For private equity (PE) firms, both buy-side and sell-side transactions are full of risk and opportunity. One often-overlooked aspect is getting a handle on both by using an assessment of the strength of the company’s relationship with its customers.
Relationships, often deemed a “softer” aspect of the investment, determine how likely a company is to continue its revenue and income trajectory. Customer diligence, the process of systematically analyzing a sample of customer data and feedback, can complement traditional financial analyses for an in-depth perspective.
There are a few key ways that customer diligence can mitigate risks in private equity deals: by examining hidden value, identifying risks, and uncovering further opportunities.
The Hidden Value of Customer Relationships
The strength of a company’s relationship with its customers is a significant indicator of long-term success and sustainability. According to Bain & Company, companies that excel in customer experience grow revenues 4-8% above their market’s average. In the context of PE, understanding and monetizing these relationships can reveal the hidden value of a target acquisition (or sale) that might not be immediately apparent through financial statements alone.
For example, a company with a loyal customer base will usually have more stable and predictable revenues. Loyal customers are not only more likely to make repeat purchases, but they are also more likely to recommend the company to others, effectively acting as a free marketing channel. This can be particularly important in industries where word-of-mouth and reputation significantly influence purchasing decisions.
Recently, firms have been approaching Loyalty Research Center (LRC) for a better perspective on identifying cross-sell opportunities. New customer growth is always welcome, but a strong customer base is frequently a far easier path to growth. Whether new products lines are being considered post-transaction or loyal customers aren’t cross-purchasing due to lack of awareness, getting direct customer assessment will enable a better decision.
Uncovering Risks
Customer diligence is not just about finding hidden value; it’s also about uncovering potential risks that could jeopardize the investment. By analyzing customer feedback and behavior, Pes can identify red flags that might indicate underlying issues within the target company. (Alternatively, if they can uncover and address these issues, revenue and income will improve considerably.)
For instance, if a significant portion of customers express dissatisfaction with a company’s product or service, this could signal quality issues that need to be addressed. According to a survey by PwC, 32% of customers would stop doing business with a brand they loved after just one bad experience.
LRC typically finds that problems occur, on average, with approximately 20% of a B2B customer base each year. However, problem experience alone does not necessarily put a company at risk. It is the resolution process where good companies differentiate themselves. Customers are far more likely to have weak relationships with a company that cannot resolve problems effectively. Such insights can alert investors to potential churn and revenue decline risks that might not be evident from financial metrics alone.
Moreover, understanding customer concentration risks is crucial. If a company relies heavily on a small number of customers for a large portion of its revenue, the loss of one key account could have a devastating impact. A study by S&P Global Market Intelligence found that high customer concentration is a significant risk factor in business failures. A few years ago, LRC conducted in-depth interviews with 8 key customers that accounted for nearly 45% of a client’s revenue. Significant problems were found in 3 of these 8! These problems could easily lead the account to reduce or eliminate their spend with the client. The client management team had no idea of the magnitude of these issues.
Further, with either a small customer base or key accounts, it is imperative to know who owns the relationship with the customer. If key personnel were to leave post-transaction, would customers leave with them? Utilizing a third party to conduct customer diligence, PE firms can evaluate the extent of this risk and plan mitigation strategies accordingly.
Identifying Opportunities
Beyond risk mitigation, customer diligence can also uncover opportunities for growth and value creation. By gaining a deeper understanding of customer needs and preferences, PE firms can identify areas where the target company can improve or expand its offerings.
For example, customer feedback might reveal unmet needs or demand for new products and services. According to McKinsey, companies that use customer insights to inform business decisions can increase their operating margins by more than 60%. By leveraging these insights, PE firms can develop strategic initiatives to enhance customer loyalty, driving revenue growth post-acquisition.
Additionally, customer diligence can highlight opportunities for operational improvements that can continue to impact the bottom line. These improvements can include identifying which activities or areas of spend add no value and can be decreased or eliminated. LRC tends to organize these recommendations into quick wins and longer-term investments to help guide their
This should set up the team to hit the ground running post-transaction to maximize ROI. As diligence studies tend to be short and focused on providing high-level insights, they can also provide a great foundation for a larger VoC study to dive in-depth to any issues uncovered.
Conclusion
In conclusion, customer diligence should be a critical component of the due diligence process for private equity firms. By focusing on the strength of customer relationships, PE firms can uncover hidden values, identify potential risks, and discover opportunities for growth and improvement. In a competitive market, these insights can make the difference between a successful investment and a costly mistake.
Investing in customer diligence provides a more comprehensive view of a target company’s potential, ultimately leading to more informed decision-making and better investment outcomes. As the private equity landscape continues to evolve, incorporating customer insights into the due diligence process will become increasingly important for achieving long-term success.
References:
- Bain & Company. (2021). “Customer Experience Tools and Trends.”
- PwC. (2018). “Experience is Everything: Here’s How to Get It Right.”
- S&P Global Market Intelligence. (2020). “Analyzing Customer Concentration Risks.”
- McKinsey & Company. (2019). “The Customer-Centric Organization: Drivers of Operating Margin Growth.”
- Image by Christina Morillo and sourced from Pexels.com.