Is high customer concentration a deal breaker?

January 26, 2021

by a searcher from University of Witwatersrand in Johannesburg, South Africa

Hey Searchers,

As I review companies I do come across certain businesses that show promising characteristics but they sometimes have a customer concentration issue and I wonder whether this is always a deal-breaker or whether there might still be a good business underneath.

I'll include some examples below and would like to see if anyone has had success in operating a company that may have similar issues but makes up for it in other areas.

Example 1:

We have certain companies in South Africa that have integrated themselves pretty well at our local power utility and their entire order book comes from the power utility. These companies work hand in hand with the utility and develop the technical standards that apply to their particular niche so it makes it difficult for new players to enter their niche and I believe the power utility has a corresponding supplier concentration issue. I'm still not 100% comfortable with this situation but I would like to hear from someone else.

Example 2:

We also have many road freight companies which have a number of key accounts which make up 10-20% of revenue per account. These customers are secured with 3-5 year contracts and in some cases the freight companies are the sole service provider, offering an integrate solution. In this case, I take some solace in the fact that these accounts are on fixed contracts and there is a strong integration element but I have seen transport companies changed almost overnight at my previous employer so I am not sure how secure I feel about acquiring this type of business.

I look forward to seeing how others think about this.

Best regards,

Atish

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

I have sold many businesses with high concentration (80%, 80%, 2 each at 40%, 25%, etc.) at top valuation and no (or very small) earn-out. Buyer should have a filter at 10%, or sometimes even lower %, not for go/no-go but to trigger deeper analysis. In certain industries you ARE going to have concentration, like auto, utilities, etc. b/c there are just few customers. Few things that one should analyze are a) Is the Target satisfying customer "need" or "want", b) are there competitors to Target?, c) How long has the relationship been? d) What are the barriers to getting the customer business and why? e) If the quality of product/service by the Target is bad, would the customer operation stop, blow up, get a front page news, etc.? I can go on, but hope you get my point that 10% is a "filter for deeper analysis". it should not be a "go/no go gate".
If you can get a discount that is great, but it is not a substitute for concentration risk unless concentration is low. Earn-out is preferred if one can pull it off.

Reply by an investor
from New York University in Nashville, TN, USA

While high customer concentration is an issue that always requires thorough vetting in DD (how sticky is the customer, is the business's relationship with this customer hindering their ability to service other customer), it isn't always the risk it seems to be at first. If the customer in question is a multinational, then they likely have multiple departments that operate independently. If the business is servicing several departments, then a question you need to investigate during DD is how independent those departments are. If the only level of management over those departments is C-suite, then each of the departments can be seen as a semi-separate customer. That “one” customer may in practice represent several customers.

Another question to consider during DD, how did the business develop their relationship with their large customer? Is that process replicable?

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