A Wave of Deals is Coming: Commercial Due Diligence for When the Tide Rolls In

Sean Mooney:
Welcome to The Karma School of Business, a podcast about the private equity industry, business best practices, and real-time trends. This episode is a special presentation of a webinar that we recorded with Andrew Joy, partner with Hidden Harbor Capital. Andrew and I discussed why the market matters, how private equity firms assess market opportunities, and the tools private equity firms use to create edge during an M&A process, and the value creation stage. This episode is brought to you today by BluWave. I'm Sean Mooney, BluWave's founder and CEO. BluWave is the go-to expert of those with expertise. BluWave connects proactive business builders, including more than 500 of the world's leading private equity firms, and thousands of proactive companies, to the very best service providers for their critical, variable, on point, and on time business needs. Enjoy.

Houston Slatton:
All right. Welcome to BluWave's Webinar on commercial due diligence. We've got a full agenda, so let's go ahead and get started. I'm Houston Slatton, I'm a managing director here at BluWave. And today we'll be diving into what commercial due diligence is, and how it's used in private equity. As we've looked at the data and have seen over time, if we look at the due diligence side, we typically see a top three diligence activities that we get demand for, and that our clients are engaging the providers in our network for. And those are commercial due diligence, IT diligence or tech diligence, and operational diligence.

And out of those three, commercial due diligence has historically been the top use case that we see. Since we started publishing the report, I think back in 2018, it's topped our due diligence leaderboards. And so what we want to talk about today is why commercial due diligence matters, or I guess why markets matter, end markets. How PE investors approach analyzing end markets, and how others can as well. So before we dive into that, I'd like to introduce our panelists for today. So I'll start with Andrew. Andrew Joy is a partner at Hidden Harbor. And Andrew, I'll give you just a second here to introduce yourself.

Andrew Joy:
Yeah, sure. Name's Andrew Joy. I'm a partner at Hidden Harbor. Started the firm with my three other partners about seven years ago now, and Hidden Harbor manages just about a billion of capital honor management. Prior to starting Hidden Harbor, I was the vice president at a firm called Cerberus Capital up in New York in their private equity group. Prior to Cerberus was at another fund in Florida here called Comvest Partners. Started my career on the investment banking side, and appreciate the opportunity to speak on this matter.

Houston Slatton:
Great. Happy to have you, Andrew. Alongside Andrew, we have BluWave's founder and CEO, Sean Mooney. Sean, can you introduce yourself?

Sean Mooney:
Great. Hi everyone. My name is Sean Mooney, and I'm BluWave's founder and CEO. BluWave in many ways is the toy I wish I had. And so for most of my career I was in the private equity industry, so I was a PE investor for nearly 20 years. Was a partner at a PE firm in New York. And every day I had challenges of needing to work with really, really good third parties. And having an extreme difficulty finding and connecting with them because every need was different. And so in a fit of entrepreneurial inspiration, some may say craze, I founded BluWave about seven years ago. And together with Houston and team, we've built a business that's being used by a reasonably large cohort of private equity. So hopefully some of the insights here are helpful, both from a prior perspective, but also current.

Houston Slatton:
Great. Thanks Sean. Andrew, we'll send the first question to you. As we jump into talking about commercial diligence and end markets, how do you think about a target's end markets? And why does it matter when considering an investment?

Andrew Joy:
Yeah, it's a great question. I think before even thinking about why it matters, it's important to think long and hard about defining the targets and market itself. And so there's a number of different ways businesses compete in across a bunch of different axes, from geographical to business models. So I think, does it compete internationally? Does it compete nationally all the way down to hyperlocally? And then within that, I'll use automotive references a lot, just because that's where I focus most of my time. But automotive is broad. So if you're looking at an opportunity there, it's not sufficient to define it as automotive. You have OEM and you have aftermarket. Within aftermarket, you have the OES channel and the independent channel. And then, is the type of product or service, is it do-it-for-me or is it do-it-yourself?

And the further you can click down and define what the target market is, the more powerful then, when you understand the trends in the market itself, is more beneficial. So really spending time upfront, defining what the target's market is can pay dividends when you then start to understand the trends in the market. Then go into, how do you think about it? I mean, it's probably the most, if not one of the most, critical aspects of underwriting in due diligence from our perspective. There's the broad topics of understanding just, is this market in secular growth? Is it in secular decline? But then it all the way goes down to market share, relative market share, value proposition. How does this company compete against its competitors? And that really then is the building blocks behind how you think about creating value post-close. And so understanding those factors and those aspects of the target are critically important to your underwriting and return profile, and value creation playbook.

