identifying these good ponds, either earlier than others, or having a unique view on why something makes a good pond for you. That's really the strategic fit. 

So how do you go about mapping, finding these ponds or markets or businesses to invest in? First, you need to map out the universe of markets and determine how far you are willing to go. This is applicable in both a corporate context and private equity or portfolio investment context. 

Some may have a strategy of being omnivorous. Any good business can be in their portfolio. And some would be more comfortable investing closer to their set of competencies, their core businesses. There is separate work that needs to happen around that.

And that will be driven by the impetus for you to invest outside. Is it just because you have some free cash flow and instead of just giving back to capital owners, you would rather try to invest it productively? Or are you in a business that's maybe dying and you need to reposition it and have a sense of urgency?

Then you evaluate these markets, these ponds, through a lens of strategic attractiveness and fit. Attractiveness people generally agree on. It's growing markets with credible and understood growth drivers, stable with good margins, good returns, good market structure, well-behaved competition. 

The fit element is trickier. It's very straightforward if you invest close to your core. If you buy competitors, you understand why it fits. That's a business I'm in. I will buy them and take out some costs and that's a synergy.

Now, the further out you step out in adjacencies in that universe of ponds, you will need to start thinking more creatively but still have conviction about the fit. And here you will often need to start thinking about the business model. 

• Like what type of business is my team good at running or investing in? 
• Is it making something small or big? 
• Is it project driven or am I selling nuts and bolts? 
• Am I going directly to customers or through distributors or is it online? 
• Is it heavy manufacturing or light assembly? 
• Is it serving a single market, or customer segment, or is it global?

You can be successful stepping out pretty far from your core business and find good investment opportunities if you can think rigorously about why it's a good fit. Why do I have the right to play fish in that pond? 

So going through the ponds is understanding the universe. I'm comfortable even evaluating and going after, and then systematically evaluating with the attractiveness and fit. 

Best in class companies would have a very precise, almost quantitative way of going about that. It's not just an intuitive feeling. All of these elements of attractiveness, like growth, returns, all of those things are quantified, but things like balance of power in the market, and elements of fit each portfolio, each company's to articulate for themselves.

What fits you? And that may differentiate you in the hunt for good ponds, because everybody will recognize attractive ponds, but not all of them will fit everybody. 

I'll give you an example that's well-known in the business world, although it's relatively dated. I don't remember the name of the brand, but think of Arm and Hammer, the consumer goods company. 

At some point, they realized they had a basic, narrower portfolio of products. And now, you'll find them in a ton of consumer products. The asset they had was a channel to big retailers and shelf space, as well as some brand recognition. They asked themselves how they could add to it. For example, once sending a truck to Walmart, what else could they put on it?

This is how you can productively exploit assets through M&A. It's about thinking, what can I add to it that wouldn’t necessarily be obvious? Take toothpaste, for instance. You can keep building it out. That’s leveraging your assets and capabilities. It's more about what I am good at. 

That's where you can invest behind businesses that look similar. It might not be the same customers; I can’t leverage my distribution channel, make it in my plant, or have my salespeople sell it. So, it’s completely unrelated. I can’t leverage any of my assets, but I know how to run that type of business.

If the product is something that sells for a thousand dollars a unit, and it’s a little widget that goes through distribution and it's a light electronic assembly, then I can invest in businesses that look like that. 

They might have nothing in common in terms of customer segments, specific customers, specific channels, or production facilities, but I understand how to run that business, doing the sales and operational planning, optimizing the supply chain for that assembly, managing distributors, and doing some of the R&D in that space.

Finding the right target company

After finding a good pond. The question should be whether it's possible to pursue it organically or if inorganic is the way to enter. Licensing and barriers to entry suggest that buying someone can give you a foothold and allow you to build from there. 

It's probably hard to enter organically, which is why inorganic may be the answer. Now, on the organic front, depending on the kind of capital you are willing to put at play to pursue a market, some of these high barriers to entry markets can still be entered if you are persistent and willing to place enough capital.

There are examples in aerospace and defense. The company Enduril, founded by the person who sold Oculus to Facebook, now Meta, is one such example. They entered a defense contractor market, which was considered a very small club industry dominated by companies like Lockheed. With sufficient insight, capital, persistence, and enthusiasm, they are making big strides

So now it's time to target a specific fish. Ideally, you have a good thesis and know where to fish, and ideally, you would have multiple ponds. Depending on your funding, your focus might be rolling up dental clinics in different regions of the U.S., for example. 

If you're in a bigger portfolio, you'd hopefully be working with multiple ponds and then fish will start appearing on your radar for evaluation.

There is a strategic element to the evaluation of targets before the confirmatory diligence. This includes things like market share, the competitiveness of the products, and understanding why customers choose one product over another. 

Analyzing wins and losses is crucial. Why do they win and why do they lose? Understanding these elements requires rigor and the ability to not just accept superficial explanations like 'they're gaining market share' or 'it's growing.' It’s important to look deeper than that.

When to perform strategic due diligence

Look, you are constantly reevaluating. Maybe you were in a company that was in a given business, didn't think about deploying capital productively, or didn't have capital to deploy. Then, the company might wake up, realize it needs to do something to be great. 

