Performing Strategic Due Diligence in M&A

26:47Some may have a strategy, I'm absolutely omnivorous, any good business can be in my portfolio. And some would be much more comfortable investing closer to their set of competencies, their core businesses. And there is a separate sort of discussion and work that needs to happen around that. And that will, by the way, be driven by what's 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 it's maybe dying and you know it and you need to reposition it and you have a sense of urgency?

27:28So there's a lot that would go into that thinking about what universe would you look at. Okay. And then you evaluate these markets, these bonds through a lens of strategic attractiveness and fit. And attractiveness people would generally agree on. It's growing markets with a credible and understood growth drivers, stable with good margins, good returns, good market structure, behaved competition. Nobody is too powerful in that market. Okay, the fit element is a little trickier. It's very straightforward if you invest close to your core. If you go buy competitors, you understand why it fits. That's a business I'm in.

28:09I will buy them and take out some costs and that's a synergy and I know exactly what business this is. Now, the further out you step out in adjacencies, in that universe of bonds, you will need to start thinking more creatively, but still have conviction about the fit. Here, you will often need to start thinking about the business model. What is the type of business my team is 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 direct to customers or through distributors? Or is it online? Is it heavy manufacturing or light assembly?

28:52Is it serving a single market or customer segment or is it global? I'll sell my product to 15 different end markets. You can be successful stepping out pretty far from your core business and find good investment opportunities. If you can think rigorously about why is it a good fit? Why do I have the right fish in that pond? 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. And best in class companies would have actually very precise, almost quantitative way of going about that.

29:37It's not just intuitive feeling, all of these elements of attractiveness, obviously 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 is to articulate for themselves what fits you. And that may differentiate you in that hunt for good bonds. Again, everybody will recognize attractive bonds, but not all of them will fit. I like that view because it doesn't get talked about much. These deals get harder to do the further you go away from your core, but you have this view of really understanding your strengths that you're going to be able to leverage despite going further away from your core, what is that you're going to be able to have that advantage around?

30:20Recognizing that you'll be taking more risk. Go read some of these studies by consultants, and they will always say that obviously, probably the bigger deals and further out from the core, more risk. I agree. And then how do you counter that with your strength? Do you have examples of what would be specific strengths that you could leverage even despite going further away from your core because I'm imagining customers could be different. Maybe it's business models fundamentally similar, and that could be a strength. I don't know if you had other examples of what would be strengths you'd latch onto.

30:51Strength, you can describe them either from a business, things I have assets that I can leverage better by adding M &A to it or things I'm good at, I can do well. They are slightly different, like assets versus capability. So I feel like incredibly good at marketing that, even though we're going further away from our core, we may still look at it and saying, hey, this is a strength we can still leverage. We can bring our marketing competency to this company. I'll give you an example. I think it's well known in the business world and relatively dated, but I don't remember the name of the brand, but this Armand Hammer Consumer Goods.

31:25The company at some point realized they had a much, much narrower portfolio of products. And now you'll find a ton of consumer products. And the asset, the thing they had was we have this channel, big retailers and shelf space and some brand recognition. How can we add? Like once I'm sending a truck to Walmart, what else can we put on it? Okay. You can productively exploit that through M &A. That's an asset. I have something. What can I add to it that wouldn't necessarily be obvious if you didn't think about it that way? Toothpaste. Right. You can keep building it up. Yeah. That's leveraging your assets, what I have.

32:05Capabilities, it's more what I talked about. What am I good at? And that's where you can invest behind businesses. It just, it looks similar. It's not the same customers. I can't leverage my distribution channel. I can't make it in my plant. My salespeople can't 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, let's say, sells for$1 ,000 a unit and it's a little widget and it goes through distribution and it's light, electronic, assembly. Okay. And I'm good at running that type of business, doing the sales and operational planning, optimizing the supply chain for it, that assembly, optimizing distributor management, doing some of the R &D in that space.

32:52Okay. I can go and invest behind businesses that look like that, but have nothing in common in terms of customer segments, specific customers, specific channels. Can we make up an example to go through the strategic diligence exercise? I can pick one for mine. I don't want to get you in trouble. Okay. We have our deal room products, our main business, which is like Emony Lifecycle Management, but we have this spinoff data room product called firm room. I have a hypothesis that is a pond, which is pretty fragmented and pretty ripe for consolidation. And our product, because it's been off operates at a really high margin we can essentially acquire something in that pond that's like a pretty straightforward and i'm just using this a general example we'll expand from here one how do you look at this pond and right away there's sort of a good sense because i'm doing the one we're playing away and then we can make up one away from the core when i started thinking about the size of this overall bond because we say this is about data room markets It's about a billion and a half market cap.

