The use of commercial due diligence has been on the rise for private equity buyers in particular. But more than a risk mitigation exercise, it feeds directly into post-acquisition strategy. Jason Sinclair looks at a service line increasingly in demand.
Commercial due diligence (CDD) is an objective enquiry to critique and assess the commercial matters relating to a target entity, such as the market dynamics, competitive landscape, customer relationships, appropriateness of the target entity’s business model, achievability of its financial projections, any risks, upsides and everything that would have an impact on the company’s sustainability.
That’s a pretty comprehensive list. Put in simple terms, Lushani Kodituwakku, founder and managing director at Luminii Consulting says: “It’s confirming to a potential purchaser or lender how commercially viable a target entity is, and whether they are likely to be able to deliver on their financial forecasts, thereby supporting their ‘go’ or ‘no-go’ investment or lending decision. Also, the CDD findings can often influence deal terms and valuation adjustments and help inform the purchaser’s 100-day plan and post-deal strategy.”
The provision of CDD has grown exponentially over the past two or three decades. As deal counterparties weigh up whether to undertake CDD work in-house or to engage the services of an adviser, they have, says David Larsson, KPMG’s lead partner for deal strategy, come to realise that “it’s a very intense process, to be able to assess an asset in a tight M&A timeline. You might need to take a lot of people out of their day jobs. And if you don’t have the capacity or capability to do that, it becomes difficult.
“Then there are other situations where the acquisition is a strategically critical move, and so the board may insist on a third-party view or a different independent perspective. If you’re a business that does serial, small acquisitions, then that’s probably not needed. But if you’re doing anything bigger than the norm, or more complex, where you feel there is a greater risk, you may well benefit both from more brainpower, more analytical bandwidth and simply another perspective.”
That brainpower and bandwidth provided by CDD practitioners is commonly tapped into by corporate clients commissioning sell-side reports, and by private equity houses using both buy- and sell-side services. Typical reports blend market analysis, competitive landscape audit and risk assessment. CDD work also digs into a company’s commercial strategy and quantifies the risks, synergies and opportunities buyers should expect. Forecasts and projections, which will probably form part of the FDD review, are only as good as the assumptions underpinning them. To be robust, they must be based upon the best commercial insight possible, – which of course includes competitor activity and likely response to any significant developments by the company modelled in the projections, and the impact of technological development on the business and its markets.
Larger trade buyers, when a deal is in their core area of expertise and who may have a strategy that means acquisition programmes rarely stray from their specific sector, often carry out CDD in-house sometimes augmented by commercial due diligence on new markets or products.
Corporate world
Chris Hunt, Rentokil Initial plc group M&A and global accounts director, has been involved in more than 400 acquisitions through his career and stresses the importance of in-house CDD assessments for the company’s bolt-on targets: “The vast majority of businesses we buy are bolt-ons. They’re businesses that are in our core market and services so we will know how to run them. So we don’t do the full market assessment you’d engage an adviser to do. We use third-party advisers when we’re going into businesses that are tangential to the ones we currently operate.”
Opportunities to cross-sell and up-sell, pricing efficiencies and routing, staffing and cost synergies “where we may be able to introduce new service lines, use our own pricing templates, help colleagues spend more time with customers and less time driving, or removing subcontractors by using our own people” are what Hunt looks for in CDD reports: “I look for that rather than just where the market is going.
Private equity, which invests in a broad range of sectors, has always been far more likely to engage external CDD advisers than corporates with sector-specific commercial expertise in-house. Alistair Brew at BGF, who is also chair of the ICAEW Corporate Finance Faculty, says the 14-year-old private equity firm has been conducting more extensive commercial due diligence in the past few years: “As markets become more competitive, private equity will want to be particularly sure about their investment case. And having some independent, expert market work done is very helpful in that regard. I’ve often found that management teams find it the most valuable part of due diligence because they can learn more from it than some of the other due diligence areas – and often more than they expected to learn."
‘As markets have become more competitive, PE needs to be sure about their investment’
So what is it that they may learn? There are several questions it is healthy to explicitly articulate. How much is your market growing? What’s its market share? What are competitors doing? What do customers really think about them? Are there other synergy and growth areas to explore? “All of those questions can come up in a CDD process,” says Brew. “You’re trying to understand the competitive advantage of the businesses and whether it’s sustainable. Using third parties to do that is helpful and something that would often never be done in the ordinary course of business.”
