PE investment due diligence 2.0- back-to & beyond the basics
It’s common knowledge that China’s economy is in a period of transition as evidenced by slowing economic growth and economic restructuring as the country re-orientates from an industrial export-driven model to consumption driven economy. This great restructuring in turn signifies increasing challenge in looking for worthy targets because whereas in the past where many targets can ride the wave of China’s boom, the present day requires much more cherry picking on firms with defendable advantages and market positioning and have the potential to grow.
At its heart, this distil into 2 key challenges- one is the ability to discern deals in the midst of uncertainty and two being the ability to grow portfolios for eventual return upon exit. To the former, there needs to be more purposeful assessment of deals- what I will call due diligence 2.0, while for the latter it will require relentless pursuit of value creation.
Due diligence 2.0- Both a back-to-basics and going-beyond-basics
Traditional due diligence has become almost a checklist of sorts- getting the commercial, financials, accounting and legal in order and within commercial, it has always been the usual list of market sizing, competitive dynamics and customer analysis.
Yet my contention is that due diligence 2.0 needs to both take a deeper step back-to-basics while also going-beyond-basics in assessment. Going back-to-basics for one entails the deeper recognition of the imperfections of the Chinese market in terms of incomplete information and even fraudulent cases at times. One will recall that in recent years, the now familiar fraud cases of Longtop Financial Technologies or Sino-Forest that left investors with write-downs and the wider market with deep concerns on fraud and panic in the market. A back-to-basics due diligence will thus examine deeper on both governance as well as financing of the company. Governance arrangements often reveal how the management team considers its responsibilities and exposes warning signs of whether there are misappropriation of company resources. Financing due diligence should examine not just financial management but also the finance relationships that a target company has with its financers (banks etc.) and if these financers are reliable and credible. Understanding historical loans and capital structure also gives more light on irregular activities- for instance historical capital raising when there were no clear needs or when there’s ample cash reported suggests that there may be more to the picture. Even more fundamentally, there should be dedicated interests in doing more field visits and assessment when conducting due diligence, such as actually checking out stores or factories of a potential target, for often you will be surprised to find in China that the reality on the ground is very different from the understanding from a financial statement or online lit search.
On the other hand, a going-beyond-basics approach should complement back-to-basics due diligence. While due diligence 1.0 will only assess likely trends of how market and competitive dynamics will change, due diligence 2.0 will look perniciously into growth drivers individually and really assess the potential risks and likelihood of growth drivers being achieved upon investment. There should be a dedicated focus on scalability, in terms of gauging the growth potential of the target in question. In addition, there should also be greater attention and focus onto management-team diligence, where investors critically assess the know-hows and capacity of the existing management team. This is crucial as even with majority or complete ownership, there’s always a limit to what we can do as investors in a company and a huge degree of a deal success depends on the management team’s capacity to drive changes and growth. The groundedness from field visits mentioned above should also give deeper perceptiveness into the actual growth potentials of how customers perceive a certain product and services and the likelihood of mass adoption.
Such more fundamental and deeper lens to deal sourcing should help out in filtering poor deals. The question then becomes once you made an investment, what’s the pathway to deal success?
Relentless pursuit of value creation
The most classic take to PE is that you do not want to invest in a great company but rather you want to invest with a good company with great growth potential. With that backdrop, it becomes critical to have a clear value creation plan to take an investment through to exit. Which is why even at the phase of due diligence, there should already active thinking into the potential value creation opportunities including new growth markets and products, potential costs reduction and synergies and other operational improvements.
As mentioned, the new normal in China means that general partners can no longer just rely on the overall momentum of the economy for expansion of multiples but will need an active spirit in creating value. For one, a deep understanding of a target company’s core consumer fundamentals and how the target’s products/ services fulfill those fundamentals will create a strong market positioning.
Another insight into value creation is in cross-fertilization of ideas from different industries and spectrum. Often by borrowing insights from other industries, it greatly helps a target in question to identify creative solutions that enhances growth. A case in point will be Hillhouse Capital that actively arranges exchange and brainstorming sharing sessions across its portfolio companies. For instance, previous exchange amongst portfolio companies Blue Moon (a detergent company) and JD (online ecommerce platform) led to Blue Moon redesigning its detergent packs to better fit with JD delivery standards.
The increasing maturity of the PE market in China creates challenges in sourcing and identifying good targets. To which, my contention is that adopting a due diligence 2.0 approach along with a relentless pursuit of value creation will go a long way in driving deal success in China.