Due Diligence for High-Tech Targets

Putting an acquisition target under the microscope

As the high-tech industry continues to consolidate during the

global economic crisis, due diligence is becoming even more impor-
tant for private equity firms in search of acquisition targets. In this
volatile market, however, many firms are forgoing comprehensive
due diligence in an effort to close deals more quickly. This can lead
to sub-optimal outcomes. Rather than dispensing with due diligence,
we suggest accelerating it.

As more private equity (PE) firms
consider acquisition in the high-tech
industry, due diligence is essential to
understanding a targets competitive
environment, innovation capabilities,
complexity and true prospects for
growth (see figure 1 on the following
page). Due diligence can also help firms
determine potential synergies and a
target companys value. Investment
managers use the process to probe for
areas to increase revenue and reduce
costs and discover the potential
benefits and hazards that lie beneath
the surface.
When time is short, however,
managers often forgo due diligence.
This is a potentially costly mistake
that can lead to overvaluation or
underappreciation of potential targets.
Rather than omitting this essential
step in M&A, we suggest performing
an accelerated two-part approach.
A target attractiveness quick scan
evaluates a target company within a
few weeks and provides information
necessary to make first bids. Then, as As more private
negotiations continue, market and
operational due diligence determine equity firms con-
the right price for the company.
sider acquisition
Time Is of the Essence
There are six due diligence success in the high-tech
factors that can help companies cap-
ture the full value of a deal after
industry, due dili-
it closes:
Identify actions that will have the
biggest impact on the top and
gence is essential to
bottom lines
Ensure the product road map
understanding a
includes a strong research and devel-
opment (R&D) pipeline
targets competitive
Evaluate synergies and their value-
add environment and
Uncover red flags, including those
associated with customers, suppliers true prospects for
and partners, early in the bidding
process, so that expectationsand growth.
bidsare set correctly
Identify and retain top talent
Address competitive dynamics within
and across high-tech sectors
FIGURE 1: Due diligence is essential to understanding a targets competitiveness
Accelerate Innovation
innovation strategy
Identify and address
innovation potential
Manage Global
complexity innovation
Structure innovation
in a global context
Source: A.T. Kearney analysis
As part of due diligence, forming
cross-functional teams will help evalu-
ate the fair value of a target company
and potential long-term goals, such as
whether to spin off the company,
merge it into the current portfolio, or
pursue some other option. The depth
and number of sectors within the high-
tech industry make this a crucial step.
When time is short, we advise
our PE clients to conduct the target
attractiveness quick scan first, which
can determine in one or two weeks if
a target is worth deeper examination.
The scan, focusing on the eight ele-
FIGURE 2: Elements and advantages of a target attractiveness quick scan
Elements
Evaluate demand and growth potential
Define areas of differentiation
Determine product value and long-term
road map
Compare target with its current and
potential competitors
Assess the best opportunities for
increasing value
Identify firm and industry red flags
Form the criteria for moving forward
with a purchase
Identify focus areas for market and
operational due diligence
Source: A.T. Kearney analysis
Invention Engineering Idea
on demand effectiveness to profit
Create product and Ensure process Adopt tactics to
process solutions to efficiencies accelerate time
fulfill customer needs to profit
Innovation Lean Complexity:
network design good vs. bad
Determine the Minimize the life- Find strategies to
necessary capa- cycle costs of new manage complexity
bilities and where and existing prod- effectively
to get them ucts or services
ments shown in figure 2, assesses the
overall attractiveness of a target and gets
to its core value. Additionally, the quick
scan accelerates the subsequent market
and operational due diligence, reduc-
ing the entire due diligence process
from six weeks to three or four weeks.
Case in Point
Early in 2009, we helped a PE firm
target a specialized global IT solutions
provider operating in the energy, trans-
portation and environment industries.
Using our target attractiveness quick
scan, the PE firm was better able to
Advantages for PE firms
Develops a fact base for the next
steps in the formal auction process
Offers a competitive advantage by
developing a deeper understanding
of the target and working closely
with its managers to identifyGlobal
areas
for improvement
innovation
Identifies due diligence focus areas
and develops a list of priority market
and operational issues
Reduces investment in performing
due diligence as the quick scan
requires a short period of time and
helps determine the need for and
scope of further investigation
analyze many aspects of the deal by
answering the following questions.
Is the target commercially viable
across geographies? The PE firm ascer-
tained the targets financial strength
and segment growth rates by gathering
data from annual reports, management
presentations and interviews.
Is there adequate demand in the
markets it serves? Our analysis found
that the majority of the targets busi-
ness was noncyclical, with significant
demand and an attractive business
recurrence of 85 percent, well above
industry averages.
Does the target have a healthy
balance sheet? Most areas projected a
double-digit compound annual growth
rate (CAGR), even using conservative
growth estimates. With a healthy bal-
ance sheet and strong growth rates
across many products and segments,
the overall outlook seemed positive.
What offerings stand out? We
identified patents and R&D capabili-
ties, and learned that the target firm
had a stronghold in operational appli-
cations, a best-in-business on-time rate,
and a leadership position in technol-
ogy compared to its chief competitors.
Even better, it would be extremely dif-
ficult for a new entrant to acquire or
replicate its areas of expertise.
What is the three- to five-year
road map? The high-tech industry is
evolving rapidly, so a comprehensive
long-term strategy is required to create
and sustain competitive advantage.
Our analysis of the target firm revealed
a clear overall vision, but the current
product, partner and go-to-market
strategies presented major challenges.
In addition, we found out that one of
its businesses had a low growth rate
and was not critical for the future,
 which made it a good candidate for pated fully in the project life cycle What red flags could curtail
divestiture. from start to finish. growth? While one of the target firms
How does the target play in the What are the growth opportunities? businesses held a leadership position in
broader high-tech industry? The firms We looked at the opportunities for North America, the company was
strong midstream offerings and its growth, including integration, which is underperforming in five out of the
size could be perceived as advantages; crucial in high tech. We found several seven largest markets over the most
however, they also make the firm opportunities and analyzed the poten- recent three-year period. There were
inflexible and slow to respond to rapid tial financial ramifications. Our analy- opportunities to move into emerging
changes in demand. This analysis sis found nearly $2 billion in untapped markets such as Latin America, the
provided PE investment managers potential in certain markets, which Middle East and Africa. However,
with a richer view of the targets com- could be targeted relatively easily follow- the company was not likely to be up
petitive value. ing some modifications to the existing to the growth challenge because it
How does the firm stack up to organizational structure and strategy. was not equipped to manage large
competitors? The targets chief com- Implementing these recommendations projects and the risks associated with
petitor had a stronger market presence would yield an attractive increase in them. Considering these findings,
in Asia and an army of engineers in revenue within four years. Similarly, we we revised downward the CAGR
other divisions to support its IT solu- found unrealized, double-digit growth originally suggested by the manage-
tions business. The rival also partici- prospects in developing countries. ment team.

