Setting the Stage for Effective Deal Analysis in Private Equity Investments
By Rick Claar and Josh Emington
Commercial Due Diligence (CDD) is often compared to the work one does when getting ready to purchase a new home. Before finalizing the offer and closing on the transaction, prospective homeowners want to make sure they aren’t getting themselves into anything that might come back to hurt them later. So buyers leverage the tools and processes available to protect themselves against unknown risk: an appraisal, a home inspection, perhaps even some environmental analysis.
But while this analogy may be illustrative as far it goes, it truthfully doesn’t go far enough. Sure, both homeowners and the investment community want to de-risk purchases, working to understand both potential and perils of a given transaction. But there are many more variables to consider and the stakes are far higher when purchasing a business. In the CDD world, not only are we working to uncover and analyze the existing reality, we are tasked with forecasting future and even unconsidered versions of realities down the road. There are many more “moving parts” in the business world that don’t apply to the purchase of a home. Effective CDD explores and evaluates them all.
When executed effectively and exhaustively, the resulting intelligence gleaned from thorough CDD provides a clear map to avoid risk, increase volume, enhance margins, and explore numerous other ways to increase the total returns an investor can capture with a specific target.
Accordingly, potential purchasers of business investments must take a more pragmatic and more proactive approach than their home-buying counterparts in the general populace — one that begins with a clear thesis.
Clarity Counts: Thesis Development
For private equity deal teams, making informed investment decisions relies on developing a clear, testable deal thesis. While this seems to be the pragmatic pathway, it’s too often not the one chosen.
At its core, developing a deal thesis means ensuring the rationale behind the acquisition is grounded in robust hypotheses that can be validated through comprehensive CDD. Crafting such hypotheses is essential in the furtherance of reducing risk and increasing the likelihood of successful outcomes.
It is helpful to keep in mind that private equity deal teams exist to deploy capital, of course. When pursuing deals, we often advise against over-exuberance, which can present the risk of the investment team catching “deal fever” — an emotional zeal that can cloud judgment or lead to unmeasurable assumptions being drawn.
One of the critical challenges in CDD is that many deal theses begin with too-vague assumptions about market potential or operational synergies. Optimism is natural and often warranted. But when lacking specificity and clarity, rosy assumptions can lead to costly errors during the post-acquisition phase. A well-crafted deal thesis needs to focus on what’s actually testable within a given market and business context, and that’s where a structured framework becomes crucial.
We’ve seen firsthand that, in M&A, a clear, actionable deal thesis can make or break an investment. One effective tool for developing these hypotheses is the The Four Cs Framework, which helps categorize and clarify the key components of a deal thesis. This framework helps investors focus on crucial aspects of the potential acquisition or merger, making the thesis more rigorous and actionable.
The Four Cs Framework: A Tool for Hypothesis Development
The Four Cs provide a structured method to break down a deal thesis into manageable and testable hypotheses. This framework ensures that each assumption about the target company and its market is clearly defined and rooted in tangible, demonstrable evidence.
- Customers: Hypotheses related to the customer base are vital. Investors need to define assumptions regarding customer needs, purchasing behavior, and potential for growth — working to determine how “sticky” they might be. For example, “We hypothesize that 30% of the target’s revenue growth will come from existing customers expanding their purchasing volume.” This can be validated through a range of CDD methodologies, including customer interviews and existing/prior sales data analysis.
- Competition: Understanding the competitive landscape is crucial to assessing the target’s future market position. A hypothesis could be framed around how well the target can differentiate itself from its competitors, both now and going forward. For instance, “The target will maintain a 5% price premium due to validated superior product quality.” This assumption can be tested by benchmarking the target against competitors in terms of pricing, market share, and customer loyalty to provide such validation (or not!).
- Company: Operational efficiency and growth potential are central to any deal thesis. Investors need to formulate specific hypotheses around internal factors such as management capability or operational leverage. For example, “We hypothesize that improving supply chain efficiency will reduce costs by 10%.” This can be verified by conducting operational due diligence, including efficiency assessments and cost benchmarking.
- Channels: Hypotheses surrounding distribution channels are also important, particularly in growth-focused theses used in developing GoToMarket (GTM) strategies.. These assumptions might focus on the scalability or effectiveness of existing channels. For instance, “We hypothesize that expanding into digital sales channels will increase revenue by 15% over two years.” This can be validated through analysis of channel performance data and customer acquisition metrics.
Notice that each of the hypotheses posited feature a numerical value, which gives the overall thesis tangible and measurable data points to vet and validate against. Such hard numbers lend themselves well to what can be studied through the course of CDD activities, remove vagaries that are difficult if not impossible to measure, and serve to temper perhaps misplaced rosy optimism by grounding the study in hard data that are insulated from emotions.
