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You are not ready to close your next deal without this…

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BEYOND EXCEL SPREADSHEETS

Quality of Earnings Report Should be Paired with Operations Diligence

The importance of a Quality of Earnings (QoE) report cannot be overstated.  They are ubiquitous.  The report is a key tool in understanding the health of a business, but it is not the only tool.  Beyond the clarity a QoE delivers on the buy-side, it can also provide sellers with a third-party’s view of potential areas for concern – areas that can be targeted to maximize the company’s future market value. 

The QoE report contents are the same regardless of who requests it (or should be!), and that information provides a full picture of the business financials with key insights into aspects of the company’s operations… or does it?

Operations Diligence – It’s not Sexy, but the ROI is

Foreseeing future negative surprises and understanding the true hidden value within an organization’s operations are essential to protecting and unlocking future profits.  Sounds simple, however it’s not sexy work and is best done by functional experts who are deeply versed in the questions to ask and things to look for.  When dealing with operations planning, it’s important to understand WHY something is done the way it is before plans are made to improve it.  It’s important to dive deep into the operations and identify future negative surprises, quantify ops challenges, and qualify whether the challenge is worth solving.  Furthermore, it’s important to identify and quantify hidden value worth claiming – before a single employee is added or piece of equipment or machinery is purchased. 

Enhancing EBITDA through operational improvements, albeit not sexy, is not only a proven way to increase ROI, but is also a critical cash flow lever in today’s environment of lofty purchase price multiples.

The Check you Write and the Check you Get:

Buy-Side

Beyond the third-party expertise of a thorough operational review by industry veterans, our process involves great, collaborative communication with both the buyers AND the sellers (and their associated service providers and investment bankers).  We are often viewed as a relationship bridge, helpful to both sides of the deal.  Buyers will sense that we seek a practical understanding and appreciation for all they have achieved with their current operations.  We’re a fan of entrepreneurs, and our passion and enthusiasm for understanding their processes are genuine.  We work to document the “as-is” and seek to claim the “could be” in operational value.   As a result of our work, buyers will have confidence in the check they write, and knowing the potential cost to generating the results they wish to achieve.

Sell-Side

We work with sellers to provide support and objective assessments that identify and quantify the impact of implementing operational improvements, which will provide exponential value in the selling process.  We provide a fresh perspective and fine-tuning of operational processes, documentation to expedite the operational diligence process, and a dry run, in anticipation of tough questions that may occur during negotiations.  As a result, we help sellers reveal the value that’s hidden in their business and increase the potential to receive checks with extra zeros on the end.

The ProAction Group, and its Operational Diligence, provides a proven process for achieving exponential value for companies in a wide range of industries and sectors, including manufacturing, distribution, and business services.

We invite you to reach out to our team anytime to start a conversation about the benefits an Operational Diligence can bring to your company, as well as any related services we may provide, to help buyers buy and sellers sell.

Business Practices, News

Are you Gambling with Your Portco Investments? The Crucial Importance of Addressing Business Risk

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Risk is inherent in all business transactions, especially when acquiring a new platform. The PE world has long-standing tools and resources to address legal, environmental, financial, and customer concentration risks. Operational risks (business interruption, unplanned Capex, margin compression, physical safety, fragility, “the rabbit hole” …) are often left to the personal experience of the deal team and the operating partner. Add to that, the buyer has a short and diminishing timeframe to evaluate all these risks; a lot can go sideways, fast (or slow… some risks may not manifest in symptoms until year 2 or 3)!

Cue Kenny Rogers and the popular 1978 country song, “The Gambler” for inspiration on the importance of making wise decisions. The tune emphasizes the idea that in life (and money making), one must be able to assess situations, calculate risks and make informed choices to succeed. The tune’s broader message underlines the importance of timing, intuition, and strategic thinking in navigating uncertainties. That is all great and good, but a lot can boil down to luck without targeted assessments and resources. We can get beyond the Gambler as we become aware of undisclosed risks, gain acceptance that they are indeed real, and then take purposeful action to mitigate, manage and eliminate!

In the context of operational diligence, and navigating the stages of risk awareness, acceptance, and action, you’ll need an expert assessment to reveal what is really going on within the operations of a company, when perhaps the financials don’t indicate trouble. It’s easy to believe that a company with healthy EBITDA, a humming production line, and happy employees will promise big financial returns – until it doesn’t.

