When assessing an investment opportunity, balancing short-term risk and long-term opportunity is critical. The go-to-market value creation due diligence work we do for our private equity clients typically covers three key areas:
1. Assessing the overall maturity of customer acquisition, retention and growth activities
2. Identifying short- and long-term value creation opportunities
3. Understand and mitigating short-term go-to-market risks
This third and final element is designed to help our clients avoid ‘catching a falling knife’. While private equity funds often target companies poised to create significant value through strategic expansion and operational improvements, investing in a business during a period of short-term instability can sometimes feel like catching a falling knife. The term ‘catching a falling knife’ is used to describe the risks of acquiring an asset that is undergoing some form of decline, under the false assumption that its fortunes will reverse.
In this article I’ll explore how private equity investors can avoid ‘catching a falling knife’ and instead distinguish between short-term challenges and longer-term structural issues within an acquisition target.
Understanding the 'falling knife'
The analogy of ‘catching a falling knife’ often applies to businesses that face operational or financial challenges but are still viewed as valuable long-term opportunities. These businesses might have encountered short-term revenue or trading setbacks, changes in personnel, or shifts in market conditions. The risk for private equity investors is that these issues may run deeper than expected. The first few months post-investment in many respects represent the period of highest risk as the business may have limited cash headroom, and the Investor-Management working relationship is yet to fully form.
Over a decade ago, I was part of a team supporting an investor that was looking to take-private a publicly listed 5-a-side football pitch operator. Recent trading had been soft, but there was general consensus that this was due to tough comparables and unseasonably wet weather. However, our work uncovered that local governments had been funding new pitch developments that were co-located with the underperforming sites, and that many new developments were planned. Our client decided not to invest, and the business was eventually de-listed a few years later at c.15% of its previous value. We stopped our client from catching a falling knife.
Our role as advisors is to understand the drivers behind these changes, using a combination of data and experience to unpick underlying trends.
Recognising and understanding the red flags
When evaluating a business facing challenges, it is crucial to differentiate between temporary setbacks and fundamental weaknesses. From a go-to-market perspective, red flags can appear in many areas, including:
Lack of strategic direction: Companies can often experience impressive growth due to good trading momentum and low-hanging fruit. However, once the short-term, tactical wins have been exhausted, there is a need for a well prioritised, scalable growth strategy. If Management doesn’t have a well-defined and operationalised ICP and a clear view on where to spend the next £1 of investment, there may be underlying issues that need to be remedied.
Changes in personnel: Investors rely on strong, experienced management teams to deliver growth. However, changes in personnel with the Sales and Marketing teams can often have as big an impact on short-term momentum as senior leadership. This is particularly relevant in B2B businesses, where the departure of a key sales contributor can severely impact the sales pipeline in the short-term (and potentially in the longer-term). Understanding pipeline health, and the extent to which this can recover, is critical in assessing whether issues are temporary or structural.
Operational inefficiencies: While most operational issues can be solved, deep-rooted inefficiencies require more systemic change to prevent long-term problems. Operational inefficiencies can take many forms – from a go-to-market perspective, some of the most common we see are:
Unsuccessful lead generation and qualification – marketing generates a high volume of leads, but these aren’t qualified or targeted, leading to lower conversion and higher churn
Ineffective marketing spend attribution - without proper tracking and analysis of marketing efforts companies can invest the wrong amounts in the wrong channels, resulting sub-optimal returns
Insufficient go-to-market reporting and insights – marketing and sales teams often generate significant amounts of data from customer interactions and digital campaigns. However, if this data isn’t analysed effectively or used to inform decision-making, opportunities can easily be missed
Identifying short-term blips and mitigating the risk of catching a falling knife
Conversely, short-term instability can sometimes present buying opportunities for private equity investors. Identifying whether a business’s decline is temporary or more structural is key to securing long-term returns. Here are some factors that suggest it may be a short-term blip:
Clear value creation potential: Most of our work at Coppett Hill revolves around value creation for investors through go-to-market opportunities. If the business is facing short-term turbulence but has a clear path to strategic and/or operational improvements, it may be a sound investment. Go-to-market improvement is one of the most tangible levers that management teams and investors can pull to create value.
Strong industry position: If the company operates in an industry with significant growth potential, its troubles may be temporary. Private equity investors should assess whether the company has durable competitive advantages – such as intellectual property, brand strength, or a loyal customer base (as measured by financial metrics and NPS) – that will support long-term growth once short-term issues are addressed.
Understanding leading indicators and the path to cash: We often see historical events impacting trading momentum in the future. A key part of our go-to-market due diligence work is helping investors to quantify the likely impacts of these and recommending a course of action to mitigate them. A good example would be the loss of a key salesperson – this could take another 3-6 months to impact the pipeline, another 3-6 months to hit the P&L given the sales cycle, and then another 1-2 months to impact cashflows. In this example, providing insight on sales team onboarding and ramp-up can help investors understand the likely hole and how it can be filled.
Alignment with Management: A critical factor for successful private equity investment is alignment between investors and management. If the management team demonstrates a clear, credible plan to address short-term challenges and drive the business forward, this can signal that the issues are temporary rather than systemic. Conversely, if Management ignore the issues, or worse deny them, this may suggest the potential for catching a fallen knife is higher.
Conducting due diligence is essential for identifying whether a company’s issues are short-term or structural. Go-to-market due diligence plays a key role in that, given the importance of short-term revenue momentum during the early days of ownership. By understanding the root cause of the business’s challenges, investors can determine whether it can recover.
Many investors will also look to offset the potential for short-term instability through deal structures such as earn-outs or deferred consideration, that seek to share the risk between sellers and buyers.
The importance of balancing caution and optimism
Private equity investors face unique challenges when navigating short-term volatility, as the illiquid nature of these investments means that catching a falling knife can be particularly costly. By conducting go-to-market due diligence and actively engaging with management, private equity investors can avoid costly mistakes and identify opportunities for value creation. Ultimately, the key is to distinguish between businesses experiencing temporary setbacks and those with more profound structural issues.
If you’d like to discuss how to avoid catching a falling knife when making investment decisions, please contact us.
All views expressed in this post are the author's own and should not be relied upon for any reason. Clearly.