Houston Slatton:
Perfect. Now I know it definitely started to dive into several topics that we'll discuss a little bit later as well. Sean, anything you want to add?

Sean Mooney:
Yeah, I think all of those were completely spot on. One thing that I would add is, as I think about prior life, but also what we get to see from the lens of just supporting things is, in many ways the market always wins. And so PE I think is also really good at understanding the basics of starting big. And if I reflect on my prior experiences, if we had a company serving a great market and we had kind of an okay team, companies still pretty much did fine. And did well, in fact. If we had a lousy market in decline and a great team, the market won also. We were doing everything, scratching and clawing. And then what I'd say is, if you had a great market with a great team, magic would happen. You would just knock it out of the park. And so I think that's one of the reasons why you also see private equity firms digging into this so much. And what Andrew shared is also in many ways the masterclass of where you got to go to use it, because it's not just the market. And so.

Andrew Joy:
Yeah, what's the expression of rising tide? Let's all boats, but totally agree. Fighting against market secular headwinds is incredibly, incredibly difficult even if you have a solid management team and the right strategy, and all the other right components of a good deal.

Houston Slatton:
And how do you go about assessing market conditions when you're looking at a deal? Andrew, you want to start?

Andrew Joy:
Yeah, There's multiple different approaches that you can take. You can start by, I'll call it the do-it-yourself model, which takes a lot of internal time and resources. And frankly learning. Unless you're an industry specialist, you kind of got to relearn all the aspects of that particular industry to then understand the trends within it. And so, a lot of times you're looking for publicly available data, or databases. Reading up on trade journals, or publications that are specifically tailored towards that industry, or end market. You can do the consultative GLG, or Guideboard model, to start to point you in the right direction. And so you're trying to take all information and data points that are available to you, both publicly and that you can pay for. And synthesize it down into a format that you can then make business decisions upon. And so that's a pretty big task, if you will.

And that's one of the reasons why Hidden Harbor, the vast, vast majority of the time, outsources that to someone who knows this industry cold. And whose job it is to really do that work on our behalf. And so Hidden Harbor's been using BluWave to identify those, and we'll get into some of that later. But identify who's the right fit to really do that work on our behalf since the beginning of our firm seven or so years ago. And so there's the outsource approach and then there's the kind of do-it-yourself approach. And despite what private equity guys may think, time of their team is a finite resource. And I'd rather have our teams focused on where their strengths lie in terms of financial due diligence and underwriting, than being able to outsource to experts to understand the market. So at a broad approach, there's the outsource model and then there's the in-source model.

Houston Slatton:
Yeah. Sean, what do you want to add?

Sean Mooney:
Yeah, I think once again, that's a 1,000% spot on. And maybe one of the things that I would add to that is, when you're thinking about the market, it absolutely is this triangulation. There's rarely an off the shelf report that's going to say, "Here's what it is." And if it is, it's highly speculative in terms of how accurate it is, and you'll pay a $1,000 to get one chart. At least that's what I did. And one of the things though, as you're triangulating that I learned the hard ways, time and time again. And have the privilege of seeing how people like Andrew and Hidden Harbor do it better than I did, was just spending also a lot of time on how you want to define market. Because one of the things that I think everyone here will appreciate and absolutely no offense intended to my investment banker friends, but they're going to show you the largest version of the market and the fastest growing market possible.

I don't think I ever looked at a confidential information memorandum or sim that didn't say it was a X billion dollar market that was growing at some crazy percentage market. And actually, they were part of that market, but it was a really, really small part of the market. So part of the artistry that we've had the privilege of seeing how folks like Hidden Harbor do this is like, let's really focus on the market that they're actually in, and then also look at what's left. And maybe up and down, so you can see where you can go. But that's something I think is really important is taking the time to frame what that market is, because it's going to be in the buyer's best interest to say it's the biggest, fastest growing version of itself that it could ever be.