The potential for undisclosed risk justifies a comprehensive assessment of an organization. Financial, customer loyalty, environmental, legal, regulatory, IT, and HR diligences are ubiquitous today. These areas may not uncover margin compression, business interruption, unplanned Capex requirements and other operational issues. 

The goal here of course is to identify the undisclosed risks that will impact the future performance and success of the target company. These risks are often hidden in plain sight and are often accepted with an unquestioning IIWII (“It-Is-What-It-Is”) attitude… such as that additional operation that takes place just before the order is shipped because no one has taken the time to identify the root cause and fix the error at its source. Here’s another risk, this one is late-stage, and this is a big one – when a company relies on a single supplier for its primary materials and hasn’t established an alternate supplier… they know their business is exposed to interruption risk, but they contentedly move forward, hoping things will continue to be OK. One recent seller explained how this risk was minor because they owned the drawings… when we asked to see one, they commented that the supplier keeps them.  Wow. Hope is not a valid response, and we need to call this what it really is – denial.    

In over 20 years of completing operational diligences, we have never killed a deal. We identify risks to create awareness, not to cause panic or worry about falling skies. We quantify the risk and estimate the effort and capital that are required to address the situation. While no investment is risk-free, accepting risk without a realistic and professional evaluation is a gamble with high stakes. Here’s a perfect example – the seller has built the business from the ground up and they know everything about the process. They have been involved from the beginning and everything runs smoothly because of their involvement in the daily processes. But what happens when the business is sold without evaluating this particular risk? The new owners will find it difficult or impossible to replicate the previous results because much of that success was due to the daily energy and expertise the previous owner brought to the business. The good news is, if we have 6 months or a year to institutionalize their knowledge, and we actively do so, the solution is inexpensive, non-invasive, and highly effective. In fact, in every case, the process to address the risk produces meaningful performance improvements. In EVERY case. If you wait to address risk – maybe next quarter, or next year, it will be more expensive, more invasive, and only partially effective by comparison. Which highlights the importance of acceptance. How often do people say, “I’ve been telling them about this problem for years, but no one listens to me!” When we accept that the risk as real, we can generate some data and bring clarity to the situation, and we can have years of meaningful improvement rather than years of loss.

The purpose of risk awareness, and recognizing risk acceptance, isn’t to walk away from the deal, but rather to create an action plan to manage, mitigate, or eliminate identified risks… to be well-prepared to handle the risks and challenges associated with the new company. This will involve collaboration with company leadership and management teams, legal advisors, and operational experts to ensure a comprehensive and well-executed risk management strategy.  This may also require interim leadership resources to ensure that risk mitigation is executed properly.

With risk, it doesn’t have to be a gamble. It all boils down to having the wisdom to fully recognize the circumstances and plan an appropriate response. At The ProAction Group, we know where to look for risk. Whether they’re obvious, hidden in plain sight, or those late-stage risks that won’t fully present until Year 2 or 3 of your investment cycle. We find that having knowledge of what can go wrong and having an action plan to address it will ensure the best possible outcomes. 

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RISKY BUSINESS AND OPERATIONAL DILIGENCE – NO SHADES HERE!

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Who could forget the 1983 comedy drama, “Risky Business” starring Tom Cruise in his breakout role.  Joel, the entrepreneurial title character, is plagued by unforeseen risks as he agrees to a less than transparent business plan to run a temporary brothel out of his parent’s home – all to pay for damage to his dad’s car.  Well intentioned – though fraught with risk!

Tom Cruise may have learned a lesson from his risky behavior.  The car in the lake became the least of his problems!  In business and in real life the risks are often subtle and can even masquerade as harmless or irrelevant facts of life.

ADDRESSING RISK REQUIRES AWARENESS, ACCEPTANCE AND ACTION

Unrecognized risks do not get addressed.  We can have sympathy for people and companies that suffer the consequences of something they truly didn’t know about.  And that highlights an important point.  Intention and ignorance do not protect us from harm.  Sometimes the risk doesn’t show symptoms until late in the process. 

Risks identified early can be mitigated, planned for, and addressed.  On top of that, when addressing risky business early, the cure tends to be non-invasive, low cost and effective.  The secondary, and often overlooked benefit is that eliminating risk will provide collateral benefit in seemingly unrelated areas.

