Secondary buyouts (SBOs) have been on the rise over the last two decades, and even more so in the last two years. SBOs now account for nearly one-third of all deals and more often than not, these deals come with a premium attached to the purchase price. According to Pitchbook, this premium now averages nearly 14%. Pitchbook hypothesizes that these premiums are attributed to the shifting profile of firms seeking SBOs: larger firms with more dry powder, increasing pressure from limited partners to deploy capital, and favorable macroeconomic conditions.

In most instances, sponsor-backed companies are put up for sale because the current owners believe that operational improvements have been realized and that a sufficient return has been (or will be) generated through the sale. The question for subsequent sponsors, then, is how to ensure there is enough runway for continued growth that will translate to returns which justify the cost of the SBO.

Determining untapped market needs and identifying white space into which the company can expand (either on its own or by being bolted-on to an existing platform) is a good place to start. Conducting customer due diligence, either pre- or immediately post-close, is key to the success of this approach. Customer due diligence is highly effective at validating which innovation and new product development initiatives have the most in-market potential.

When evaluating an SBO, consider the following best practices:

DO: Stress test new product or service concepts in the real world, with real customers
DON’T: Take the seller’s word that the new product or service is what customers want, unless there has been third-party validation of the concept

DO: Quantify the size of the opportunity based on customers’ willingness to buy, the timeline for a potential purchase, and whether or not there are in-sourced or competitive substitutes
DON’T: Rely on revenue projections attributed to a new product or service concept until the in-market impact has been independently validated

DO: Assess the company’s ability to bring new products and services to market-based on the success of their past launches
DON’T: Use company-generated scorecards to measure success; many times, they are adjusted to reflect a more optimistic outcome than financial results or customer feedback would suggest

DO: Determine if there are other market trends or disruptors that customers believe are on the horizon which can translate to longer-term innovation opportunities
DON’T: Act on broad commercial diligence or market research alone; results and insights from these sources are based on secondary research, not direct feedback from the target’s most critical and highest value customers

Customer diligence can help define and optimize the customer experience but, perhaps more importantly, it can be highly insightful and influential in defining what the next ownership team must accomplish to grow the business. If, in fact, there is little room to create value through operational improvements, then there is no place to turn to for organic growth except to capture greater wallet share and acquire new customers. For that, there are no better people to ask than customers themselves.

Kay Cruse is a Vice President at Strategex. She can be reached at kcruse@strategex.com.