Houston Slatton:
Yeah. No, that makes sense. I know you touched on this briefly, Andrew, in terms of the outsource model if you will, but do you want to give us your definition of commercial due diligence? And why you use it?

Andrew Joy:
Yeah, absolutely. And so, the definition of commercial due diligence in my mind is a synthesis of all factors, both historically and in the future, that affect the growth and the competitiveness of the target in that particular model. And so again, stepping back, that can be a huge number of factors. Not just from end market demand drivers, but also things like regulatory input from the EPA, for example. And automotive to global competition, and threats from low cost countries, and demographic shifts within your target market. And so there's dozens of inputs, if you will, or variables that affect that ultimate number that you're striving for to plug into your model. Which is, what are we underwriting this company to grow at, the rate of growth to grow at? But also what is the deviation from that base case? In other words, how do different economic cycles take you off of that base case, i.e. how cyclical is it?

How does the industry respond to those cycles? And so, at its core, it's answering the fundamental question of, what do we believe this business will grow at over our whole period, and beyond? And so the scope of it being typically isn't just five years, it's more 10, 20 years. Because just as important of the next five years growth is, what matters just as much is the growth beyond that. As you think about your exit and the exit multiple that you'll be able to garner on your business is a function of the market trends that are 10, 15, 20 years out. So it's all to answer those fundamental questions. And then how we use it, I would say it serves a number of different purposes, down to voice a customer. How does the customer think about your target? What is it good at? What is it not good at?

So there's the macro part of the commercial due diligence, but there's also the micro element that helps to inform you of, what are you going to do with this asset once you own it? And so it really creates the foundation for that value creation playbook. So by the time we close on a transaction, we have a really strong hypothesis around, what are the value creation levers that we are going to pull over our whole period to create outsize market returns? And that's informed by the commercial due diligence as well. And that can be obviously number of different facets that get informed by commercial due diligence, whether it's, what adjacent markets should this target enter? Where is its right to win from new geographic perspective? What is its competitive position relative to others? And how do you capitalize on that? So just as important as the market part of it is to understand that tide, and if it's going to lift all boats or not. But then there's the micro side of it of, how are we going to generate outsize market returns with our particular asset?

Houston Slatton:
Yeah, perfect. Thanks Andrew. Sean, how would you define commercial due diligence, and why to use it?

Sean Mooney:
Yeah, once again, I think Andrew's description is a 100% spot on. One thing I would add, I think for our private equity investors on this call, they're going to know exactly what this is. For entrepreneurs, business builders, family, business owners, just maybe framing it. Commercial due diligence is a term of art for a market study. It's typically provided by market strategy firms. And it is, as Andrew shared, it is standard operating procedure by the best private equity investors in the world. And maybe double-clicking on what Andrew shared is, there's been an evolution of the product that's been really interesting to watch over the last multiple years, certainly the last five to 10. Whereas before, it started off as this document that a private equity firm that was more about trust, but verify. Is the market as big as the market they said it was? It hasn't been growing at those rates, is it what it was?

And that's frankly, most of due diligence products 10 years ago were trust, but verify. And the really interesting evolution that we can maybe go in a little deeper on is, in the next questions, is that it's evolved to not only trust but verify, but what can a company could or should be. And what Andrew says, "What will it be in the future?" Which I think is really important. And I love Andrew's perspective also on this. It's not just the five years, it's the next 10 years. And so for the CEOs and business builders on this call, that's the mindset you have to have. You're not building for the next five. Because if nothing else, if you're going to sell the next person, there's got to be some cream left to build it for the next five years. And so I think Andrew's point there was incredibly insightful about how far to look out as well, in terms of how to make this thing useful. Because if you're only thinking three to five years ahead, you get in kind of a chess versus checkers game.

Houston Slatton:
Yeah, exactly. As kind of a segue almost, Andrew, how does the result of a commercial due diligence engagement inform the competitiveness of your bid strategy typically?

Andrew Joy:
Yeah, for sure. Look, I think as information and data has become more commoditized and more accessible, it's becoming harder and harder to really find areas where you have a competitive advantage, or an angle. We like to say, "What's our angle on this target or deal?" And to borrow an example from the hedge fund industry, 15 years ago it was a competitive advantage to use satellite images of Walmart's parking lot to determine how much demand for quarterly earnings there was. That is now commoditized and the ante to just get in the game. And so, to go back to private equity, we all have access to the same tools. Everybody uses GLG Guidepoint, and that's just the ante to get into the game. And so you really have to then figure out how this target, or this opportunity, fits within an angle that you can play. Whether that's operationally, whether that's commercially, so that you can justify to your committee why we think this asset is more valuable, and we're going to be the winning bid.