FIGURE 3: Typical category analysis for a high-tech firm

Illustrative
Leak detection

Irrigation network control Companys industries

Mature

Automated Hydraulic resource control

Water suite weather
Control and observation Meteorological
simulation system Water-quality monitoring system
system Air
for desalination plants

Low-level wind shear alert system

Market position*

Aeronautical terminal information system Revolver

High growth

Weather radar networks

Road weather information system

Seismic phenomena
detection
Hydrometeorological
networks
Air-quality
monitoring Continuous emissions
monitoring

Dispersion models
Early

Mobile air-quality monitoring unit

Decision support systems for forest fire suppression

Mobile units for
forest fire suppression

Early-market initiatives High-growth markets Mature markets

Portfolio category
*Mature represents the market heavyweight in terms of share and influence; high growth reflects the leading alternative, Source: A.T. Kearney analysis
usually second place in terms of share; early reflects a player that is competing on price or some other measure.
 We generally look for company-
and industry-specific red flags.
Common company-specific red flags
include a lack of strategic focus, inef-
ficient organizational structures caused
by unwieldy growth, and blockbuster
products that have reached the end
of their life cycles. Industry-specific
red flags might include the ease with
which other players can enter the
industry. Apples entry into mobile
phones is a good example.
What are the focus areas for due
diligence? Overall, the firm was a
compelling acquisition target but the
red flags needed further investigation.
During due diligence, the focus turned
to organizational capabilities such as
large-scale project delivery, customer
satisfaction in select geographic regions,
and the ability to replicate early suc-
cesses in other geographic regions.
Market and Operational Due
Diligence
After the target attractiveness quick
scan, we challenge our PE clients to
exploit the time between rounds of
bidding to engage in a more compre-
hensive analysis of the target company
and its industry.
Market-focused due diligence
assesses growth prospects by taking
a deeper look at customer segments,
customer purchasing criteria and dis-
tribution channels. Since the high-
tech landscape changes so quickly,
the focus is typically on probable dis-
ruptions, the unique selling positions
of the targets products and competi-
tors innovation capabilities. We also
focus on achievable product prices,
competitiveness and success factors
for a company in the specific high-
tech segment.
Operational due diligence focuses
on the targets organizational capabili-
ties, production and operational cost-
competitiveness, and overall business
performance. PE managers examine
what it will take to realize the desired
amount of growth, and evaluate reten-
tion and compensation issues, includ-
ing determining which staffers to
retain or replace. Managers also iden-
tify potential risks from merging cul-
tures and the role of investors, so they
can be mitigated early.
Our analysis of high-tech targets
often reveals that product categories do
not correlate with how shareholders
view the business. In addition, resources
are often allocated to fulfill obligations
of the internal organization rather than
to increase shareholder returns. To
better evaluate a target companys
potential, and meet shareholders
expectations, the targets portfolio is
categorized into three main areas
early-market initiatives, high-growth
markets and mature markets. We then
differentiate resource allocation models
accordingly. Figure 3 on the previ-
ous page illustrates a typical category
analysis for a high-tech firm.
Realizing Value in High Tech
Capturing value in high-tech acquisi-
tions requires broad industry expertise
and a meticulous focus on detailsin
terms of both the target company and
its industry. A target attractiveness
quick scan, followed by thorough
market and operational due diligence,
allows PE firms to unlock the hidden
treasures in this rapidly and constantly
changing industry.

Authors
Alex Liu is a partner in the San Francisco office. He can be reached at alexander.liu@atkearney.com.
Sieghart Scheiter is a partner in the Dsseldorf office. He can be reached at sieghart.scheiter@atkearney.com.
Jan Stenger is a principal in the Frankfurt office. He can be reached at jan.stenger@atkearney.com.
Venkat Tummalapalli is a consultant in the San Francisco office. He can be reached at venkat.tummalapalli@atkearney.com.
Nishant Kumar is a consultant in the San Francisco office. He can be reached at nishant.kumar@atkearney.com.

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