You go through an exercise, find ponds, and decide to be more aggressive. That’s more of a one-off exercise. But then, you need to maintain and constantly update your views. The world is dynamic and changing faster than ever. One market may be red hot one year, and the next year it's not.

You need to stay up to date on all the ponds you’ve chosen to keep validating the thesis: Yes, it’s still investable. But also, some of the ones you've written off or deprioritized may become more investable over time. So it’s an ongoing, iterative activity.

Proactive vs. Reactive deal sourcing

Well, it's both at the end of the day. You can't rely just on one approach. If you follow the process I laid out, identifying the ponds, validating that there are fish there, you would know what that fish is. Constantly having a long list or short list of both ponds and fish targets in that pond and trying to cultivate it would be the best practice. 

This is a way to cultivate what people call proprietary opportunities before they become auctions and highly competitive. But you do need that network, you do need a flow, especially if you hunt in the middle market, lower middle market. Most of the deals we do here at a middle market, you will probably not know a hundred percent of the targets that are available.

Sometimes, you will see a target that's in a pond you just didn't think about. Once you see it and go through your thought process, you realize it's attractive and fits. Why? Because that process of laying out what ponds to look at is kind of creative.  

You can say the whole economy, the whole universe, I can invest in. People usually don't do that; they draw a line somewhere reasonably not too far from the business they are in, and you can miss interesting markets and ponds. It's okay; it's an iterative process. Then you learn about that pond, sometimes just through getting an inbound target.

Importance of culture

I would say it's an element of fit, probably not so much about the pond or the market, but about a specific target. So, I'm down to the fish. You can argue some markets have a certain way of doing business in a given industry. 

Some industries have a reputation, and you can think about whether that's the kind of culture you want to be part of. By the way, that could include ethical risks, as some industries are more prone to it.

When we look at building this investment thesis for a specific fish, the question is whether the culture fits into the story we're presenting to the board and why there's such a good culture fit for us. I would argue it should be. 

If you identify yourself as an engineering-driven, R&D-driven, technological company, you want to see a similar culture in the target you acquire. It should definitely be a part of diligence and negotiations, evaluating that culture when interacting with the leadership and management of the company. 

You can pick up signals about what kind of culture they adhere to by how they negotiate with you. This is especially important if you plan to retain the sellers as management for your business, as their behavior in negotiations can be very indicative of their culture.

Sometimes you get early signs just from negotiating the NDA. I've had experiences where dealing with a seller of a smaller business revealed quirky things about how private sellers and entrepreneurs approach M&A. 

I have immense respect for them; they’ve built businesses, sometimes acquiring or inheriting them, making them stronger. But M&A is not what they do, so they might have interesting ideas about how to do M&A. 

Once, I remember a seller treated selling a company like selling a house, wanting an earnest money deposit to show we are serious and a standard pre-negotiated contract before allowing diligence. People can get pretty creative in this process. You get a sense of culture from how we're going to do the deal.

When to start integration planning

Early on, an important consideration is whether the business deserves investment. A key element of this is assessing if they can integrate and execute, focusing on the team you will be entrusting. In a corporate context, this is different compared to, say, a private equity context. 

In a corporate environment, when adding a business to your existing one, it's crucial to think about whether your team can integrate and execute that piece as well, assuming you have a capable team. Generally, this is a role for senior management, at the CEO level.

Red flags during strategic diligence

Big hockey stick projections are extremely common, but there's still a spectrum in how it's articulated, ranging from complete hand-waving, just trusting us, to at least some attempt to have a driver tree explaining how a 7%, 10%, 20% growth rate will be driven by specific factors.

From a business evaluation standpoint, understanding big wins and losses, and why they're happening, is crucial. If it wins, it helps you understand why they're strong, why they are winning. If they lose customers, ensure it's not due to obsolete technology or an emerging competitor.

Market share gain projections often mirror the market growth rate plus a few percentage points for market share gain. You need to pressure test why, especially if it's projected over the long term. It's important to consider the competitive response to your continued attempts to gain share from them. It's all about thorough analysis and understanding the underlying reasons.

Assessing incoming people

Well, it's highly situation dependent. Sometimes you are more reliant on people that you are bringing over versus less. Often, the closer to core you invest, the more comfortable you are in figuring out how to run the business. 

However, it's essential to understand, especially in less sophisticated, smaller, less mature businesses, that there could be key man risks or a repository of knowledge that's not documented or codified but is very important. Identifying those people in diligence and thinking about their retention is a big element of any good M&A process.

Biggest challenge when performing strategic diligence

I like to tell people on my team that you have to have an almost quantum mindset. You need to be both the biggest proponent of the deal and the biggest skeptic of the deal at the same time, and not have cognitive dissonance because of that. 

This will change depending on the audience. When working with diligence teams, driving both strategic and confirmatory diligence, you want to be a skeptic. Don’t take things for granted or just trust. You need to pressure test and validate, being thoughtful about things that matter.

At the same time, as a person who helps decision-makers deploy capital, build better businesses, and get the deal through approval processes, such as investment committees or executive boards, you want to be the proponent. 

Use the learnings from being a skeptic to strengthen your thesis and be a good proponent of the deal. This isn’t trivial. People may default into one mode or the other, and there is some art in trying to maintain both perspectives.

‍