Yet, at the same time, we're not overpaying for the asset. And that's always looking for that angle or competitive advantage where you have information asymmetry that other bidders don't have. And by finding, not just a commercial due diligence provider, but the right one is critically important to answering that fundamental question of why we believe we can be the prevailing bidder and still create outsized risk adjusted returns. And so it's becoming more and more competitive just generally in private equity, and you have to find ways to create that angle for yourself. And convince yourself that this asset is more valuable and you should be paying a higher price, but at the same time, do that through understanding at a more fundamental level what the market is doing. And how you can create value with the target in that market.

Houston Slatton:
Yeah, in a more data-driven way in some sense.

Andrew Joy:
Yes.

Houston Slatton:
Yeah, exactly. Great. Sean, what do you want to add on bid strategy?

Sean Mooney:
Yeah. I think the only thing I would add is there's this evolutionary trend in the private equity industry where, as Andrew said, they want to cause as much information asymmetry as possible, and expose as much of the value creation plan as possible to all the buyers by the investment bankers. And I don't begrudge investment bankers at all for doing it. That's their job, and they're really good at that. So they want to expose as much information as possible, whereas the private equity firms want to see something that no one else sees. And one of the big trends is investment bankers are starting to put sell side commercial due diligence studies in the data rooms. And for some the incentive maybe for private equity firm's, "Oh, this is great. I can rely on the money that they've spent and I'll just take their word for it." But kind of the news flash is if you're buying the market study, you get to pick what it says, so you can frame it.

And so I think that's one of the reasons why the private equity industry still is very much using their own source of truth because it goes down to cat versus mouse, buy versus buy. One person's going to say it's the best version of itself, whereas the truth probably lies somewhere close to there, but not necessarily in the upper right quadrant. And so that's one of the things, as you think about this evolution and competitive dynamics in the industry, is you're seeing private equity firms continue to evolve in how they use this tool. Even when people are saying, "Here's a trusted source of information that's better than the off the shelf study." That we used to all buy and pay $3,000 for to get one picture six years ago. So that's all I have there.

Houston Slatton:
Perfect. Andrew, you made a great point a minute ago saying, "Finding the right provider is critical to making sure that your bid is competitive." Can you talk to us a little bit about the pros and cons of the big box firms versus some of the more specialized firms?

Andrew Joy:
Yeah, for sure. And I fundamentally think, more important than the logo of the firm, is the particular team that you'll be working with. And I think that's true, not just in commercial due diligence, but in investment banking, or QB, or what have you. And so it's critically important to find the right team in that commercial due diligence provider. And that team can be found within the big boxes, or in the more boutique providers. And you can get really good value in either one of those buckets. I think each of them have a list of pros and cons that I can mention, but that doesn't make one necessarily any better or worse than the others. I think with the big boxes, you know what to expect in terms of materials and deliverables. And sometimes the bigger firms have wider networks and more access to information.

On the kind of con side is, just given their mandate they tend to be less niche, if you will. They tend to be more generalists within industry groups. But really, if you come to them with a project, they're going to say yes, and find the team to staff it. That is the closest experience with it. I think on the boutique side, they tend to be more tailored, more niche. They tend to have a lower cost as well, just given they don't have the old gray haired guys, and the infrastructure taken a cut from. And so there's a role for both of them in this industry, and there's pros and cons, but I think it's really finding the right team that has the most relevant experience, and just knows the market cold. I mean, that's really what you want to find. They know the players in it, they know how it operates. They know who to reach out to to get what questions answered.

They know where the data lies, and they're not figuring this out for the first time, if you will. And that's frankly why we have used BluWave in the past, for that very reason. There's not a lot of transparency in the marketplace of professional services. And I'd say it's been one of the most frustrating parts of starting a private equity firm has been finding good reliable professional services. And BluWave creating a level of feedback loop, and transparency where they have proven firms that have worked with other private equity clients. And when, take for example, an engagement that we do, they're following up and saying, how did they perform versus expectations? Where did they do good? Where did they do bad? So they can continue to tailor that roster. And having an aggregation of that versus just a sample size of a small end of firms that we have used, just makes it a exponentially higher chance that you're able to find the right person, or the right team for that particular project.

