Creative Industry DD Tips & Hacks
November 4, 2021 | Issue #49
Big Deal Small Business: Creative Industry DD Tips & Hacks
November 4, 2021 | Issue #49
In private equity, I have the benefit of a seemingly unlimited due diligence budget. When you’re investing $100-200 million of equity at a time, you can spend a BIG number to get all questions answered.
I’m not talking about Quality of Earnings or Legal Due Diligence or anything like that.
I’m talking more about squishier, harder-to-define industry due diligence questions that ultimately matter WAY more than your QoE:
Who are the winners & losers in the industry value chain going forward?
How stable & resilient is the industry?
What are the key trends in the industry?
How fragmented is the industry?
How does consolidation in suppliers or customers impact this business?
In private equity (or strategic acquisitions), they can answer these questions with experience and connections. When those don’t suffice, they can throw money at answering the questions. You can pay high-priced consultants to do market studies, you can pay for industry experts’ time, you can buy useful data sets, etc.
In search & small business acquisitions, we are generally less experienced in the target sector than the average PE partner or strategic acquirer. We often have fewer relevant connections as well.
And we are extremely cost-conscious, partially due to deal size, but primarily because deal costs impact our runway.
If you don’t come from a “professional M&A” background, you may not realize just how much experience & money are spent on larger deals.
Couple of anecdotes from my experience:
I did a deal in 2020 that last sold in 2006. The lead partner I worked for had looked at the business in the 2006 auction and chose to pass on it. He has continued to follow the industry & business for the past 14 years. When it came back for sale in 2020, he pulled the trigger now that industry dynamics had shifted and the valuation was better. The sellers took a bath on their 2006 purchase; he had been right to pass on it the first time, and he had the conviction to buy it this time around.
On a recent deal, we and our consultants did blind phone interviews (they didn’t know who we were) with ~10 suppliers, ~25 middlemen/distributors, and ~25 customers. We also completed a 1,250-person customer survey.
Most PE firms will budget 2-5% of the deal in deal costs. So a middle-market deal (say $30M of EBITDA at 10x = $300M EV) will generate $6-$15 million in deal costs. Even if you assume 90% of that is spent on lawyers, accountants, and bankers, it still leaves you with a couple million bucks for just industry diligence costs.
Look, we can debate whether all this is necessary or just false precision, but the reality is that searchers are playing with one arm tied behind their back when it comes to industry diligence.
So, we have to get creative.
I’ve written up a few ideas that have worked for me in the past - if you’ve got more, I’m all ears.
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Public Companies
Use the public markets to your benefit. Start by figuring out who the biggest public companies in the sector are. I'll run you through a quick example.
Say you're looking at a landscaping company. Start by literally googling "largest landscaping countries in the USA" - that will reveal a list. Go see which of those top firms are public companies. In landscaping, the #1 company is Brightview and it is public.
First, go read their 10-K to learn the basics about the sector. Specifically, read the business overview. Look for what KPIs they track and what industry lingo they use. Go to the Segment Information section to drill down a bit deeper into specific product lines that may be more relevant to you.
Second, go to their investor relations website and find their latest Investor Presentation. Flip through that. This will give you a sense of their long-term strategy & focus areas.
Third, go to their quarterly earnings call transcripts and read at least the last 4 quarters. This will give you a sense for short-term trends. Pay attention to what kind of questions the analysts ask during the Q&A portion - they're mostly bad questions, but some of the good questions will reveal what the "market" is actually worried about.
Fourth, go through their financial information, specifically analyst projections and valuation basis. The actual numbers & valuation are not that relevant to SMB - you're looking at the trends. For example, has revenue grown consistently over the last several years? How did the business perform during the 2008 recession? Analyst projections provide insights into market views: if the business grew 20% in 2020/2021 but is expected to decline 20% next year, you know the market views the 20% growth as a "COVID bump". That's not definitive by any means - projections are always wrong anyway. But it's directional data and helps you understand where to focus with your target company.
Lastly, if you have a friend who works at hedge funds, asset managers, etc., bug them to look for an initiation report from one of the equity research groups at investment banks, even if it's a few years old. These serve as useful industry primers but are generally only available to bank clients.
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Public Data
First, start with trade & industry research organizations. For example, when I was looking at an Alaskan tour operator, I found the Alaska Travel Industry Association, which runs a comprehensive Visitor Statistics Program.