33:52When you start looking at it in the fragmentation, I know there's three companies that have maybe about 70%, 75 % market share. And then the rest is like fragmented with a bunch of little companies. When you start looking at that, does that give you any indicators or do you start putting consideration around that in terms of how diversified, how many fish are in there and how big they are? Okay. So maybe there needs to be a third element of a pond assessment, strategic attractiveness. fit? And can I do something with it? Sometimes you will see pond. Yeah, it's a great business. It's a duopoly and none of those are available.

34:28It's not investable because it's not actionable. Finding out the number of fish in the pond and the actionability, what is the reason to believe I can actually go and buy some of them should be that third element. One deal is not a strategy. Just saying like, oh, that's the market and I can go buy this target to enter that market. market, okay, that's very binary, like it will happen or not. So the strategy, if you are convinced, I want to invest in a given market, you better make sure there are like three, four, five, six targets, and hopefully you get one or two. Now there are 15. Yeah, your thesis can be well go and roll up seven of them.

35:04It had to be in that direction. You would have to look and say, okay, there's probably a hundred different companies out there. Three of them control 70 % of the market. Could we string together 10 of them and start getting towards 15 % market share? then it's more of a role at play. We're trying to arbitrage a multiplier. If there is already like three market leaders and you're rolling up some sort of long tail, is the thesis that you are creating a scale competitor that will be able to take some market share from the leaders or not? This isn't that sexy. Let's find a different one. Let's go out of our core.

35:38Obviously, we got AI's hot. I see a bunch of data companies popping up. I'm sure you're getting a lot of calls from folks that want to sell you data to go find targets. There's integration software, but that gets a little murky. But maybe if we went for our services, that's further away from the core. If we got into BCG type business, M &A consulting. So if you think about it, the core is just Data Room as a segment. There is other M &A related software. There is deal pipeline management. That's not Data Room. There are other tools, but they're still within M &A. So you would be leveraging your channel.

36:13Hey, I know corporate development professionals. I can sell them. Can I add more things in my sales bag? Okay, so we're not going to jump too far from the core, stay in the software domain. But even before going to software, okay, there is M &A software and there is other business software. Maybe a vector could be, okay, so I have data room and I can expand in other M &A software, or I can leap and say, hey, I'm good at selling professional workflow automation software to highly professional users in corporate America. Okay. That's a capability. There's other software that's not M &A related that fits that.

36:49And maybe you can find. Now, many of those markets are mature, but maybe you find a niche that's more emerging. It's AI powered. And I would argue after that, you would leap into more of a service. And you can also think about, I can provide more services around M &A than just Dealer Room. I can buy some M &A. I like where you're going with this. Yeah. Let's pick one. I want to get to the other steps. of we build our hypothesis and we want to create our investment thesis if we did aerospace defense government that's like its own sector and if they look at project management type of tools those are like super outdated and pretty enterprisey that's definitely an area we want to get into because you pretty much need to get fed ramp certified to really play in that space and that's a big blocker for us like we don't have that capability but we do have a lot of that workflow examples and stuff like that.

37:39But we start mapping that out and this looks like a nice, you know, away from the core, but we see some of these strengths that we have that we can bring some of the modern. Now we're building AI and bring it to this old, pretty slow moving industry here. So if we start building that, next thing is just pressure test. Like what are those things? How would that actually fit in? Is there any like thinking that you would start with in terms of pressure testing that investment thesis? So you found a good pond. And then I think the question should be, is it possible to pursue it organically or is inorganic as a way to enter?

38:11Because when you say licensing and all these barriers to entry, okay, go buy someone and that gives you a foothold and you can build from there. What you're saying is that's probably hard to enter it organically, but that's why inorganic may be the answer. Now, on the organic front, depending on what capital you're willing to put at play to pursue a market. Some of these high barriers to entry markets at the end of the day can still be entered if you are persistent and you're willing, again, to place that bet with enough capital. There are examples in aerospace and defense. The company you may have heard, Enduril.

38:50I think it was founded by a person who sold Oculus virtual reality to Facebook, to Meta. Yeah. And I think he went on and founded this basically defense contractor, which was considered a very small club industry, Lockheed and some of these primes, with enough insight and what's needed, capital to put at work, persistence and enthusiasm. I think they're making big strides. Be open-minded. There may be a way, or in this example, like partnering with a reseller could be an avenue to get into the industry. But we found something. We found the pond and maybe we are getting so you're right there's those are good areas to pressure test and then if we get past that saying hey this seems like the opportunities are valued pretty reasonable especially if we find a business that's pretty stagnant with the growth that we could acquire them and expedite getting into this industry then what am i ready to build my pitch i think we talked more about ponds that is evaluating the fish that's where the deals start hitting your inbox So now my investment thesis has got to target a specific fish.

