1. AUSTRALIAN PRIVATE EQUITY & VENTURE CAPITAL JOURNAL MARCH 2011 Page 18
COMMERCIAL DUE DILIGENCE:
MORE THAN A RUBBER STAMPCarl Brostrom*
Few would question the need for legal,
financial or tax due diligence prior to
committing to an acquisition. But commercial
due diligence ... surely that should only
confirm the business case?
Not necessarily. Our experience indicates that
independent commercial due diligence may
raise strong doubts over the business case in
as many as 25 per cent of planned acquisitions.
And where it does confirm a business case it is
unlikely to be a rubber stamp possibly
identifying unrecognised risks, threats and
opportunities as well as testing the overall
investment thesis.
Conducting commercial due diligence is about
assessing the value of a potential investment
and managing risk. Conducting a thorough due
diligence process is essential when making a
corporate acquisition and can often be the
difference between success and failure. For
small acquisitions this process can sometimes
be managed internally but for larger
acquisitions there is a strong business case to
employ external support. Gone are the days of
two-month exclusivity periods ... as well as
physical data rooms with hundreds of ring-
bound documents (and no copy machines!).
With tight deadlines and high stakes applying
in typical current acquisition scenarios it is
ever so important to put the best team
together to achieve a short and efficient due
diligence process.
There are many reasons to invest in a robust
commercial due diligence, including: accessing
specialist expertise or experience which is not
available in-house, getting a second opinion on
the investment thesis through further research
and analysis, obtaining an independent report
for the banks to be approached for debt
finance, getting a deeper understanding of
customer satisfaction levels, assessing growth
opportunities, or to provide a decision basis
for the board.
The key reason to conduct commercial due
diligence is to assess whether a target is a
good or bad acquisition. Out of more than 50
due diligences that our business has
completed over the past three years, a quarter
did not meet the required investment criteria
for one or another reason. It is our strong
belief that conducting due diligence is not
about “rubber stamping”, but understanding
the real strengths and opportunities that exist,
how they can be leveraged to deliver value,
and what are the potential risks and threats
that may be encountered along the way.
In most commercial due diligences there are
nine key questions that you need to ask
yourself:
1. What generates revenue and profit?
Not truly understanding the business
model leads to uncertainty around the
valuation and future strategy.
2. What is the attractiveness of the
markets in which the target is
operating? It is critical to understand
the size and growth of the markets in
which the target operates to assess the
revenue upside and risks associated
with the investment.
3. What is the positioning of the target
within the competitive landscape? We
need to understand how competitors
are positioned to assess the
sustainability of our revenues and
margins.

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4. How do customers perceive the
services/products offered by the
target? Understanding your customers
is critical in order to estimate risks and
opportunities associated with the
acquisition.
5. What are the key risks that the target is
exposed to? Identifying risks, assessing
their likelihood and impact and ways to
mitigate them are important for every
acquisition. For instance, how could
external factors such as forex
fluctuations impact on EBITDA and
other bank covenants?
6. What are the opportunities? Identifying
and testing opportunities are crucial to
develop a fair understanding of the
current value and potential future value
of the target.
7. What is the quality and fit of the
management? Will management be
able to deliver on forecast and work
with you as a team?
8. How sustainable are revenues and
profits? Taking all of the above into
account, how sustainable are the
revenues and profits and what is the
likely upside/downside?
9. What is the exit strategy? For
acquisitions conducted by private equity
companies it is also important to review
the exit opportunities.
There are of course many good acquisitions
available in unattractive markets, and bad
acquisitions in highly attractive markets – it is
the combined assessment of all of the above
criteria and the mitigation of risks that will
ensure the ultimate success of an investment.
In our due diligence work, we have helped
uncover findings that have led our clients to
walk away from an acquisition; including:
Major customer about to shift to a
competitor (derived through customer
interviews)
Industry relying heavily on government
subsidies to exist, with questionable
future outlook
Too much reliance on one customer (e.g.
>50% of revenues from one customer)
No barriers to entry protecting the
business model from imports (e.g. in
industries with comparably higher
domestic input costs)
Business exposed to Australian sector in
structural decline (automotive supplier)
Competitor investing in superior
technology and thereby achieving a cost
advantage
High exposure to bad debts (low tier
personal lending)
Profits driven by non-core services
No barriers to entry protecting the
business from new entrants in the
domestic market (often the case in many
service industries)
Too much risk associated with regulatory
changes (e.g. tax reforms)
Exposure to cyclicality (e.g. high degree of
discretionary spending)
On the other hand, we have also helped
identify new business opportunities, allowing
our clients to value those in their assessment
and future ownership.
Structuring the due diligence
process
There are a number of important practices
that form a successful acquisition process:
1. Prepare early: discuss the due diligence
process with your key advisors early on.
This allows them to prepare the best
possible team and assist you in the pre-
due diligence work
2. Test key value drivers upfront: it often
pays off to test the most critical
investment thesis upfront before
committing to a major due diligence
across all streams (commercial, finance,
legal, and tax).
3. Allow sufficient time: due diligence
processes are typically time constrained
by nature. However, the value you get
from a three week DD compared to a
one week DD is typically much greater.
Consider the time it takes to accumulate
data and get all your advisors up the
learning curve when planning the
process.
4. Work as a team: you will get the best
value from your advisors by integrating
them in your thinking. Don’t wait for a
final report; conduct a number of
working sessions throughout the
process.
5. Build a winning team: having the right
external advisors around you is just as
important as your internal team. When
working with the same external advisors

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you learn to trust each other and get a
more honest dialog going.
6. Select the ‘right team’: working with
the same advisors only adds value if
they have the right skills to complete
the work. There is no logic to engaging
an FMCG specialist for an acquisition in
the mining industry.
7. People skills are important: the ability
to engage with management and
successfully interview key stakeholders
are often the most important parts of
the due diligence process.
8. Listen to the advice: do not hire
advisors to rubber stamp your
investment thesis. Listen to their input
and be prepared to accept a negative
recommendation.
*Carl Brostrom is a partner at Value Line
Consulting. Value Line Consulting is a
specialised strategy consulting firm providing
services to the Australian and New Zealand
private equity industry.
**This article has been recreated from the
version published in the Australian Private
Equity & Venture Capital Journal. Some of the
formatting may appear different.