From this data, I was able to find 10 years of tourism data for Alaska, including what activities they did, where they came from, how they got there (cruise, air, car), etc.
That allowed me to build conviction that the tourism sector in Alaska was rock solid (ex-COVID). Summer visitors to Alaska had grown at a 4.2% CAGR from 2010 to 2019 and total spend by air travelers on package tours was growing ~8% (that business was 100% exposed to air travel, not cruise travel).
Second, join public Facebook groups or Reddit threads focused on the sector. You start to get the "feel" for what people are complaining about, what they're focused on, etc. You also start picking up important lingo & abbreviations.
Third, look at job postings on websites like Indeed or Linkedin. This will help you assess if the current staff is being paid market, below market, or above market. If all the job postings for a service tech are at $40/hour and your target is paying $25/hour, you could inherit a big problem.
Fourth, look for government/non-profit data sources. While you likely know big governmental sources like the FRED for macro data, you'd be surprised at how much great data is collected by smaller non-profits. For example, the UNLV Center for Gaming Research has reports covering 10+ years of betting data to the # of tables & slots in Nevada for every year going back to 1963.
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Experts
Sourcing Experts
In private equity, we do anywhere from 5 to 50+ expert calls on any given deal. We basically pay $1,000/hour to talk to handpicked industry experts.
For example, if I'm looking at a toy brand, I email our expert network provider something like "Hey, I want to speak to purchasers at big box retail and independent toy stores."
The expert networks gets back to me in 24 hours with a list of ~10 purchasers I can speak to on an anonymous basis. It's pretty sweet, and I miss that cheat code in search A LOT.
So how do we find our own experts?
First, I start with my alumni network. I went to a large university with a business school, so I've had a lot of luck here. I'll do a search of each of the big companies in that space and see who I find. On any given deal, I can usually found 1-2 experts in that industry who are willing to talk to me from a cold email.
Second, I use Linkedin to find 2nd & 3rd connections, big surprise. You know how to do that (or google it and it'll be clear).
Third, I go back to industry associations and try to find membership lists. Barring that, the board of directors of the association is usually published at a minimum, so I can start with someone on that list and see if they're willing to chat. With this approach, you have to be extra careful around confidentiality given a lot of these search-focused sectors are quite small.
Lastly, work the personal network. You should be telling everyone & anyone you know about your search endeavors anyway (to generate potential deal flow through moments of serendipity). It's a great excuse to re-connect with investors or smart people in your life who you know are well-connected.
Do not attempt to learn an industry without talking to someone, ideally a lot of people. You can read a million online reports and public company financials. And yet, 30 mins with the perfect expert can totally change the way you look at a deal.
Utilizing Experts
In private equity, I try to do 3-4 calls early in the process - the experts are a tiny sample size with heavy personal biases, so the actual "data" from them is questionable.
The reason I do them early is to 1) get the industry overview quickly, 2) ask a lot of dumb questions BEFORE talking to the target, 3) figure out all the public sources of information, and 4) try to learn what I don't know I don't know.
For example, I will always ask them to walk me through the 5-6 largest companies in the space. What are their strengths & weaknesses, what is their market position, etc.
I'll get a bunch of basic questions out of the way, particularly around business model. For example, do companies in this sector charge on a fixed fee basis or a time & materials basis.
I'll ask them about the best industry associations, niche publications, data sources, and trade shows - that unlocks my ability to access more people & data quickly.
Most importantly, I use time with experts to assess concerns that I didn't know were concerns. I ask questions like, "if you were starting a new company in this sector, what would you be focused on?" or "what are the top 2 risks facing this sector in the 5 years? 10 years? 25 years?"
The goal is to elucidate open-ended responses that triggers a long list of questions that I can go talk to my target company about.
In search, you have to make some adjustments given experts are harder to come by, but the approach is largely the same.
These conversations obviously won't be on an anonymous basis, so that does give you some latitude to lay out your vision for the business. Put it all out there - you want them to shoot it down and poke holes. That is high-value advice, even if you end up disregarding it.
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Conclusion
This is a non-exhaustive list of ways to get smarter on industries & businesses quickly and cheaply. I hope it's a useful toolbox and the examples generate some ideas for you.
I'm sure many of you have figured out other "hacks" - I'd love to hear them.
As always, please feel free to send me your thoughts. Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing
P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, located in Seattle or the Bay Area).