39:58So ideally now you have a good thesis, you know where to fish, but ideally you would have multiple ponds. Again, depending on maybe you're a little funded just rolling up dental clinics at your pond and then your ponds could be different regions of the West. Now if you're in some bigger portfolio, you'd be hopefully worth multiple ponds and then fish will start hitting your radar and you will need to be evaluating. And again, there is a strategic element to evaluation of targets before the confirmatory diligence. Things like market share, the competitiveness of the products. Why do truly customers buy that product over the other product?

40:38Analyzing wins and losses. Why do they win and why do they lose? Do you truly understand that? Going back to some of this, it has to be rigorous. You have to be able to pivot and not just sort of accept, oh, they're gaining market share. It's growing. this hand wavy yes so it goes back to on the why part it's answering why this pond why this fish and then you're basically doing like a swat on both of those and then who for a little company 50 people i pull a few other leaders in place probably a coo and a few other leads identifying who's involved in the team the when is an interesting one that ties back to doing this research and really spending the time to know this market so that we are identifying right company and making sure stars are aligned to go execute at the right time.

41:25Maybe you were in a sleepy company that was in a given business, didn't really think about deploying capital productively or didn't have capital to deploy. Okay. And then maybe the company woke up, realized we need to do something, right? Be great. And you go through an exercise and you find ponds and you want to be more aggressive. That's more of a one-off exercise. But then you do need to maintain and constantly update your views. It's a dynamic world and it's changing faster than ever. One thing, one market is hot, red hot one year and the next year it's not. You need to stay up to date on all the ponds, both that you've chosen to keep validating the thesis.

42:11Yes, it's still investable, but also maybe some of the ones you've written off, deprioritized, maybe they are becoming more investable over time. So it's an ongoing iterative activity. One of the things that we didn't talk about is in terms of sourcing these opportunities. Do you proactively source these opportunities with building your own pipeline and finding what's available in the market? Or do you network with the bankers and get on their radar for them to bring you deals? Let's both at the end of the day. I don't think you can rely just on one approach. If you follow the process I laid out, identifying the ponds, validating that there is fish there, you would know what that fish is.

42:52Constantly having a long list or short list, both ponds and fishes, targets in that pond and trying to cultivate it. Yeah, that would be the best practice. And that's 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 this middle market, lower middle market. And that's where most of the deals we do here, middle market. You will probably not know 100 % of the targets that are available there. And sometimes you will see a target that's in a pond you just didn't think about.

43:33And then once you see it and you go through your sort of thought process, is it attractive? does it fit? And you realize, yeah. Why? Because that process of laying out what ponds I should be looking at, it's creative. You can say the whole economy, the whole universe, I can go invest. But 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 and it's okay. Again, it's an iterative process. And then you learn about that bond, but sometimes just through getting an inbound target. I agree. That's a really good way to learn an industry is to see what's being marketed and study it.

44:15And then you can be more proactive. You can learn about an industry reacting to it, but then you can get more proactive. Yeah, with that knowledge, absolutely. When does culture come into the picture? It comes up a lot when I do these interviews, but as I'm going through this exercise of strategic diligence, culture anywhere there, or does this stuff happen after we sign? I would say it's an element of fit. Probably not so much about the bond, the market, as it is about a specific target. It's something like to be doing business in a given industry. Some industries have reputation and you can think about, is that the culture I want to be in?

44:50And by the way, that could be like ethical risk because some industries are just more prone to it. Fair enough. When we look at building this investment thesis for the specific fish, Does that culture come up to the story I'm presenting to the board of why they think there's such a good culture fit for us? I would argue it should be. If you identify yourself as a, let's say, engineering-driven, R &D-driven, technological company, you want to see that similar culture in the target you acquire. Yes, so for sure. And by the way, in diligence and negotiations, it certainly should be an element of evaluating that culture.

45:26When you interact with the leadership, the management of the company, then you pick up the signals, the data points about what culture they adhere to, how they negotiate with you. There is a signal of culture, especially if you plan to retain the sellers as management for your business. how they behave in negotiations, how they treat, how they approach it is very much a signal of culture in the business. You ever had that where they're such a pain in the ass just negotiating the NDA? You just said, forget about this? Yes, there are more painful processes. So you get early signs just from that.

46:02I've had once I saw a seller of a smaller business and you see a lot of sort of quirky things when buying businesses from private sellers and entrepreneurs. And I have immense respect for all of them. These are people who built businesses. Sometimes they acquired them. Sometimes they inherited them. But they made them generally stronger or maintained them. M &A is not what they do. And so they would have some interesting ideas about how to do M &A. Once I remember, I was a seller. I was thinking about selling a company. I was selling a house and wanted an earnest money, like a deposit. that we're serious and have some sort of like standard pre-negotiated contract for allowing even the diligence.

