Just like a quality of earnings (QofE), the use of operational diligence is growing in relevance and utilization. Identifying undisclosed risks pre-close is not about avoiding deals, rather it allows better clarity for the prospective private equity sponsor to negotiate well pre-close, and approach the deal with a more complete plan to address those issues post close. Identifying risks early in the diligence process is central to addressing those same issues before they achieve critical mass two or three years after closing.
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Playing Blind: The Impact of Uncertainty on the Field and in Business
Close your eyes. Imagine you are a football player, stepping onto the field during a crucial game. The stakes are high, and the pressure is immense. Your heart races with adrenaline as you take your position. You hear the thunderous cheers of the crowd. The energy is electrifying, and you are determined to give it your all.
But then, something strange happens. As the referee blows the whistle to start the play, you realize that you have no idea what the score is or how long you have been playing. The scoreboard is blank where the scores should be, and there’s no clock in sight to show how much time is left. You try to shake off the confusion and focus on the play ahead, but that nagging uncertainty lingers in the back of your mind.
Without knowing the score, you can’t gauge whether your team is winning or losing. You don’t know if you need to push harder and take risks to catch up, or if you should play it safe to maintain a lead. Every move becomes a gamble, and anxiety creeps in, making it difficult to think clearly and execute your plays effectively.
As the game progresses, you notice that your teammates are also affected by the lack of information. Some seem to be playing with a newfound sense of urgency, assuming that they must be behind. They take bold, reckless actions, hoping for a miracle comeback. Other players seem overly cautious, unwilling to take any chances, fearing they might jeopardize a potential lead.
The uncertainty takes a toll on team coordination too. Communication becomes fragmented, as each player tries to interpret the game’s situation based on their own observations. Without a common understanding of the score and remaining time, it’s challenging to work together seamlessly as a unit. The absence of critical information begins to impact your individual performance as well. You find it hard to focus on the task at hand, and doubt clouds your judgment. Your confidence wavers, and you become hesitant in your decision-making on the field. Your plays lack the usual precision and timing, and frustration mounts as mistakes start to pile up.
OK…you can open your eyes. Not fun, right? Yet, this is the situation so many business leaders put their workers in… no posted metrics, no start-up meetings, no daily review.
The story of the football game without a known score or remaining time serves as a powerful analogy for business owners. It underscores the importance of having access to real-time data, analytics, and insights to make well-informed decisions.
At The ProAction Group, we understand that success in business hinges on making informed decisions backed by data-driven insights. Our mission is to help organizations thrive by identifying operational improvements, mitigating risks, optimizing procurement, and maximizing revenue and profits. In a rapidly evolving market, the ability to adapt and stay ahead is paramount, and that requires having a finger on the pulse of your company’s performance.
Much like the football player needed to know the score and time remaining to devise an effective game plan, businesses must rely on key performance metrics to make strategic decisions, and managers use key performance indicators to set appropriate expectations on the floor. Our expertise lies in shedding light on the vital aspects of your business that might otherwise remain obscured. We provide the tools and insights needed to navigate confidently through the challenges, helping you stay agile and responsive.
Furthermore, we work with your team to establish clear benchmarks of success, guiding you on what to measure and how to interpret those metrics effectively.
Education is also an essential part of our approach. We believe that arming your team with the knowledge of these key metrics empowers them to act decisively and collaboratively towards shared goals. By keeping everyone on the same page and speaking the same language of success, we help nurture a culture of achievement and continuous improvement.
The analogy of playing blind on a football field underscores the importance of having the right information to succeed. With our assistance, you can navigate the complexities of your business’s operational challenges with a clear understanding of your performance metrics, enabling you to seize opportunities, mitigate risks, and propel your organization towards lasting success. Together, let’s bring clarity to your path, so you can achieve remarkable results and secure a winning position in the market. How can we help?
The Illusion of a Seemingly Stable Business
Gauging the stability of a business can be tricky. Strong financial performance, high profit margins, and healthy balance sheets can create the illusion of stability, but these indicators alone may be masking underlying risks and vulnerabilities. Believing your business is stable based only on these indicators can provide a false sense of security among business leadership and can lead to complacency on the shop floor. Success can hide risk.
Stability is the foundation of practically every production metric… cycle time, lead-time, OEE, fulfillment rate – all depend upon stability. A lack of basic stability prevents improvements from either taking place or being sustained – continuous improvement is impossible without a stable process. Add to that, the fact that we tend to tolerate poor performance in the absence of a squeaky wheel, and you find that no squeaky wheel is a signal worth investigating.
How should a business gauge stability? Many people (and lots of engineers) tend to mistakenly connect stability with a high quality rating or fulfillment rate, but stability is so much more than that. You first need to recognize that stability has three separate components – predictability, sustainable outcomes, and consistent processes, and you need to realize that stability requires all three.
