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This is the third article in a series of five were we present our take on how the most effective PE firms approach due diligence in China.
1. Understand the industry… including how companies “game” the system
Make sure your investment professionals spend enough time in the field to gain a deep understanding of the competitive dynamics of the Target’s industry. All market segments are “gamed” to some extent; make sure you understand how and to what extent this happens in the Target’s industry.
2. Confirm competitive advantage
Make investigating the Target’s competitive advantages and the future sustainability of these advantages a key part of the due diligence. Don’t mistake “strengths” for competitive advantage. All companies have strengths, but only few have competitive advantages that can be relied upon to beat the competition when times get tough.
Our Perspective: Focus less on industry growth rates and Target management forecasts and more on competitive advantage
According to our experience, more China private equity deals fail due to lack of target competitiveness than due to any other factor. In short, most Target-specific failures occur because funds invest in Targets that are not positioned to win.
Succesful investors are not blinded by the ‘China growth story’ and high industry growth rate projections. First, macro level forecasts are often misleading. It is essential to look at growth rates with the right granularity; growth in the Target’s sub-sectors /product markets can differ substantially from that of the sector as a whole. Secondly, industries with high projected growth rates often see intensive competition as new money is invested by established players and new entrants. Many companies in high growth sectors do not grow at all. This is especially true in sectors with modest barriers to entry where new investment can quickly result in excess capacity and price-based competition. Investors often fail to catch this because they do not determine the extent and sustainability of the Target’s true competitive advantages vis-à-vis its peers. This requires a solid competitor benchmarking and a critical mindset when trying to disprove a Target’s competitive advantage.
Read the other posts in our series on how the most effective private equity firms approach due diligence in China:
Learn more about our methodology and approach to Private Equity Due Diligence and China Acquisition Due Diligence, to discuss how we can help you organization please contact us.