Importance of Commercial Due Diligence (CDD) in M&A

Published:2014-05-21    Source:HICG

Most investment institutions overate the importance of financial due diligence (FDD) and legal due diligence (LDD), neglecting the market position, industry development trend and relevant market scale of the target company. The core of FDD and LDD is to investigate that whether there were any material financial or/and legal frauds in the past. In addition, validity of the available documents draws the attention. When investing into niche markets, investment institutions tend to overestimate the future development of a target company solely based on their own analysis of historical financial information. In practice, investment institutions fail to notice that the industry has reached the ceiling in terms of the total market scale. Such situations are usually seen in the industrial equipment markets which are occupied by few oligopolies. Although those new entrants may grasp tiny market shares in particular regions to gain high growth in beginning years, they might reach their market ceiling very soon and be exposed to the market leaders.

Thus, investment institutions shall introduce a CDD team to analyze various external factors comprehensively before the capital injection. From the perspective of investing, the CDD team shall estimate the market scale, competition landscape and subject’s advantages in a niche market.  

Huaran Consulting, hereby, would like to share a case study based on the historical CDD experience. 

Huaran was once retained by a foreign private equity to conduct CDD upon a Chinese pharmaceutical packaging company. No market research has been ever conducted regarding the Chinese pharmaceutical. After one-month research, Huaran found that the target company had experienced 25% compounding growth in last four years and became a leader of the tier 2 players in the industry. However, the target company met its bottle neck for future development. Meanwhile, the top leader of industry occupies nearly 45% market share and the top three oligopolies take almost 70% market shares. This market structure has remained for a decade. 

If the targetintends to achieve substantial growth in the industry, it has to invest large amount of capital in updating facilities to improve product quality and in expanding sales channel.   

Moreover, Huaran Consulting noticed the profitability of pharmaceutical packaging industry is relatively low. From the perspective of the client, which is a foreign PE, it is difficult to keep the investment payback within 5 to 8 years or go for a public offering. As the industry is highly related to the pharmaceutical industry, the product quality is strictly regulated. Meanwhile, trusted business relationship between a supplier and a pharmaceutical company is built upon long-term cooperation. Therefore, becoming a supplier of a large pharmaceutical company is very difficult for any new entrant. Huaran Consulting then deliver the CDD report to foreign PE and facilitate client to revalue the target company’s future development and income.