When assessing operational risk, even during a pre-close due diligence, we search for early risk indicators, especially in the following areas:

  • Safety
  • Margin Compression
  • Business Interruption
  • Unbudgeted Capital Expenditures
  • Obstacles to Scalability / fragility
  • Customer Loyalty / Attrition
  • Sensitivity to economic headwinds / black swan events
  • Over / Under Estimated Capacity
  • The Rabbit Hole (resources are being applied energetically in an irrelevant or unactionable area)

If none of the risks above got your heart pumping, you may skip the rest of this post! 

Examining risk is not just an exercise in avoiding pain or bad situations.  A clever and practical assessment of the risks can expose costly surprises before the deal closes.  Go in with your eyes open, your models accurate, and your value creation plan relevant.

And here is the punchline.  In 20 years of conducting operational diligences, we have never killed a deal.  Every risk, especially when identified early, has a solution… modest capital, some appropriate management attention, some one-time resources. 

The second punch line…  When done well, the inoculation to the risk provides its own ROI.  Addressing margin compression leads to increased margins.  Shoring up against business interruption risk will create new stability and increase capacity.  Increasing worker safety will help you scale.

Have you ever gone to bed one night thinking about how you are preparing to exit a deal and wake up to the reality that you have to, essentially, start over?  Margins are falling, quality issues popped up, a customer moved to a competitor.  The trick here is not to avoid unforeseen headwinds, or to avoid change.  The answer is to prepare to handle change.  We know more black swan events will come, and the vaccination is healthy, good, and available.

The ProAction Group has a team of professionals ready to turn on the proverbial flashlight… and venture into the dark spaces to provide knowledge of risks that are actionable and almost always – solvable.

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Leveling Up – Your Deals & Gaming Have a Lot in Common.  What Level are you Operating At?

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Dungeons and Dragons was the first game to bring the concept of character leveling to the mainstream market.  When you level up, you gain experience points and advance to higher levels within a game.  Leveling up is the primary way to measure progress and success within the game, and it’s a helpful concept in M&A as well.

Leveling up isn’t just a way to measure progress, it’s also a way for your company to compete where there’s more risk and higher margins – and that translates to better returns when you’re successful.  As experts in Operational Diligence, we have some ideas about leveling up through pre-close and post-close activities. 

Level 1 – Basic Level of Play

This is where all activity starts – with pre-close diligence activities.  The deal team is looking for risks and operational improvements, and may call on industry leaders for additional insight.  Once the deal is won, the Management team is relied upon to develop the value creation plan to realize the investment thesis, and the deal team takes on a new role as the corporate development team.

At this level of engagement, the risk of post-close negative surprises is very high. Had these negative surprises been called-out earlier by Operational Diligence experts, they would have been part of the value creation plan and likely would have lowered the cost of the deal.

The Basic Level of Play leverages the experience of the deal team and any industry leaders they bring in.  It is low cost, but will not consistently uncover undisclosed risks and latent value.

Level 5 – Significant Skill Set of Play

A level 5 is generally achieved by a player who has progressed beyond the beginner stages of the game.  Level 5 may represent a significant milestone, allowing the player to unlock new abilities, access new areas or questlines, or face tougher challenges.  In our work, Level 5 PEGs often have an Operating Partner or an external resource like The ProAction Group for pre-close activities.  The ops leader works alongside the deal team and looks for hidden risks and operational gains to get ahead of plan and to fuel the value creation plan.  We/they may identify dozens of areas for operational improvement, yet provide the one insight that implementing one single improvement post-close could provide significant scores for the team and begin the momentum for extreme value creation.

This elevated level of play brings focused and experienced attention to the process, identifying risks that the seller may not have disclosed (or even known about) as well as providing fodder for the value creation planning process.

Level 10 – Effort, Strategy, and High Scores

Players who reach the higher levels in the game get amazing skills and can fight dragons, take castles, and save the distressed!  For the gamer, this is endlessly interesting and exciting.  They get to explore the potential of their character and take over the world!

In our real world of M&A, achieving this level allows us to go into a deal with our eyes open, our models accurate, and with a value creation plan that is clever, practical and designed to drive a real win.  We are in a position to truly explore and tap the full potential of the platform. 

