Operational Due Diligence: Let the Buyer Beware

The days of easy buy-and-flip deals are over, at least for this cycle. In a soft market and under increased public scrutiny, private equity firms must now dig deeper into the operations of their portfolio companies to deliver outsized results rather than just applying the once-ubiquitous financial engineering approach. Despite this paradigm shift, too many PE dealmakers continue to take a traditional, high-level, and often woefully inadequate approach to pre-deal operational due diligence. The financial fallout from such superficial assessments can give painful new meaning to the old adage, “let the buyer beware.” Indeed, operational unknowns can cost PE stakeholders millions.

If building value is the focus of most M&A transactions, firms will seek out and optimize revenue and expense synergies. Although reviewing operating reports, participating in management Q&A sessions and the occasional facilities walk-through may prove helpful, they do not provide a solid foundation for formulating a plan that will in fact optimize synergies. For this reason, PE firms should adopt an intensive, late-stage operational approach to M&A due diligence that will enhance and accelerate the realization of benefits when combining organizations.

Meaningful and informative due diligence is possible only if the potential acquirer has full access to the target company. Therefore, such fact-finding should be conducted between the signing of a definitive agreement and the close, if possible. At the very least, it should take place immediately following completion of the deal. Recognizing its importance, PE firms are increasingly trying to make operational analysis a contingency for close.

True “bottoms-up” due diligence focuses heavily on the line organizations of both companies. Most importantly, it attempts to answer the question, “How will value be created?” There are three steps to finding an answer:

Develop a detailed integration strategy with key stakeholders of the new company on a function-by-function basis to determine which functions should be preserved, consolidated, leveraged or integrated.. Representative areas include human resources, information technology, finance and accounting, new product innovation and development, sourcing and procurement, manufacturing, sales and marketing, customer service, forecasting and planning, order processing, and distribution and logistics.

Assess the two organizations, qualitatively and quantitatively, through the prism of people, process, asset utilization and technology enablement to identify emergent value opportunities where the combined whole will be greater than the sum of its parts.

People – Develop an inventory matrix that takes into account the length and level of experience; skill sets, training and certifications; work environment and culture; and supervisory/management style.
Process – Assess discrete processes using proven tools and techniques such as value stream mapping and analysis, time and value mapping, waste analysis, service-level performance, and standard work.
Asset Utilization – Assess asset utilization using proven approaches such as 5S, overall equipment effectiveness and work cell design.
Technology Enablement – Determine to what degree existing information technology is being utilized before investing in additional technologies.

Implement a plan that is fast-paced, time-certain, customer-focused and fully resourced. Build consensus from the bottom up, but don’t let the perfect get in the way of the good.

Executive and investor expectations for emergent value, increased synergies and new business opportunities run high in M&A. Meeting those expectations is tougher than ever, so PE firms must comprehensively assess operational challenges and opportunities at the outset. Deep operational due diligence is critical to optimum realization of benefits. When millions of dollars are at stake, no one likes surprises.

John Bogush is the head of The Highland Group’s M&A practice. Opinions expressed here are entirely his own.