46:46Oh, wow. Yeah. So yeah, people get pretty creative. Yeah, that's a fair point. You get a sense of culture from how we're going to do the deal. The integration part, how do you start thinking through integration? It varies obviously by organization. I almost probably should have framed it more as when do you start thinking about integration? Early on. By the way, I would say you go back all the way to, does the business deserve investment? An element of that is, can they integrate and execute whoever they are, the team you will be entrusting? This is before conversations with the team or early conversations?

47:21Your business team. So if you're in the corporate context, that's a little different in, let's say, private equity context. If you're in a corporate environment and you are adding business to your existing business, thinking about the team I have, can they integrate? Can they execute? Who would you rely on for that insight? Whether it's the business unit leader or is it, here's a designated integration function? I mean, in general, let's say it's a role of senior management. Okay. CEO level segment or even corporate management. Yeah, it's... And you'd want to get their pulse of, hey, we're looking to bring in fish in our company here.

47:56Would that we have the capability or capacity to do it? Very much, yeah. You get some validation, like, yes, go ahead. But then there's not like too much clicking in and trying to build like a real detailed plan, more of going back to the assessment, if there's a real strong strategic fit, building out this investment thesis. Well, ideally you would have a blueprint very early on, even before you start this final confirmatory expensive diligence phase, while you're still formulating your thesis in a strategic diligence phase, you do need to have a blueprint of how I'm going to run this, how I'm going to integrate it and some of the main opportunities, risks, and decisions involved in that.

48:35And then obviously you flesh it out as you go through in more and more detail. So you have a blueprint before LOI. Hey, this is a rough idea of how we're going to integrate. Look, by blueprint, I mean, it can be in somebody's head. Whoever will be responsible for delivering needs to be able to convincingly say, okay, and I have a general idea how we can run it and how it fits into our existing organization. I feel like this thinking gets along the lines of the big red flag items that you would start looking for early in the deal. Obviously, a big integration risk would be one of them. What are other big red flag items that you're looking for in this strategic diligence phase?

49:10Big hockey stick projections. That's every bank deal. Yes, there's still a spectrum there. And how it's articulated, there's also a spectrum from complete hand-waving, just trust us, to at least some attempt to have a driver tree. The 7%, 10%, 20 % growth rate will be driven by this and this. So there's a spectrum there. from business, evaluating the business standpoint, like big wins and losses, customer wins and losses, understanding why they're happening. If it's wins, it will help you understand why they're strong, why they're winning. If they lost customers, you really need to make sure it's not some sort of obsolete technology or there is an emerging competitor coming up.

49:57Really need to think about that. Market share gain projections. You would often see SIMs just, that's a market growth rate, and then a couple percentage points for market share gain. And you really need to pressure test why. And especially if it's happening over the long term, it's a finite strategy to gain share. You need to be thinking about what will competitive response be, your continued attempts to gain share from them. So it's all of those. Market strategy, customer base. What about the people? How do you know these people are going to be good long-term investments versus you're going to have to invest in changing some things?

50:33That's highly situation dependent. Sometimes you are more aligned on people that you are sort of bringing over versus less. Sometimes, again, closer to core you invest, the more comfortable you are that will figure out how to run this business. Now, you do need to understand, especially maybe in less sophisticated, smaller, less mature businesses, There could be key man risks, some repository of knowledge that's not documented, codified. It is very important. And identifying those people in diligence and thinking about the retention, obviously, is a big element of any good M &A process. I don't know if anybody listening to this is getting convinced M &A is like really easy to do.

51:14There's so many variables here to unpack. What's your best advice for people approaching strategic diligence? I like to tell people on my team, you have to have a almost quantum mindset. You have 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. And that will change depending on the audience. Working with diligence teams, driving diligence, strategic and confirmatory, you kind of want to be skeptic. You don't want to take things for granted or just trust. You want to pressure test, validate, again, be thoughtful about things that matter now.

51:52But at the same time, as a person who helps decision makers deploy capital, build better businesses, get the deal through approval processes, whatever they are, investment committee, executive boards, you want to be the proponent. You want to use the learnings and being a skeptic to steel man your thesis and be a good proponent of the deal. And that's not trivial. People like the deal or not, they may just default into one or the other mode. And I think there's some art in trying to keep both. That's really good. Because one, it's not a good opportunity. You eliminate it quicker. And two, it's very defensible when you're presenting this opportunity to leadership.

52:33Andrei, thank you so much for the time today. I enjoyed this conversation. You helped me become a better M &A scientist. All right. Sounds good. I enjoyed it too. Thanks for coming. Those of you still with us, thank you for sticking through. Till next time, here's to the deal.

53:14We're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com. Or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter. Again, that's mascience.com. Here's to the deal.

53:56Views and opinions expressed on M &A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is...