Operational diligence, and its impact to the buying and selling process of a business, should be a critical component of the due diligence process. The following frequently asked questions can bring additional clarity to what is involved in the process of operational diligence:
What is an operational diligence?
- An operational diligence is a pre-close review that exposes hidden risks and hidden opportunities in the target, in relation to the investment thesis. For each risk, we quantify the exposure and highlight paths to eliminate, manage and / or mitigate the issues. For each opportunity, we re-cast the income statement and balance sheet to reflect the impact that addressing the opportunities will bring.
- We help you say “yes” to a deal with open eyes, an accurate model, and the foundation for an effective value creation plan.
Can you describe an operational diligence? What is the process of operational diligence?
- An operational diligence is a project, lasting 2 to 3 weeks, where we connect with the leadership team to understand how they run their business and a bit about why. We spend about one week to prep and schedule time with Leadership and management teams, 1 to 2 days onsite for meetings and tours, and about a week to complete our analysis and write the report. Also, we connect with the deal team after the visit to provide our working hypotheses and to highlight any green or red flags we see. Throughout the process, we are looking for three things: negative surprises, hidden value, and the path to scaling the company. Post close, we then review the report with the leadership team.
We are working hard to build a good rapport and working relationship with the leadership team during the pre-close exclusivity period. How do you perform an operational diligence without adding unneeded stress to the situation? We are already doing a financial audit, environmental, legal…
- We start by being respectful, and courteous, and genuinely interested in the processes and culture the acquisition target has built. We listen to Leadership about their business, what they’ve worked hard for, and their vision for the company. We look for the good stuff we can honestly compliment them on. We recognize the positive outcomes of their investment, and in the process discover what we need to know for your decision on whether to invest (and how much) – negative surprises, hidden value, and the path to scaling the company.
What does the operational diligence process look like – from start to finish?
- Prior to the site visit, we meet with the deal team to understand your view of the investment thesis and to learn your early view of the leadership team. We review the Confidential Information Memorandum of the Target company prior to an on-site visit. During the site visit, we meet the leadership team and learn about the business. We tour the facility and observe. At the end of the visit, we thank everyone and comment on the truly positive things we can honestly compliment. Finally, we write the final report from the client’s investment thesis perspective, including negative surprises, hidden value, and the path to scaling the company.
What are some of the main “negative surprises” that you can expose during an operational diligence?
The negative surprises fall into a few buckets. At the end of the day, we are looking to:
- Calculate how big of a check you will have to write AFTER you write the purchase check
- Identify risks that can be addressed with appropriate attention and time. And, if they are not addressed, will expose the company to potentially equity-crushing situations.
- Identify risks that will require complex solutions, investments and/or a change outside the company’s direct control
- For each of these risks we will then outline the steps, costs and timeline to:
- Eliminate the risk
- Manage the risk
- Mitigate the risk
Some of the risks we look for in an operational diligence include:
- Reliance on tribal knowledge
- A dependence on key personnel vs. a cross-trained team, especially key individuals that will receive a life-changing check.
- Hidden CAPEX, such as worn production equipment that looks good but requires near-constant adjustment
- A volatile supplier or supply chain, which adds risk to order fulfillment
- The stated capacity is inaccurate and either over or under stated
- The company has an ERP system, but it’s not being effectively used. This could require a new ERP system, a re-launch, or behavior modification / new processes.
- The management team isn’t going to be able to execute the investment thesis
- The company will need to add personnel in key roles or make other investments to continue current performance levels
- There is one or more risks that could lead to a loss in EBITDA or another key performance area
What are the main deliverables included in an operational diligence?
- Building a unique bridge between the buyer and the seller that a pure financial deal team may not be able to accomplish. We build rapport with the seller by understanding, and reflecting back to them, the complexity and challenges related to running their business.
- Answers to these questions – Can the company realize the investment thesis? What negative “surprises” should the investor expect post close? What is the impact of the “hidden value”? Are there obstacles to scaling this company? How much effort and cost will it take to address the risks and realize the hidden value?
What is the difference between an operational diligence and an operational assessment?
- In short, an assessment is a review of an existing portfolio company. A diligence is a review of a target acquisition, pre-close. The process and the information gathered for each is very similar, but each differs in perspective and urgency. A diligence is a buy-side service, where there’s competition for the deal, making it time-sensitive (urgent) and the question is – should we buy this company? An assessment has no “deal” urgency because you already own the company, and the question now becomes – how do we add more value to this company?
What do we communicate to the seller during the operational diligence process?
- We look for opportunities to give honest compliments on what they do well. Often this includes the dedication of their people, isolated high performing processes, and evidence of customer loyalty.
- We also will acknowledge and vet with the management team, the complexities they face in filling demand well. Another way of thinking about this is, what does the seller believe makes them unique? What do they view as special about their business that needs to be considered when evaluating any future state, change, or new process?
- We never communicate any unstated risk we see. We update the deal team and let them decide what to share and when.
- We never communicate any hidden opportunity we see. We update the deal team and let them decide what to share and when.
- We follow the seller’s / bankers’ lead on how we introduce ourselves. Often, we are introduced as bankers, consultants working for the owner / seller, or even prospective customers.
What are the critical success factors to getting the value of an operational diligence?
- Build a positive relationship between the buyer (your client) and the seller. Listen to your client to understand their investment thesis, and listen to the seller to understand why they’ve built the processes the way they have. Be respectful of the transaction and recognize that we may be in a position to be a bridge from the present to the future.
How many operational diligences have you completed?
- Over the past 27 years, we’ve completed hundreds of operational diligences across many industries. We have completed these reviews for over 90 different PE firms with more than half taking place within the last five years. These have been done primarily in the manufacturing, distribution, consumer goods, and food industries.
Who goes on site during an operational diligence?
- Typically, one or two consultants will be onsite for one or two days – depending on the size of the company, the number of sites, and the type of diligence the buyer is requesting. Total time for a diligence project is typically three weeks. We always provide preliminary observations about halfway through the project. This communication helps mitigate possible surprises for the buyer and allows for the diligence to be further honed during the last 7-10 business days.
What questions will an operational diligence answer?
- Answers to these questions: Can the company answer the investment thesis? Are there any negative surprises? Is there hidden value? Are there obstacles to scaling this company?
Is this operational diligence tied to a Quality of Earnings report, otherwise referred to as a QofE?
- The intent is similar, but they are framing different environments. A QofE report looks only at the past – what are the real earnings of the acquisition Target, what EBITDA currently is. An operational diligence recasts what EBITDA should be.
- Often, our PE clients schedule the operational diligence to take place after the QofE substantiates the EBITDA