This level often means using an Operating Partner with subject matter expertise for both pre-close and post-close activities – the “been there done that” for several businesses in the target’s vertical.  High achievers in pre-close Operational Diligence will:

  • Calculate Capacity – as currently run, and with improvements in place.
  • Recast Inventory required to run the business (this is the canary in the coalmine…)
  • Segment SKU/service, Customer, and Inventory profitability.
  • Test for numerous risks that would show up in year 2 or 3 if not addressed early.
  • Recast CAPEX requirements.
  • Benchmark sourcing rates and costs.
  • Develop a detailed financial model integrating the addressed risks and operational improvements.

Operating as a Level 10 pre-close also entitles you to bonus play – and post-close magic:

  • Integrate financial model and budgets into expectations for the leadership team.
  • Develop a full value stream and/or process map to expose any additional opportunities and risks.  Understand how the money is made, how to satisfy demand, and how to operate the company among the sponsor, the leadership team, the management team, and the operator expectations.  (This step might bring you to level 15 on its own!)
  • Conduct a formal value creation working session to address identified risks and opportunities.

Don’t we all want to play at Level 10 and access the magical post-close play?  At The ProAction Group we bring Level 10 from day one.

We can implement changes that will get you ahead of plan in the short term, development containment plans to manage risk, stage, and stagger operational improvements based on ROI, confidence, time required, and bandwidth.  We’ll show you how to leverage your opportunities to address risks and improve performance, while developing new leaders and a problem-solving culture.

 Contact us today to Level Up – right to the bonus round. 

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DATA DRIVEN DECISIONS SET YOU UP FOR SUCCESS POST CLOSE

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Overall, validating data related to operational efficiency requires a systematic approach to collecting and analyzing data, as well as an understanding of the key drivers of efficiency in the specific industry and company.  By validating data in this way, companies can identify areas for improvement and implement targeted strategies to increase their efficiency and profitability.  This information is valuable to have for a buyer of an organization and invaluable to help steer opportunities for improvement post-close.

Having tools to validate data is important.  Equally important is having a deep talent bench with experience in specific verticals who know how to uncover improvement opportunities, as illustrated by two of our recent engagements:

DISCOVERING AN UNDERESTIMATED CAPACITY

The ProAction Group was retained by the buyer to conduct an operational diligence on a co-manufacturing company.  The CIM stated the company was operating at 80% capacity, with plans to expand the facility and add additional equipment.  Upon our analysis of the operational data and observations at the facility, we calculated that operating capacity was closer to 40%!  This discovery dramatically influenced our client’s CAPEX plans and shifted their margin projections due to overhead absorption and labor utilization improvements.

WE’VE GOT A 2-FER!

Our client was challenged to keep up with their 10X growth in SKU’s.  Although inventory was growing, they were also missing out on sales opportunities.  As a result of our DeepView Turn & Earn analysis, we were able to identify and segment their product demand patterns.  The data and analysis revealed they had two businesses under one roof – a low-mix/high-volume business, as well as a high-mix/low-volume business.  Continuing to operate the company as a one-size fits all process model was the culprit.  Our recommendation to run each of these two businesses differently resulted in dramatic reductions to inventory, elimation of lost sales and an immediate increase in EBITDA of 18%. 

We can assist you in identifying and planning for operational efficiencies, often leading to big gains.

The ProAction Group provides industry leading transparency and clarity around data generation and validation where data may not be available.

Our operational diligences highlight potential negative surprises and provide post-close value creation strategies, with suggested implementation plans, management guidance, and interim leadership as needed.  We bring the plan to eliminate, manage or mitigate the risk.

We help you to say yes to the deal, with your eyes open.

We eliminate the ability for secrets to exist, as we are taking the time to truly understand operationally what is going on.  All this helps our PE clients and management teams in a smooth transition post-close.  

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Buying That Business – Negative Surprises

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The backbone of surprise is fusing speed with secrecy.

When working to close a deal, there are so many moving parts.  Some parts move faster than others, as the desire to check off a box is strong to move onto the next aspect of a company deserving of validation or scrutiny.

In our operational diligence work, we often find our private equity clients come to us because they have been negatively surprised one too many times.  They go through their traditional due diligence checklists, work through the Quality of Earnings and, because of that report, address any visible operational issues.  During this process, however, the actual constraints are influencing operations and what is really bubbling beneath the surface often fails to show up until after close. 

Operational improvements are largely ignored because they are often considered pedestrian.  Labor is often a small percentage of sales.  Why care about that?  The equipment works, the people are there.  Are operational improvements really going to have a positive impact?  The company is growing, their customers are happy, they are profitable.  Given these positive signs in the financials and customer satisfaction, are there really any risks?