Houston Slatton:
Exactly. Sean, how would you compare and contrast the big box for specialists?

Sean Mooney:
Well, I appreciate the kind words by Andrew. And that really was the inspiration for, what some people described as the biggest midlife crisis in private equity history. So doing a startup is not common. But really I think that speaks to so much of what I felt, and one of the things that if you think about the world of private equity, it's starting to become this tension between alpha and beta. Are you going to buy with the market? Are you going to see something that the market doesn't see? And as the competitive tension of supply and demand kind of intersected in private equity with more and more capital under management chasing the same supply of deals. What's causing pressure for me to say, "I can't just be a market taker anymore because the surplus is being skimmed." I have to see something that no one else can see, because at the same time, the investment bankers were really good at exposing all of the good things about the company, which was making us purchase at the intersections supply and demand.

And so, one of the things that I saw and certainly see much more clearer here is with the advent of sell side market studies, or commercial due diligence and buy side. The undifferentiated commercial diligence firm is calling the expert networks to get the insights about the markets that they're sharing. And odds are, if one over the other is not using a specialized group that sees something that the expert networks don't, everyone's getting beta. They're spending hundreds of thousands of dollars on the sell side study, which is calling two of three market expert networks. Your buy-side group is doing the same thing. So you're paying on both sides hundreds of thousands of dollars to get the same information as each other.

And so, where we're seeing private equity firms really go in... For instance, if they're trying to get a handle on what's going on with the auto industry and the strike that's going on, you could call a big group that is an expert in it. Or you could call one of two groups that are in the boardrooms of the big three every week and they're going to truly tell you what's going on.

Now, I completely also agree with Andrew within the big boxes, there are some very good groups. And so it's not to dissuade or say they're not. But the only advice I'd have is, when you are looking at the two to Andrew's point, which is a hundred thousand percent on, comes down to the team. And so making sure that that team really has the experience with the target, the market, the end market, the industry. So that they're not calling the expert network right after you call, before you submit your IOI, and learning the market at the same time as you. And so that'd be the only advice I'd say is that's where specialization of a team within a big group, or specialization with the firm gives you alpha.

Houston Slatton:
Agree. I know we're a few minutes over here, so we'll hand it back to the panelists for any final best practices, tips, or tricks that you guys have. And then I think we've got a few minutes to take Q&A, if you both do. Andrew, I'll start with you. Any final thoughts?

Andrew Joy:
I don't think it's additive, but maybe just reinforce the message of over-investing on the front end to find the right firm. I think that will really dictate whether you feel like this expensive investment was worth it, or it's just pretty stack of papers. And so the deal process is laborious and it's fatiguing, but really taking the time upfront to find the right group that will answer the critical questions that you're really have to, will pay dividends. A lot of groups that'll say yes to the project, but the ones that will provide real value is a lot smaller.

Houston Slatton:
Sean?

Sean Mooney:
Yeah, I think what we would say, kind of dovetailing on what Andrew said, is when you're vetting your group, so I'll show exactly how we do it. It's your experience in the defined industry you're exposing? Which projects have you worked on in this industry? When did they work on it? Who was the team that worked on it? Going back to Andrew's comments about alignment and getting the right people on that. Then the other thing that's really important that I didn't appreciate during a lot of my career is the concept of behavioral economics. You have to know where they're happy to get their margin and where their price points are, because different players play at different price points. And so we spend a lot of time, and I certainly got this wrong a lot of time, where I try to pull an upmarket firm down to my budget.

And invariably what happened is I'd get the 23-year-old, no offense to the 23-year old, who they dared to be great and say, "All right, kid, this is your chance to show your chops." And then we just wouldn't get a great product, because it's not that that group wasn't phenomenal. They have scarcity of capacity in their own right, and so they would have to make choices about where they put the quality of their respective teams. So make sure that's aligned.