That’s particularly true of smaller businesses, where CDD can add value and provide a blueprint for post-acquisition strategy. The process can be viewed as a chance to step back, look at the business and ensure it has the most appropriate strategy.
Brew’s colleague at BGF, portfolio talent manager John Coburn, says: “From pricing to management, CDD reports inform future strategy and how the business is operated, as well as helping the investment decision. Most of the businesses we’re investing in are run by founders who may not have had access to this level of external support. And that’s not just on CDD, but across all the different diligence streams we’re using on deals.”
Learned behaviours
At Pearson, the FTSE 100 learning company, VP for deal operations Matt Edmonston says: “Our first port of call would be to ensure we’ve mobilised our internal resource. We have good muscle memory within Pearson across all of our key functional areas. In terms of scoping more broadly, then it really depends on the size of the deal, and as we start to get a little bit bigger, it might be that we need more capacity.”
Corporate development director Chris Botsakos adds: “When we start to get away from our bread and butter we need to go to external providers and the larger the ticket size, the more we’ll want to make sure we’re 100 per cent buttoned up as we spend meaningful capital.”
In a typical CDD process, he says: “We go in with an open mind. We’re trying to flush out value on the one side and risk on the other. This means getting under the skin of the target as quickly as possible. There does come a tipping point, relatively quickly, where we get to understand the level of risk we are taking on if we continue. But it’s both value and risk we’re looking at.”
‘Our first port of call would be to ensure that we’ve mobilised our internal resource’
Upside leverage
The framing of CDD, Coburn says, is very much: “This is not just us coming in and putting you through the ringer, and then making an investment decision.” Rather, he says, “This is about introducing top-quality consultants, who can prepare a piece of work that we will leverage together to enhance the business longer term.”
Luminii’s Kodituwakku says many clients tell her the CDD report is the one document post-deal that both investors and management teams revisit to start implementation of the recommendations, “because a lot of CDD goes into post-deal strategy, and strategic and operational recommendations naturally come out of the CDD findings”.
‘From pricing to management, CDD reports inform future strategy and how the business is operated’
This is perhaps the major distinction between CDD and financial due diligence, which provides financial advice on a deal, some of which will come from looking at similar data. Kodituwakku’s colleague at Luminii, director Ioana Nobel, adds: “We place significant emphasis on strategic recommendations where we articulate an area that needs improvement or is an opportunity that has to be actioned to propel the company’s future growth, and we get asked to work on that post-deal.”
One of the difficulties with CDD, and yet one of its beauties for practitioners, is that there’s a wide range of sources and methodologies to address the questions you are facing. KMPG’s Larsson says: “It therefore often requires an element of creativity that isn’t always the case in some other types of due diligence, where there is perhaps more standardisation. There’s an incredibly varied range of datasets and analyses that you might use to get to an answer to your questions.”
One way of viewing CDD is that it brings the outside in, more than the inside out. “Whereas financial due diligence is looking at the internal financial health of the business,” Kodituwakku says, “we look at the external market and external environment and the impact that will have on the business and its growth. You could also say financial due diligence is more backward-looking as to what the performance was, and the commercial more forward-looking, asking what they are going to achieve in the future, taking into consideration the market and the external environment.”
‘Where there is an opportunity that has to be actioned to propel the company’s future growth, we get asked to work on that post-deal’
And, of course, CDD can be as long as a piece of string. It can be a very targeted exercise, or a broad, deep and insightful output. One change over the past decade or so, adds KPMG’s Larsson, is that as buyers become more sophisticated and practitioners more experienced, CDD has become less about identifying the risk: “It’s about isolating risk and then thinking about what to do about it. It has become a much more positive and proactive piece of work than it used to be. If I look back over my career, it’s amazing the amount of new data sources that now feed into a CDD report. Whether it’s credit card data, digital online traffic data, consumer ratings data – these are all things that 15 to 20 years ago you couldn’t dream of. There’s the increase in the number of data sets on the one hand, and then on the other, the amount of analysis you can perform on that data. Both are of a different order of magnitude to what they used to be. The role of being a CDD practitioner has evolved enormously over the past 20 years.”