Yes!

Despite going into a deal with eyes wide open, you will always be limited to what people want to show you, and the speed of dealmaking is often paired with secrecy on the sell-side.  Maybe intentional secrecy, or maybe just undiscovered challenges because the owners may not even be aware, the right questions were not asked, or the speed of the deal masked those challenges.  As a result, the negative surprises could be numerous:

  • The estimate of capacity in operations was grossly overstated or understated
  • There are key people who are not capable of achieving the plan, or there are impediments to the growth of the management team
  • Operations is not making use of the information system that’s available
  • A key piece of equipment is on its last leg and needs replacement
  • Vulnerability to key talent or operators leaving the company post-close 
  • Volatility in the supply chain or reliance on a key supplier
  • The company is reliant on tribal knowledge and/or lacking standard work and process documentation
  • The current management team is fully committed to an ineffective approach to running the business

Negative surprises don’t happen if we can provide insight.

The ProAction group provides DeepViewä Operational Diligence to bring industry leading transparency and clarity around:

  • Business interruption risk (including supply chain)
  • Undisclosed CAPEX requirements
  • Undisclosed investment required to maintain current performance levels
  • Management isn’t prepared to lead the company to realize the investment thesis
  • The company is static and not prepared to act as a platform
  • Evaluation of operational systems to support the investment thesis
  • Real-time insight to the industry’s market and its customers
  • Data generation and validation where data may not be available

Our operational diligences highlight potential negative surprises and provide post-close value creation strategies, with suggested implementation plans, management guidance, and interim leadership as needed.  We bring the plan to eliminate, manage or mitigate the risk.

We help you to say yes to the deal, with your eyes open.

Beyond our valued pre-close operational diligence work, we also serve as an important relationship bridge between the seller and the buyer.  We engage sellers with genuine appreciation for a company’s history and a desire to understand why the company operates the way it does.  We acknowledge the good and plan for where the gains are to be claimed.  We eliminate the ability for secrets to exist, as we are taking the time to truly understand operationally what is going on. All this helps our PE clients and management teams in a smooth transition post-close.  

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ProAction’s 2022 December Digest

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  • The end of the year brings time for reflection and openness for doing things differently in the new year. Do you have a portfolio company (Portco) that is underperforming and needs help determining the problems and solutions to get earnings back on track?
  • At the ProAction Group we bring the Action. We provide momentum, process, and tools to impact results with our industry leading experts who will work with your existing team to guide companies through operational improvements.
  • Check out the Conferences we will be attending. Hope to see you there.
  • There are no surprises in the deal when we provide “The Knowing” through a DeepView Diligence.
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This is Alarming, but not entirely unexpected…

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Identify Underperforming Suppliers

Morgan Stanley reported Monday that jaw-dropping inventory levels are a key risk to retailers, and there is a 19% discrepancy between inventory levels and sales growth.  Additionally, according to Descartes, which aggregates U.S. Custom data, reports that US imports sank in September and posted the steepest drop since 2020 lockdowns.

The headlines are daunting. 

We can chalk this up to skidding demand amid a lot of inventory.  The reverse bullwhip effect that many predicted back in May.   

Companies with high consumer exposure have slashed their ordering — even though this time of year tends to be when retailers are beefing up their warehouses ahead of the holiday season.

According to the Morgan Stanley Shipper Survey, in which some 100 corporations regularly share their transportation needs and macro expectations, net ordering levels have reached the lowest point in the survey’s 12-year history. Ordering levels are down 40% year over year. Net inventory levels are also unusually high.

The report offered guidance, “Faced with a glut of inventory, companies will need to decide whether they want to accept high costs to continue holding inventory, destroy inventory, keep prices high and take a hit on the number of units sold, or slash prices to stimulate demand. We believe many will turn to aggressive discounting to solve their inventory problem which is likely to spark a ‘race to the bottom’ as companies attempt to cut prices faster than peers and move out as much inventory as possible. This dynamic will weigh heavily on margins and fuel the earnings slowdown.

How do you maintain, but ideally grow EBITDA in this challenging environment – make the operations more efficient? That’s where we can help. 

Our team at The ProAction Group works with organizations to identify operational performance improvement processes that get an immediate 22-40% performance gain without adding a single employee or piece of equipment.

We will be honest.  This is a lot of work, and it will require some meaningful changes on your part.  If this truly is a problem worth solving, let’s talk.