And then the other thing, I think particularly times like now when deal markets get frenzied, as people rush even in this market, to the year-end capacity comes an issue. So really vet the capacity of the team. And I think that's one of the things that has made this engine that we've built work, because literally we have over the thousands and thousands of projects, tens of thousands of their quals built into this cognitive engine that we've built. And then we're constantly checking with them on a capacity. So by the time the PE firms call us, we already know who they need, why they need it, what their quals are, what their availability is. And then have the ability to compel them to bring the A team to our clients, because there's a broader set of recourse beyond, for me, when they could move one block over in Midtown if they burned me. And so that would be the only other thing that I would add to that.

Houston Slatton:
Thank you both. I think we've got a couple of questions from the audience here. First question is just for you Andrew, "What's the best way to reach out to you at Hidden Harbor?"

Andrew Joy:
Best way to reach out to me was via email, ajoy@hh-cp.com. So ajoy@hh-cp.com.

Houston Slatton:
Perfect. That was an easy one, just warming you up here. And then the next one's for both of you. "How do you use the findings from a commercial diligence to inform your value creation?" I know we touched on that throughout the conversation, but can you dive into that just a little bit deeper?

Andrew Joy:
Yeah. Look, I think there's a universe of where private equity plays in convincing themselves that they can create value post-close. And that universe spans supply chain to manufacturing, to new product introduction, to R&D investments, and everything in between. And the validity or underwritability of that really boils down to the learnings that you find in the commercial due diligence. And you really ask the question of, where's this company's right to win? And how do they get that right to win? And how does that extend into growth? And so it's amazing to see sometimes. And that when you do a full cycle of investment from closing to selling and you look back, and you say, "What were the three biggest and value creation drivers of our return?" And you're able to say, "Those were the three that we identified in diligence." That's pretty powerful to have that amount of conviction, and be right about that. And being validated.

And it goes back to the just competitiveness of the market. Where Cerberus had a concept called fixed EBITDA. It was more an operational approach of saying, "Hey, headline price on this is seven times TTM EBITDA, but once we do our operational fixes, we're really buying this thing at four times EBITDA." And a lot of that was informed through operational and commercial due diligence. And so it's a way to at least convince yourself that you can pay a bigger price for this stuff, but you're still getting a good value. So it interplays a lot with both the post-close, but also in a lot of regard increases the probability that you're able to win a process.

Houston Slatton:
Perfect. Sean, how did you use commercial diligence to inform value creation planning?

Sean Mooney:
Yeah. I think the exact way that Andrew said as the right way. Can you use this as a tool to help you get alpha, not beta to see things that other people don't and can't? And then the art of the business terms changes from how we optimize it to how do we transform this into something that's more beautiful, and larger, and stronger, and better. And the way that Andrew does it is the exact way, the best of the best PE firms like Hidden Harbor do it. So I have nothing else to add.

Houston Slatton:
Great. I think that covers all the questions we got. So appreciate the submissions. And thanks to Andrew and Sean for joining us. Appreciate your time. If anybody would like to be connected to Andrew, he shared his email. Or feel free to contact us at BluWave, and we can get you in touch with him as well. And as always, if you need best in class PE grade commercial diligence firms, or other things like interim leaders and other professional services, for both diligence or value creation needs, you can reach out to BluWave via your client coverage representative. Or through our website.

Sean Mooney:
Special thanks to Andrew for joining. If you'd like to learn more about Andrew or Hidden Harbor Capital, please see the notes for links. If you'd like to be connected with the world's best in class, PE grade professional service providers, independent consultants, interim executives, or anything else that we discussed during this episode, give us a call or visit our website at bluewave.net. That's B-L-U-W-A-V-E, and we'll support your success. Please continue to look for The Karma School of Business Podcast anywhere you find your favorite podcast, including Apple, Google, and Spotify. We truly appreciate your support. If you like what you hear, please follow, rate, review, and share. It really helps us when you do this, so thank you in advance. Onward.

Private equity insights for and with top business builders, including investors, operators, executives and industry thought leaders. The Karma School of Business Podcast goes behind the scenes of PE, talking about business best practices and real-time industry trends. You'll learn from leading professionals and visionary business executives who will help you take action and enhance your life, whether you’re at a PE firm, a portco or a private or public company.

BluWave Founder & CEO Sean Mooney hosts the Private Equity Karma School of Business Podcast. BluWave is the business builders’ network for private equity grade due diligence and value creation needs.