Diligence has changed for Jonathan Hatch, president of private equity firm Little Mountain Industries, because of the supply chain disruptions. 

"That's a huge difference," Hatch says. "We barely scratched the surface on looking at suppliers five years ago when we were looking at deals. It's a huge issue."

He says in deals where there's a significant assembly component — a long bill of materials — it's going to require a big diligence effort. The threat, he says, is if you're missing just one nut and can't get the part out the door, you're sitting on inventory.

"It's a major issue financially, cash-flow wise, which is what we live on," he says.

For little Mountain, it means, in part, that the firm must be much pickier because it doesn't have the resources to do diligence at that depth on every potential deal.

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"If you're a big private equity company and you're looking to do an add-on, you've got a lot of resources you can throw at it, you're building size that mitigates some of that risk, then it's not as much of a problem when you're willing to go through the extra diligence," Hatch says. "But I'm sure even at the upper end it's increasing the diligence."

That, he says, could make it easier to do an add-on deal rather than a new platform that might have a number of supply chain issues and require more diligence.

"It's going to impact a new platform investment certainly much more than an add-on," he says.

The biggest concern, he says, is the risk.

"To us, it's a go/no-go decision," he says. "The value for us is the value, but add some risk in and — we don't do 20 deals where we mitigate our risk by doing a lot of deals. We do only a few and we have to bat a thousand. So, we can't really take on any of that type of risk."

Bigger funds, he says, might be willing to take their chances and still do deals at the valuations that are being demanded, which he doesn't see as being impacted by the supply chain issues. Those who can spend the resources on these issues and buy up companies that have the right operating people in place who can manage through these supply chain issues can win. So, in that sense, he says there are opportunities created by this challenge because some competitors are going to struggle.

Hatch spoke on the Smart Business Dealmakers Podcast about the lower-middle-market manufacturing scene and how broader macro issues are affecting the deal math for firms such as his. Hit play on the player to catch the full interview.