Bridging the Due Diligence Gap

Operations due diligence helps PE firms find hidden value in targets

The proliferation of new funds and increased competition has made it necessary for private equity firms to look beyond financial due diligence as a means of value creation and unlock the hidden value in operations. Companies that perform operations due diligence (ODD) are able to bridge the "due diligence gap"—maximizing value and returns in investment targets. Operations due diligence provides a deeper understanding of a target's entire business operations

Historically, private equity (PE) funds have been very successful in identifying companies with untapped growth potential. And by using a mix of financial engineering and some limited operational restructuring, they have been able to increase the value of these targets and generate substantial returns for their investors. However, more competition for good deals has led to higher-priced assets and a simultaneous increase in the required returns hurdle. At the same time, financial engineering has become less of a differentiating factor for value creation. And because of the global financial crisis, the higher price of debt, and increased level of covenants, PE firms have been forced to seek value elsewhere, primarily through operational levers. We believe that operations is an underexploited route to value creation.

Unlocking the value in operations is both art and science. Doing it well requires:

• Understanding the true "full operational potential"
• Identifying and quantifying improvement opportunities that can be implemented quickly
• Determining possible "land mines" that may constrain or, even worse, disrupt the growth of target companies
• Developing a resource plan and implementing the initiatives with the cooperation of the operations team (a critical—but often neglected—element of the due-diligence process)

Due Diligence: The Classic Approach

Figure 1: An integrated approach to due diligence includes financial, legal, commercial and operations due diligence

Due diligence is an overall term that typically refers to three broad areas: commercial due diligence (CDD), which seeks to determine if a market exists, whether it's attractive, and the competitive landscape; legal due diligence (LDD), which analyzes contracts and other documents; and financial due diligence (FDD), which looks for inconsistencies in the accounts. We refer to this three-in-one approach as "classic" due diligence. While it has served PE investors well in the past when increases in earnings multiples or the ability to increase financial leverage might have been sufficient, the approach fails in critically evaluating a firm's operations and the ability to execute a business plan successfully (see figure 1).

The financial and legal due diligence work streams focus on building an historical fact base, particularly in relation to regulatory and compliance issues. They typically provide caveat emptor advice, often with many facts but little prioritization of risks, and are backward-looking by nature. These work streams provide a context within which a target's future performance can be evaluated.

By contrast, the commercial due diligence work stream typically provides a forward-looking evaluation of the target's prospects, focusing on the business and industry fundamentals and evaluating the firm's strategy and competitive position. Often, however, commercial due diligence critics say it places too much emphasis on best-case scenarios.

Investors use commercial due diligence analyses and insights to refine their bid-valuation model but, as we have noted, this often does not adequately consider the firm's operations. Consequently, performance gaps that could provide short-term value-creation opportunities, when overlooked, lead to two significant challenges for PE investors: first, the inability to establish the firm's true full potential and, second, the inability to determine the real business risks. This is a huge conundrum for PE investors—they realize that successful exits are based on improving EBITDA, not just hoping for a multiple's increase.

In short, commercial due diligence can lead to investments in target firms that appear attractive but ultimately fail to generate the expected returns. This happens because the pre-deal analyses fail to uncover the target's internal inefficiencies.

Operations Due Diligence

Operations due diligence complements the scope of commercial due diligence and, through its focus on the target's operational capabilities, aims to bridge the classic due diligence gap. Operations due diligence is executed in an integrated manner alongside commercial due diligence, with the two work streams collaborating to incorporate each other's findings.

Commercial due diligence focuses on the target's strategy, competitive position and industry attractiveness, and assesses growth opportunities and portfolio synergies. Operations due diligence focuses on providing a deeper understanding of the target's business operations, including manufacturing, supply chain, cost base, organizational structure, resourcing and operations planning.

