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

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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.

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 Convest Partners, started my career on the investment banking side and appreciate the opportunity to speak on this matter.

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 Bluewave 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.

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 a 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 than when you understand the trends in the market itself is more beneficial. So, really, spending time up front defining what the target's market is can pay dividends. When you then start to understand the trends in the market. Then going to, 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.

We were doing everything, scratching and clawing. And then what I 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 master class of where you got to go to use it. Because it's not just the market.

But I 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.

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 Bluewave 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 firms 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 kind of outsource model, and then there's the insource model.

And at least that's what I did.

And one of the things, though, as you're triangulating, that. I learned the hard way time and time again and have the privilege of seeing how people like Andrew and Harvard 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 kind of 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 market that was growing at some crazy percentage mark. 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 Ken and Harvard 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 right, 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.

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. As 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 outsized market returns? And that's informed by the commercial due diligence as well, and that can be obviously a number of different facets that get informed by commercial due diligence. Whether it's what adjacent market should this target enter, where is this right to win from a 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 votes or not. But then there's the micro side of it of how are we going to generate outsized market returns with our particular asset.

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 than verify. Is the market as big as the market? They said it was, it hasn't been growing at those rates, you know, 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 the company could or should be? And what Andrew says, like, 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.

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 and 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.

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 firms. 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 newsflash is, if you're buying the market study, you get to pick what it says so you can frame it. 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, spy versus spy.

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 to add.

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 you know, and sometimes the bigger firms have wider networks and more access to information. You know, on the kind of con side is, you know, just given their mandate, they tend to be less niche. If you will.

They tend to be more generalist within industry groups. But really, you know, if you come to them with a project, they're going to say yes and find the team to kind of staff it. That is the closest, you know, experience with it, I think. You know, on the boutique side, you know, they tend to be more tailored, more niche, you know, they tend to have a lower cost, you know, as well. Just given they don't have the, you know, old gray hair guys, you know, and the infrastructure taking a cut, you know, from.

And so, you know, there's a role for both of them, you know, in this industry, and there's pros and cons. But I think, you know, it's really finding the right team that has the most relevant.

Experience, and, you know, 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, you know, they know, you know who to reach out to to get what questions answered.

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

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 was 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 is making us purchase at the intersection of supply and demand. And so one of the things that I saw, and certainly see much more clear 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 or 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 out two of three market or 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're looking at the two to Andrew's point, which is 100,000 on. It comes down to the team and so making sure that team really has the experience with the target, the 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.

Andrew, I'll start with you. Any final thoughts?

What'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 firm calls, 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 would, just they could move one block over in midtown if they burned me, and so that would be the only other thing that I would cover.

I know we touched on that throughout the conversation, but can you dive into that just a little bit deeper?

And how does that extend into growth? And so it's amazing to see sometimes 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 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. So 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.

If anybody would like to be connected to Andrew, he shared his email. Or feel free to contact us at Bluewave 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 Bluewave via your client coverage representative or through our website.

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