Middle Market Missteps: Lessons from acquisition due diligence

Why should we care about due diligence?

The middle market and lower middle market (LMM) spaces are attractive to investors. Private equity firms, family offices and other capital providers injected $370B into the US middle market during 2015, in 2,017 transactions. Momentum will likely continue in 2016, driven by acquirer liquidity, founder demographics and an expected slow-growth economy. The popularity of smaller-sized deals rests on the sheer number of such companies, the lower valuation multiples and the relative perceived ease of effecting operational improvements. Yet the risks are also higher. Many pursuits do not result in done deals, after months of hard work and expense. Other investments fail to generate the expected returns. Raising the success rate of acquisitions, through the right due diligence, is therefore of prime concern.

Definitions vary, but we would consider the middle market to extend from $25M to $1B in transaction value, with LMM firms at the lower-size end. These are typically privately-held, often founder- or family-owned businesses, seeking an outsider to cash out the owners or to fund expansion.

Senior consultants at New Harbor have been leading acquisition opportunity scans and due diligence efforts on behalf of investors for three decades. We have examined potential targets across industries – from software to consulting, from transportation to financial services, from North America to Europe and Asia. We generally take an outside-in perspective, conducting market, customer, competitor and regulatory research; testing assumptions about future growth; examining various kinds of risks; and assessing the scalability of management, processes and systems. Our work complements that of accountants, lawyers and the investor’s own financial analysts by bringing an objective view of the business’s positioning and prospects within its commercial ecosystem.

What can go wrong in the due diligence process?

We have seen at least six ways potential acquirers can miss the mark:

External issues

Segment dependence. Lower middle market companies can easily be over-dependent on one market sub-segment. The expertise gained may have fueled past success, but without diversification, a smaller target can be particularly vulnerable to a downturn. Shale oil’s recent decline is a case in point. Collapsing E&P activity is obviously hard on oilfield service and equipment suppliers. But it is also tough for flatbed truckers moving pipe and steel and for many other suppliers to this market. In another case, falling demand for department store fixtures hurt a service provider specialized in that industry segment.
Opportunity exaggeration. Unique strengths are not necessarily applicable to other adjacent spaces. Owners of small-to-midsized businesses naturally overestimate potential success in markets and industries they’re not familiar with, based on historical results in their own sandbox. The seller’s offering memorandum may convey vague statements about growth opportunities, with little hard evidence. Examples abound: Dominance in one local market, achieved over many years, is presumed to assure strong results in another area already well-served by others; superficial analysis suggesting that a successful centralized distribution system could be profitably regionalized, ignoring additional inventory and management costs; or that a unique relationship with one large supplier will remain in place forever, without moves by that provider to disintermediate or raise prices.
Nascent gamechangers. Disruptive technologies, non-traditional competitors, regulatory changes and macroeconomic developments (such as exchange rates) can have an outsized impact on smaller, non-diversified companies. These trends may be off the radar or simply ignored, until it’s too late. For example, court rulings limiting class action suits have been tough for firms providing settlement services. Other developments that have changed the landscape for small-to-midsized service firms include the offshoring of analytical work to India, the use of e-discovery for legal work or the printing of books on demand by Amazon.

Internal issues

Management (un)scalability. Management and sales teams may not be scalable. In one set of customer interviews, a manager was widely praised. But that’s one person – how much more can he do? And how well codified is his approach, so that others can replicate his success? In another case, a fast-growing business showered unheard-of sales bonuses on a handful of stars, with no limits in time or dollars, but did not create a sustainable compensation framework for future growth. People and approaches that worked well in a highly-entrepreneurial, closely-knit company culture can fall flat when it comes to reaching the next stage of growth.
Platform problems. Systems, especially customer-facing information technology, may not be adequate to support growth. In businesses ranging from logistics to financial services, customers demand real-time data access and status updates, plus convenient reports online. These capabilities are table stakes. Yet smaller companies often plod along with subpar homegrown or legacy systems that can’t compete with what the big guys offer. Building the right platform can be a cost and a distraction waiting to happen in the future.
Strategic fog. The existing owners may lack a clearly-defined strategic direction. Entrepreneurs are often hands-on operators, without the time or inclination to think about the next two to three years. Yet clarity is needed, to build confidence that bolt-on acquisitions or investments (e.g., for new hires, better processes or IT) will be warranted, beyond the initial purchase. Justification for the EBITDA multiple typically rests on assumptions about future performance. A strategy for a lower middle market company should at least include a set of prioritized initiatives, linked to top- and bottom-line growth, with a clear supporting rationale.

What can be done to improve due diligence effectiveness?

To avoid foundering on the rocks, strong due diligence should include:

Market and customer research. Conduct third-party interviews with non-customers and departed customers, as well as happy current customers, for maximum insight. This is a critical part of a sound ‘outside-in’ approach. Insights gained are valuable to the target’s management, as well as to investors. Research findings can thus be offered to the seller, as an inducement to close the deal.
Competitor research. Top management, sales and marketing execs at competitors are a great source of intel about the market, external trends, the competitive landscape, and the target company itself. These sources are not unbiased, but reflect different biases than those of selling management, and can provide a valuable perspective. Such conversations and other research enable development of a robust radar screen depicting the competitive environment, including threats just appearing on the horizon.
Management assessment
- Strategy. What is it? What drives it? Is it written down? How can new ownership and capital drive progress? How can targeted add-on deals help drive profitable growth?
- Leadership. How strong is the senior team? How widespread are professional management practices?
- Operations. What are the key top- and bottom-line initiatives, such as salesforce effectiveness, strategic sourcing or automation?
- Business systems (sales, compensation, technology). How robust and scalable are the business processes and tools that form the company’s critical infrastructure?
- Risk. Customer concentration risk, sales executive departure risk, supplier concentration risk and projection assumptions risk (e.g., growth in adjacent markets, new product penetration, pricing power, cyclicality) are a few of the risk areas to investigate.

Getting the most out of an initial acquisition opportunity scan or due diligence is both critical to acquisition success and doable. Choosing the right consultants is a good first step. Professionals with domain expertise, strong contacts, analytical horsepower and a responsive approach can do more than just check the box – they can lay the groundwork for exceptional returns.

David Bovet is the Managing Partner of New Harbor Consultants, a management consulting firm located near Boston. He focuses on helping clients translate their vision into practical results. David brings 30 years of experience across a range of industries, from manufacturing to transportation and financial services. Projects focus on strategic direction, market positioning, operational improvement and hands-on implementation.