On the front foot
Vendor CDD is “increasingly part of the standard pack sellers prepare” says KPMG’s David Larsson. “Generally, it leads to better outcomes as you can educate bidders upfront, so you get greater transparency.” As with vendor financial due diligence, it can cut the process time and improve cost efficiency overall.
Initial will use vendor CDD for larger divestments. Its group M&A and global accounts director Chris Hunt says it is a “market norm” if involving private equity bidders. Unlike buy-side CDD, Hunt says, “’On the sell side, we engage somebody to do that for us and it’s almost like an independent view that can be handed over to a potential buyer.”
For Alistair Brew, BGF will engage in vendor CDD “particularly if selling to PE, or if the company is in an unusual area and we want to be on the front foot painting a picture about the business. It also helps maintain competitive tension for longer because you have control of the information flow for longer. If you’re on the buy side and in that situation, you would read all that, take it in and it would inform your bid. However, follow-up questions are usually necessary and buy-side work can follow.
“The market for good assets is seen as more competitive and so investors have to be more confident on a bid that is required to win the mandate. CDD is helping to grow that confidence, which is why the CDD market itself has grown.”
‘We engage someone to do sell-side CDD; it’s almost like an independent view that can be handed to a potential buyer’
Private equity often wants to understand the operations, but trade views the commercials from a slightly different angle. “Trade always wants to think about integration,” says Larsson. “What are the skill sets? How do they operate? What’s the structure? It’s all about synergy and efficiency once they land in a new home, and so they need to think very proactively about how the two come together.”
And all of this means the valuations put on a business earlier on in the process are likely to be more credible, and that companies and PE houses are more likely to be aware of what they’re buying. And so completion has greater certainty. Larsson echoes this: “That means the outcome for the buyers is likely to be better going forward. And frankly, in the long term, that’s what we’re all after – right?”
Advances in AI?
“We need to look out for any change in how you run a process and where you may become more efficient, but there are important parts of the process you may lose. We know there’s a tendency for AI to ‘hallucinate’, where it doesn’t come up with the right answer. You still need to ensure you have the wherewithal and experience to be able to test that what comes out of AI makes sense, and is in line with other findings you’ve produced. You do that through the traditional triangulation and consideration before you offer recommendations. There’s an element, in my mind, of AI generating both excitement and an element of caution. You can execute more at a greater pace – a clear step up. On the other hand, there have always been new tools, new data sets, new analyses – it’s just a natural continuation, but the pace of change it is generating will probably be a step change.”
“At Pearson, we aren’t using AI extensively across the M&A process, but we definitely see the genesis of something that could be used extensively in CDD. It’s particularly good at informing where a target sits in the market, and some of those bonuses you want to get a sense of before you’ve even entered into the due diligence process. I think AI use will inevitably only increase over the next few years.”
"AI is something we cannot ignore. We've already started using it. Incorporating it into CDD can be helpful in getting research done faster. But on the flip side, we cannot depend completely on AI, as there can be quite large inaccuracies."
In the CDD guideline Luminii produced with KPMG and the ICAEW Corporate Finance Faculty, one recommended action is that CDD reports or their findings are not put in the public domain.
“Commercial due diligence is, by nature, highly confidential and very specific to each deal. That's why the use of AI in this space needs to be carefully internalised. While AI can certainly support the process, it cannot replace the critical human judgment required to navigate the nuances and risks involved.
"AI is useful for streamlining more routine tasks — such as initial data collation and basic analysis — helping to improve efficiency. However, the outputs still need to be reviewed, refined, and contextualised by experienced professionals.
“We’ve started developing our own internal tool, LumiAI, which is designed to assist with these foundational tasks. But it’s important to note that it’s not used for generating deeper insights or recommendations. That level of analysis still relies heavily on individuals with years of sector-specific and CDD experience.
Ultimately, it’s not just about presenting findings in a report; it’s about interpreting them and advising clients with a human touch. I’m a strong advocate for AI, but it won’t fully replace the expertise CDD practitioners bring to the table.”
The guideline
Access the Commercial Due Diligence guideline, written by ICAEW’s Corporate Finance Faculty, Luminii Consulting and KPMG