Specifically, operations due diligence provides for the following:

• Evaluates target's entire operations, including sites, volume, what is produced and where, costs, resources and supply chain efficiency, among others (see figure 2)
• Benchmarks performance and identifies improvement initiatives
• Considers the potential capital expenditures and working capital levels required to realize the target's full potential
• Accounts for the risks and constraints that current operations place upon the target's ability to achieve its business plan

Figure 2: Operations due diligence evaluates the target's entire operations

Operations due diligence is an integrated approach that provides a balanced view of an investment's opportunities and potential pitfalls—nailing down the full potential value, prioritizing improvement initiatives and ease of implementation, and, finally, providing the chance for a credible conversation with the entrepreneur about the business.

PE investors obtain significant advantages from this deeper understanding of the target's operations, not the least of which is the ability to identify opportunities for unlocking incremental value. For example, in a recent project we determined that the capital-expenditures plans for a manufacturing plant were too aggressive—and that they could be postponed by easing certain bottlenecks. The result: improved cash flow and, in turn, value. We then commented on how capital expenditures were prioritized and developed a business case for the investments—giving PE investors more confidence in the source of earning improvements and allowing them to bid more realistically.

The Approach: Six Areas

The operations due diligence approach focuses on the six areas shown in figure 3, evaluating both a target's internal capabilities and how effectively it interfaces with its external environment. It is a balanced assessment, taking into account the target's costs, operations, revenues and margins, and includes an evaluation of support functions such as finance, human resources and IT. This ensures that outsourcing and shared services concepts are fully leveraged.

Figure 3: Operational issues consist of six areas

The areas of focus for an operations due diligence project are established both by the market and the target's unique situation. The objectives, for example, could be (1) conduct a diagnostic to understand current operations, (2) benchmark current operations, or (3) quantify opportunities for value creation, or a combination of some or all of these. Our approach is based on the following:

Site visits. Site visits provide crucial information about a target's operational capabilities and a first-hand view of asset health, and help evaluate the site team's capability.

Processes and capabilities assessment. Given the operational due diligence time frame, the focus is limited to high-priority, mission-critical processes. These processes for each industry or function are assessed using a comprehensive set of questions and process maps.

Benchmark operating parameters. The best quantification of operations value comes from benchmarking operating parameters; the benchmarking is supported by a solid database of information provided both by external consultants and key technical experts in the industry.

These three elements feed into the "operations upside model," which is similar to the commercial upside model, and provide information on the following:

• Operating expenditures plan
• Capital expenditures plan
• Potential upside from release of additional capacity
• Risks with asset integrity
• Risks and bottlenecks with the current operations setup

Operations due diligence can help potential PE investors unlock a target's full potential value and identify ways to capture this value. It can also be used to begin a more wide-ranging conversation with the target company's owners that goes beyond the funding, managing and monitoring role that many PE funds end up playing. Finally—and perhaps most important—operations due diligence helps investors identify the potential risks of an investment before making a financial commitment.

Frequently Asked Questions

When we first approach companies with our operations due diligence strategy, we typically seek to answer several key questions at the outset:

Can operations due diligence take place without access to the target? Unrestricted access to the target company is desirable through the due diligence process, but often is limited due to confidentiality and commercial concerns. When such restrictions exist, operations due diligence can still be performed by internal industry experts, and through the use of intellectual property and global benchmarks.

Can this be undertaken on our portfolio? Some form of pre-deal assessment of the target's operations should always be undertaken. When an investor has considerable operational expertise in the target's market, an internal review may be sufficient. However, when industry familiarity is lacking or the operations are sufficiently complex, a formal operations due diligence process is preferred.

How long does the process take? Operations due diligence is run simultaneously with the commercial due diligence work stream and typically spans three to four weeks. The scope of the pre-deal operations due diligence is determined by considering both the industry and the target's situation, while initial hypotheses and focus areas are determined in consultation with the client. A two-phase process highlights key "red flags" during the pre-deal evaluation and then provides value-creation assistance during the investment holding period.

Authors

Vikram Chakravarty is a partner and head of the strategy practice in Asia. He is based in the Singapore office.

Badri Veeraghanta is a principal in the strategy practice in Asia. He is based in the Singapore office.

Francesco Cigala is a principal in the operations practice in Asia. He is based in the Singapore office.

Adam Qaiser is a consultant based in the Melbourne office.