In my last post, I complained about those in private equity talking nonsense when sizing markets. But in this post, I want to be a little more constructive and give you a few of my thoughts on market due diligence.
Private equiteers conduct due diligence on markets for one simple reason: we want to understand customer demand for a firm’s products and/or services. We become ensconced in the security of this demand because it will support future revenue and drive future growth, which underpins future value and decides our investment returns.
Understanding customer demand is quite difficult for most investees; it involves a lot of prodding, poking and probing to gather masses of data, most of which is useless, to make inferences about what customers may or may not do in the future. But as long as you understand it’s not a perfect science, it won’t drive you too crazy.
There are two main objectives in market due diligence:
Both of these steps require talking to other people, lots of people… and doing a little textual research on the side. Private equiteers often get too caught up in using Google to understand a market, when really, you have direct access to someone who has operated in this market for many years (the investee’s founder). Additionally, you should see customers, suppliers, competitors, regulators, commentators and anyone else whom has first-hand experience in the market. In comparison to aimless Google searching, you’ll be amazed at the info you can garner from face-to-face encounters with real people.
It’s best to start the market due diligence by defining the hypotheses for your investment. Each hypothesis should relate to the question of whether you should invest in the firm. Once you’ve decided what will make (or break) the deal, go about discovering the market while testing the hypotheses. It’s important not to focus solely on the hypotheses, because you’ll be left with a couple of answers and no real understanding of the market. Equally, don’t focus just on understanding the market, because you’ll end up with a pile of information and no clear decision on whether to invest.
During your travels, you’ll find a lot of people that rely on Gartner and other research providers. But, not only shouldn’t you rely on others for such critical tasks, but you don’t want to give up the experience (and resultant knowledge) of rolling up your shirtsleeves, getting your hands dirty, and learning everything about the industry yourself. To really quantify your research, use a bottom-up approach to understand demand, the future spend of customers, your market share, complements and substitutes, opportunities and threats… and then extrapolate to derive estimates on market size and growth. Even if you’re way off, you’ll have at least learned a lot from the experience.
Good luck… and as Steve Blank mentioned in a post today, you can’t test hypotheses from within your building. Get out there!