China is hotbed of private equity investment. PE funds raised $27 billion in Mainland China, Hong Kong and Taiwan in 2007. With so many candidates—and so many funds in pursuit of China's best prospects, how do private equity firms decide where to place their bets in one of Asia's largest private equity markets? Private equity's best buyers are masters at taking a cold, realistic look at enticing opportunities and reaching a decision based on proven information, not untested assumptions.
Private equity acquirers determine a company's true value through rigorous and dispassionate due diligence. A top-to-bottom examination of the company allows them to test their "going in" assumptions against the facts. It also provides a clear understanding of the business's full potential and what it could be worth in three to five years.
This tightly focused due diligence process builds an objective fact base by scrutinizing several factors that help answer the fundamental question: Will this acquisition make money for investors? In the intensely competitive Chinese market, such scrutiny can help private equity buyers discover a compelling reason to pay more than another bidder—or throw up red flags that put the brakes on a flawed deal.
While due diligence is a difficult task anywhere, in China it's more daunting and more important for private equity investors. Unofficial payments and other hidden costs are part of doing business in China, and they aren't reflected in a profit-and-loss statement. Also, because published accounts aren't as transparent as they are in other regions and sources of information are inconsistent, it's hard to get a handle on true costs and industry competitors.
Sending in a due diligence team
The due diligence process starts by verifying the cost economics of an acquisition. Veteran acquirers know better than to rely on a company's own financial statements. Often, the only way to determine a business's stand-alone value is to strip away all accounting idiosyncrasies by sending a due diligence team into the field. The team collects its own facts by digging deeply into such basics as: Does the target's competitor have cost advantages? Why are the target's costs above or below expectations given its relative market position? What is the best cost position the target could reasonably achieve?
The due diligence team also gets to know the customers. They begin by drawing a map of the target's market, sketching out its size, its growth rate, and how it breaks down by geography, product and customer segment. This allows them to compare the target's customer segments—their profitability, promise and vulnerability—to its competitors. Has the target fully penetrated some customer segments but neglected others? What is the target's track record in retaining customers? Where could you adjust its offering to grow sales or increase prices? Can the target continue to grow ahead of the market? In researching those questions, private equity teams don't rely on what the target tells them about its customers; they approach the customers directly.
Good due diligence practitioners always check out the competition. They dig out information about everything from strategy, operations, cost position, finances, even technological sophistication. They track pricing at stores. How does the target compare to its rivals in terms of market share, revenues and profits by geography, product and segments? They look at industry profit pools and try to determine if the target is getting a fair (or better) share compared with its rivals. Once again, effective teams don't rely on what the target tells them; they interview competitors where possible and piece information together by comparing notes from wholesalers and retailers. It's likely that such due diligence led investors Blackstone and Bain Capital to pull out of its deal with China's home appliance and electronics manufacturer Haier to acquire Maytag.
Examining the capabilities of competitors is critical. Take the bid of a global food company for an overseas maker of fruit flavorings, which we'll call FruitCo. The lure was that FruitCo had considerable global scale, but when the acquirer studied the market, it realized that the key competitors were regional. Regional scale was the critical driver of cost and competitors were better positioned than FruitCo to share costs and build regional scale. So, its strategy—that FruitCo would make money by growing global scale and competing on cost—wasn't feasible.
Analyzing the micro details of a deal also helps acquirers get a head start on making smart strategic decisions. When a global cosmetics maker decided to buy into the Chinese market by taking over a large hair care player, the acquirer—which was not a private equity fund—used information from due diligence to develop an integration strategy. The analysis showed that in order to reach the hair care maker's full potential, it made better sense to run the company as a stand-alone business and keep its existing management team before fully integrating it. This approach improved the odds of achieving the deal's projected pay off a sales increase of more than 10 percent and increased distribution.
While due diligence is a powerful tool for unmasking an acquisition's fatal flaws, executives must wield it judiciously. China Mobile Communications' stymied attempt to acquire Millicom International Cellular illustrates the risk of alienating the targeted company by being overzealous. China Mobile thought it was doing the right thing by conducting exhaustive due diligence, but its approach left Millicom uneasy. According to some accounts, those concerns, along with pricing issues, ultimately led Millicom to reject a long-term relationship with China Mobile.
Lessons for entrepreneurs
So how can entrepreneurs and corporate managers use these private equity lessons to make their companies more attractive to perspective investors? By asking critical questions and digging into the data, managers can help discover their company's full potential and the underlying weaknesses that could make them less attractive acquisition targets.
Winning managers start by stepping out of the 12- to 18-month budget planning cycle and asking: How high is up? What is the company really worth? Which handful of key initiatives, either undertaken from scratch or reinvigorated, will have enormous impact three to five years down the road? Think "blank sheet of paper." Why would somebody want to own this business or its component parts? What can this business become?
It's unlikely that a company's management accounting system will spit out good answers. In fact, many corporate management teams know far less about the environment in which they operate than they think they do. As a result, they often don't challenge their own conventional wisdom until it is obvious what needs to be done—in other words, too late.
Emulate the private equity investors' due diligence process by examining the factors that drive demand and measuring products and services against competitors. Like private equity acquirers, entrepreneurs or corporate managers must ask: Are there gaps in performance that need to be addressed? Where and how? What are the customers' future purchase intentions if we do nothing? How will that affect our market share? If we change things, what is the upside? What are the risks?
All of these questions are hard to answer. The key is knowing where to find the hard data and knowing how to piece that information together to define a future environment for the company. For others, like macroeconomic cycles and technology changes, there will be ranges of outcomes that need to be evaluated. The bottom line: to fully define the full potential of a business, managers need to see what the facts say about the company and what levers can be pulled to create value. They also need to fully understand the investments and risks facing the business in the future to complete the picture.
Smart private equity investors take the long view and look ahead to the time when they'll be selling the company to another acquirer. With that in mind, the goal is to not only hit a three-to-five-year growth target, but also build sustainable growth into the company's DNA. When the time comes to sell, the next set of owners will do their own due diligence. If they sniff out future deterioration in value, it could devastate returns—and convince them to walk away from the deal.
Orit Gadiesh is the chairman of Bain & Company. She is coauthor of the book Memo to the CEO: Lessons from Private Equity Any Company Can Use (Harvard Business School Press, February, 2008). Vinit Bhatia is a partner based in Hong Kong. Michael Thorneman is a partner based in Shanghai. Bhatia and Thorneman colead the firm's private equity practice in Greater China.
Learn more about how PE firms use six disciplines to attain their edge.