Predictability: Let’s say a manufacturer can’t or doesn’t measure OEE for their processes – without it, no prediction can be made for the output and the process is unstable. Here’s another example – you talk with the CFO on the 25th of the month and they share that the company is on course to hit their plan for the month, but five days later you find they have missed the plan by 20%. Not predictable, not stable.
Sustainable Outcomes: A sustainable outcome is one that continues to meet customer demands – quality is high enough, fulfillment rates meet demand, and cost is low enough. If lead times for a company are growing, they may eventually start losing orders because of it, at which point it becomes an unsustainable outcome. Sustainable outcomes are the result of robust systems that can respond to ever-changing market, supply chain, and employment needs, to name a few.
Consistent Processes: Consider this – at the end of an operation, employees conduct a final visual inspection and box up the items. Each employee chooses the process they wish to use, and no employee has the same output as the others. But there’s one employee who was clearly inspecting and packaging twice as much product as anyone else, but because everyone could choose to do it their own way, the impact of any good work was negligible. If everyone were to follow the process used by the best operator, productivity would increase and production costs would be reduced.
If we’re all in agreement that predictability, sustainability, and consistency are the core requirements for stability, how does instability manifest itself in operations? Here are a few indicators of instability:
Efficiency and Productivity: An operation isn’t stable if the output changes each time there’s a change in employees, shift, production line, supervisor, or facility.
Quality Control: An operation isn’t stable if you have to sort the outcome, inspect quality into the product, or if you’re not tracking rework and scrap.
Cost Control: An operation isn’t stable if lead times are growing, parts are unavailable, or if absenteeism continues to be a problem.
Compliance and Regulation: An operation isn’t stable if a product (like a safety harness) fails to perform to specification, or if employees are at risk of injury.
Risk management: An operation isn’t stable if any of the following risk conditions go unaddressed –
- If your company is growing but your margins start to decrease when new products are added, or if you have anyone in management who doesn’t take off more than a day at a time, your operation is not stable (tribal knowledge risk)
- If you don’t have a thoughtful hedging strategy or a history of passing on pricing increases to customers, your operation is not stable (margin compression risk)
- If you don’t have alternate sources for your materials, or a secondary port of entry negotiated in your supply chain, or a disaster recovery plan, your operation is not stable (business interruption risk)
- If your Emod rate (or EMR) is above 1.00 or if you don’t know what your Emod rate is, your operation is not stable (safety risk)
- If your maintenance department spends more than 15% of their time on reactive maintenance, your operation is not stable (CAPEX risk)
- If you don’t know your churn/loss rate, or which of your customers are vulnerable, your operation is not stable (customer loyalty risk)
Perhaps the greatest benefit of stability (predictable processes) is the ability to scale and grow your business. When businesses have established and repeatable processes, they can more easily replicate and scale their operations. This is particularly important when expanding into new markets, introducing new products or services, or onboarding new employees.
At The ProAction Group, we help businesses create reliable processes. We work with leadership, management, and the employees on the floor to raise awareness for business stability and its connection to predictability, sustainable outcomes, and consistent processes. Verifying the presence of these components in your processes is the key to true business stability.
ProAction Productivity Pulse – Summer Newsletter
Kevin Hofert Expanded Role
We are pleased to share that Kevin Hofert has been promoted to Vice President, Business Development and Sales Management. In this expanded role Kevin is primarily responsible for driving revenue growth, acquiring and retaining clients, and ensuring successful project delivery. Kevin will serve as a bridge between our consulting team and our clients, leveraging their expertise to build relationships and identify business opportunities that add value to client portfolios.
Kevin has over 28 years of business management, engineering, and leadership experience, and has a proven background in operations management, design engineering, and overall P&L leadership. His operating experience, engineering mindset, and the combination of his law degree and MBA, provides a unique perspective that will continue to inform his decisions and direction in this new role.
Prior to joining The ProAction Group, Kevin was CEO for a large, midwestern sign manufacturer where he collaborated with ownership and financial institutions to expand operations to 2 additional states, taking the business from $29M in 2016 to $56M in 2019. Throughout his career he has successfully integrated add-on business acquisitions and operational improvements, and has continuously managed a wide range of business risk reduction efforts. Earlier in his career, Kevin held the roles of VP of Engineering, Chief Engineer, and construction field manager.
Please join us in congratulating Kevin on his promotion and wishing him well in his new role.
Kevin has an MBA from Keller Graduate School of Management, BS in Civil Engineering from the University of Michigan, and Juris Doctor from the University of Illinois-Chicago Law School.
RISKY BUSINESS AND OPERATIONAL DILIGENCE – NO SHADES HERE!
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.
ProAction’s Spring Newsletter
DATA DRIVEN DECISIONS SET YOU UP FOR SUCCESS POST CLOSE
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.
Buying That Business – Negative Surprises
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.
You are not ready to close your next deal without this…
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.