Once The Four Cs hypotheses are clearly defined, they become testable through focused Commercial Due Diligence. The data gathered during this phase helps validate or refine each assumption. For example, customer interviews may confirm or challenge growth assumptions, while market data may adjust competitive hypotheses. This iterative process ensures the deal thesis remains grounded in reality, evolving as evidence is collected.
A Second Lens: Defining Valid and Testable Hypotheses
Building a deal thesis begins with understanding the target company and its industry. However, it’s not enough to just know “the basics.” Investors must establish hypotheses about the company’s future performance, which should then guide the due diligence process and future-proof forecasts as a result.
The framework for constructing these hypotheses can be broken down into several key components:
- Market Growth and Dynamics: Hypotheses about the target’s market should be measurable. For example, instead of broadly stating that the market will grow, frame it around specific growth drivers. For example, “We hypothesize that the target’s core market will grow at 5% annually, due to increasing demand in these specific emerging markets.” These types of statements can be validated against external data sources, industry reports, and customer interviews.
- Competitive Positioning: Testable hypotheses around competition might involve the target’s ability to maintain or improve its market share in a particular segment. For example, “We hypothesize that the target’s strong brand will allow it to capture an additional 2% market share over the next three years.” Validating this would require analysis of the company’s competitive advantages and an understanding of its competitors’ strategic moves, and the defined numbers increase our ability to test the assumptions.
- Operational Improvements: Operational assumptions are often a key driver of the investment thesis. For example, an investor may hypothesize that, “Improving supply chain efficiencies will lead to a 10% reduction in costs.” This hypothesis should be specific enough that, during due diligence, operational assessments and benchmarking can be conducted to determine whether this outcome is feasible, or how to calibrate assumptions based on clearer pictures of reality.
- Revenue Synergies: For platform acquisitions or bolt-on strategies, synergies play a major role. Hypotheses here might be something like, “We hypothesize that cross-selling the target’s products to our existing customer base will increase revenue by 15% in the next 18 months.” These are testable by conducting customer interviews, analyzing purchase behaviors, and assessing channel overlap.
- Risk Factors: Every deal thesis should include hypotheses that focus on potential risks. This might include hypotheses about potential regulatory changes, shifts in customer behavior, or supply chain vulnerabilities. For example, “We hypothesize that potential regulatory changes will increase the cost of doing business in this market by 7%.” Identifying and testing these risks is essential to prevent surprises after acquisition. Ignoring or downplaying them due to the aforementioned exuberant zeal presents more risk than those unaccounted for, potentially.
Testing the Hypotheses: From Theory to Reality
Once the deal thesis and hypotheses are framed, the next step is the validation process. Commercial Due Diligence plays a crucial role here, providing the data, insights and on-the-ground inputs needed to confirm or refute each hypothesis.
This stage involves gathering quantitative data (market size, growth rates, customer preferences) and qualitative insights (expert interviews, competitive assessments). The hypotheses provide the guideposts, ensuring that the due diligence process is focused and relevant, enabling better decision-making once the insights are analyzed and reported back to the investment team.
For instance, when testing market growth hypotheses, Commercial Due Diligence teams would analyze macroeconomic trends, customer demand forecasts, and industry growth projections. Similarly, competitive positioning hypotheses can be tested by benchmarking the target against competitors on performance metrics like market share, pricing power, or brand strength.
Refining and Revising
It’s important to note that the initial hypotheses are rarely perfect. That’s not typically the point or objective at first; but rather to provide said goal posts and guard rails. The due diligence process is iterative; as data is collected and insights emerge, some hypotheses will need to be refined or revised. A successful deal thesis is one that evolves based on evidence, improving in precision and reliability as the diligence process progresses — the proverbial “living, breathing document.”
The Power of Clarity in Decision-Making
Clarity is the linchpin of a successful deal thesis. When investors have clearly defined, testable hypotheses, they can systematically validate their assumptions, assess risks, and focus on high-impact areas. This clarity helps avoid the dreaded and dangerous “deal fever,” where emotional or anecdotal factors skew investment decisions, ensuring that the final investment rationale is grounded in evidence.
The Deal Thesis Brief: Validate Your Investment, De-Risk Your Deals:
To streamline your hypothesis development, we invite you to download The Martec Group’s Deal Thesis Brief. This worksheet guides you through the process of categorizing and documenting your hypotheses, assumptions and requirements related to The Four Cs: customers, competition, company operations, and channels.
By structuring your deal thesis around testable and measurable prognostications, you enhance the clarity and rigor of your commercial due diligence, leading to more informed, less risky, and optimally successful investment decisions.
Download the Deal Thesis Brief today to start building a clearer, more actionable deal thesis.
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