High Client Concentration

April 15, 2024

by a searcher in Kelowna, BC, Canada

I'm evaluating a potential dealing the manufacturing sector that presents a significant concentration risk: 60-70% of its revenue comes from just one customer. Imagine a scenario similar to a local gasket manufacturer supplying to an automobile producer. While typically such concentration would be a deal breaker for many, there are compelling factors to consider:

Critical Dependency: The customer relies solely on this supplier for a critical component but represents a minor fraction of their total production costs. Suggesting a lower incentive for the customer to switch suppliers.

Barrier to Entry: There's minimal competition. There is a high entry barrier, making it less likely for new entrants to disrupt this relationship.

Expansion Potential: The facility is well-positioned to diversify its product line for retail and online sales with minimal capital investment, presenting an opportunity to improve revenue diversification.

Would love to hear thoughts from the community on this scenario. Are there potential pitfalls I might be overlooking? If anyone has come across case studies, podcasts, or discussions that delve into similar investment scenarios, could you please point me towards those resources?

Reply by a lender
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA

You pretty much covered all of the risks I usually go over with clients for customer concentrations. If you can cover off on the below list, you should be good.

1) How long as that business been a customer of the company? The longer the more likely they are to stay a customer. 2) How many items does the business produce for that customer? The more items produced the stickier the customer is likely to be. 3) What does the competition look like in the market for other potential suppliers to that customer? Is there a lot of competition? What does pricing look like from that competition? 4) How easy is it to move that customers business to another operator and is there a cost to do so? And do you need special licensing or knowledge to manufacture that product or molds, making it harder to move the product. 5) How important is this product to that customers overall operation? Is it product likely to stick around and continue to be needed going forward, or is it something that might eventually go away. 6) Lastly, who at the company manages that customer's relationship and how contingent is it upon the seller remaining for that customer to stay. This can be the hardest issue to figure out, but sometimes there are lifetime relationships between customers and sellers that can pose a significant risk.

Reply by a searcher
from The University of Chicago in Nashville, TN, USA

Your point on being a "minor fraction of their total production costs" is a big one. You have likely already read it but it is called out in the HBR guide as a good example of when concentration isn't as worrisome under the header of "The importance of being unimportant". Don't give them a reason to even look your way, keep what others may consider "excess" inventory, keep on time delivery high and you probably won't hit their radar to have prices squeezed or contracts threatened. The first time you cause production losses keep in mind that they will likely start qualifying others. A book that I enjoyed that highlights some of these types of companies that fly under the radar is "Hidden Champions of the 21st Century" by Hermann Simon

With that said, setting up the deal with forgivable seller debt triggered if you lose the customer would likely be recommended by the majority of people. It sounds like an interesting opportunity.

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