If you have worked in private equity for any length of time, you are likely familiar with the concept of a growth potential analysis. This type of analysis is referred to in several ways. Common terms are whitespace analysis, infill study, greenfield study, and market study. Regardless of the term used, it is a staple among commercial due diligence reports.
However, not all growth potential analyses are created equal. A thorough report serves several purposes in the commercial due diligence process: proving the runway, supporting accurate valuations, and understanding unit-level performance drivers. In this blog, we’ll explore each of these purposes to provide a more thorough understanding of potential analysis objectives.
Growth Potential Analysis Purpose #1: Prove the Runway
Investment theses for retail and healthcare targets often rest on the assumption that there is adequate runway. Buyers of early stage companies must be convinced that there is room to begin expanding the network while resting assured that there is plenty of pipeline left when it comes time for divestiture. Similarly, firms looking to invest must identify room for incremental unit and sales growth to justify the investment. A costly mistake is to move forward with an investment without first proving the runway.
The last couple of years have exhibited strong fundraising for PE while asset prices have soared. This dynamic coupled with high IRR expectations leave general partners (GPs) with a challenging landscape. They are required to put capital to work in an increasingly competitive environment. Accepting higher multiples inherently increases downside risk. To take this risk, GPs must be certain of the runway in a potential target, and firms looking to exit will be required to convince buyers that adequate runway does indeed exist.
Growth Potential Analysis Purpose #2: Support Accurate Valuations
A second purpose of many growth potential analyses is to provide data-driven estimates of future revenue, which is important since revenue projections are leveraged in valuation models and lead to earnings estimates. Multiples are subsequently applied to obtain reasonable bid/ask prices.
The ability to derive network-wide sales estimates through unit-level forecasting instills confidence in valuation estimates because the revenue predictions are not a generalization of network sales growth. This is an important factor. A generalization of sales growth consistent with unit count growth fails to take into consideration priority of investment. In contrast, the growth potential analysis can arm PE firms with investment prioritization in terms of revenue potential. This enables firms to focus on investment in top-tier trade areas and avoid wasting capital by opening sub-par locations and ultimately sacrificing IRR to limited partners.
Driving organic top-line growth is highly effective in achieving multiple expansion and requires a targeted and surgical approach to ensure that incremental units will indeed perform above current network AUV. A growth potential analysis can support this objective.
Growth Potential Analysis Purpose #3: Understand Performance Drivers
The growth potential analysis not only supports the goal of understanding what a realistic foreseeable unit count and sales expectation looks like, but also reveals strategic insights throughout the analysis process that can be used to refine operating practices post acquisition. Competitive insights, core customer definitions, and other insights regarding performance drivers are examples of things that are often products of the growth potential analysis and may be just as valuable as the growth potential number.
Competition analyses are often conducted during the due diligence process of a transaction. Is this a fragmented or consolidated industry in which competing companies are most harmful to the target company? Is this industry one in which employing a colocation strategy is most effective? Is there a reason why certain geographic areas lack competition? These are just a few of the competition related questions that must be addressed prior to the transaction. A comprehensive understanding of the competitive landscape is essential to an accurate growth potential analysis.
In retail and healthcare settings, the most important performance driver is the consumer. An effective growth potential analysis will always include some degree of customer segmentation modeling. It’s obvious that not all consumers should be treated the same and some are going to be more valuable than others. Customer segmentation modeling provides insights regarding who the best customers are, where they are located geographically, and the value that is associated with them. This level of insight can also inform customer acquisition efforts. Having a thorough understanding of the customer is critical to driving top-line growth at the unit level.
Conclusion
Proceeding through competitive rounds of bidding without a comprehensive growth potential analysis is akin to flying blind. This specific due diligence component is integral for firms looking to acquire but can also be leveraged to underscore valuation in cases of divestiture. Growth potential analyses have become a standard aspect of thorough commercial due diligence. Firms that ignore this research are at a severe disadvantage.
Not all growth potential analyses should be treated as equal. Quality reports lay the foundation for quality earnings estimates and confident bids. Growth potential reports should not only quantify incremental unit count and revenue, but also reveal insights on drivers of unit-level performance.
Buxton’s private equity consulting team has prepared growth potential analyses for hundreds of transactions. Learn more about our approach to buy-side and sell-side due diligence.
