Finding Opportunity When the Deal Pipeline is Light

The Martec Group researchers

Applying Commercial Due Diligence from Macro to Micro

By Jim Durkin, Founding Partner

The results are in for 2023 and, as most of us experienced, it was not the greatest show on Earth with respect to private equity deal flow.

We saw a number of metrics trend downward, including:

  • The number of due diligence “opportunities,” as measured by requests for commercial due diligence, was down more than 30 percent.  
  • The number of deals that we participated in was down, just under 30 percent.
  • The average deal size was also down slightly, perhaps due in part to large PE firms chasing smaller deals.
  • The “quality” of deals could be characterized as “down” as well, based on our PE client feedback.

While most signs point to increased activity in 2024 — our year-over-year number of opportunities almost doubled in January — there may still be a need to get creative with respect to identifying and evaluating potential deals.

Searching Far and Wide to Zero In

Though most private equity firms typically engage in commercial due diligence once an acquisition target has been identified, there is another research approach that involves a combination of thematic and funnel analysis that can be employed — especially during times in which a more proactive approach is necessary.

This methodology utilizes a three-phased approach:

  1. Market Prioritization
  2. Target Prioritization
  3. Target Deep-Dive

Consider, for example, a firm that has historical success and particular competence in a given manufacturing segment. Despite a long track record of identifying acquisition targets and deals in that space, the deal market cools, given all of the external realities we faced in 2023. The PE firm prefers not to “wait it out” and stand pat until the deal flow pipeline improves, instead preferring to be proactive and innovative in its deal search.

Perhaps, they posit, there are adjacent or look-alike markets they could explore. Their existing holdings demonstrate a core competence that might be suited for these markets, however their knowledge of the market size and structure, the competitive landscape, and the nature of customer relationships is minimal.

This is when commercial due diligence can be applied first to the market, then to a number of targets, and finally to the identified target or targets themselves.

How to Follow the Prioritization Pathway, from Market to Dealmaking

In this type of market research, rather than applying commercial due diligence to a single deal opportunity under LOI, we step back and apply similar analysis to targeted adjacent markets first.

Phase One: Market Prioritization

The initial phase explores and answers the question posed, “Given the product offering we have, which of multiple markets identified present the best opportunities?” The research team then narrows the potential markets down to the most logical few. From there, analysts work to understand each potential market. We work to understand the nature of the customer base; we examine and analyze the competitive landscape; and we use research to conduct market segmentation and analysis to attain an informed understanding of where the existing product or service set fits into each overall market. 

These insights are used to narrow the potential markets down to a limited few — perhaps only two or three — prioritized and presented to the PE firm for consideration, along with recommendations and data supporting the prioritization.

Phase Two: Target Prioritization

Once the target market has been decided upon, the next phase of commercial due diligence is to identify potential acquisition targets in the chosen market. Sometimes, the targets become self-evident during the Market Prioritization phase; in others, the research team needs to conduct additional research to identify them. A preliminary list of potential targets is then further vetted to prioritize those that offer the greatest upside, present the best fit within the portfolio, and portend growth with the greatest degree of confidence.

Just as in the previous phase, the Target Prioritization phase relies on a scoring system that eventually orders potential targets based on data science and analytics to bring greater clarity and confidence to the prioritization offered to the PE firm.

Phase Three: Target Deep-Dive

By the time we get to phase three, one or two acquisition targets have become evident, and the project team feels confident to move on to the last step: sizing up the opportunities that were previously unknown or unconsidered. A vast landscape of unfamiliar territory has been narrowed down with rigor and research to present individual opportunities to vet. This economizes market commercial due diligence so that significant resources are invested only in specific opportunities, while potential poor fits or even perilous pitfalls have been eliminated along the way. 

This targeted deep-dive then resembles the commercial due diligence that private equity professionals are accustomed to, using the same methodologies and revealing the same clarity and insights one would seek when evaluating an identified, pending deal.

Exploring Horizons, Not Hunches

While 2024 may, in fact, deliver on the promise some are anticipating with respect to increased deal flow, it is understandable that many firms would eschew the “wait and see” approach. With a long track record of supporting deal makers in the private equity space, we applaud both enthusiasm and innovation when it comes to shaking opportunities from the trees.

But as researchers, it is also in our DNA to rely on intelligence and insights to better inform us and our partners as to which trees to shake, so that the fruit one bears is the fruit one wants. “Proceed with caution” is easily converted to “proceed with confidence,” once the data is gathered, analyzed and understood. 

By starting at the macro level and moving down to the micro level, PE firms might not exactly be lucky enough to grab the “low-hanging fruit” they can when dealflow is high; but they will be able to enjoy the fruits of commercial due diligence’s labor when it’s not.

Jim Durkin is a Founding Partner of Martec Group. Contact him at [email protected].

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