Operations Diligence – Assessing the Foundation for Future Performance

Years ago, Fram oil filters had a catchy commercial; “pay me now or pay me later” – which meant you can end up paying a much larger amount later on if you do not take appropriate steps up front. Along this same vein, we see some private equity companies failing to perform rigorous operational diligence and paying the price later in sub-par financial performance. They hire external firms to perform legal, Quality of Earnings (Q of E), competitor, and HR diligence —and invest significant internal time building “investment thesis” models—but fail to bring in professionals for a rigorous review of their Operations processes and systems. Since many of our private equity engagements at FortéOne are focused on correcting issues that existed with companies before they were purchased, we know that Operations Diligence would have alerted those PE clients to pre-purchase issues, and saved them from “paying a much larger amount later on.”

What is Operations Due Diligence?

Unlike Quality of Earnings, competitor, and HR diligence, the areas included in operations diligence are not well understood. At FortéOne, the focus of Operations Diligence is the critical internal factors that are required to sustain and grow the business. We assess foundational areas that are necessary for performance and how they can scale to support growth. Whereas Q of E and legal diligence focus on historic performance, operations diligence focuses on factors that impact future performance of the company.

The Value of Industry Experience

The first step of our Operations Diligence is providing a diligence team with the appropriate industry and subject matter expertise. Business operations have become increasingly complex and require special industry knowledge to accurately assess. Gone are the days when Operations Diligence can be accomplished with a series of short interviews, a walkthrough of a manufacturing location and a warehouse, and supplemented with leadership team meetings. Understanding the nuances of a complex supply chain, the food safety needs in a consumer products manufacturer, or the implementation requirements for a middle market ERP system requires an experienced team. Not only are internal manufacturing or service delivery capabilities important to evaluate, but their impact on customer satisfaction and retention along with the overall performance and health of the supplier base must be considered in the “value to risk” analysis.

The Importance of Data

Prior to coming on-site, we request available data from relevant areas of the company. Buyers who have anticipated the data needs and have acquired the data (and populated a comprehensive data room) prior to the signing of the LOI will reduce the time and cost associated with operations diligence. And Sellers who have prepared their data in advance usually have a much smoother sales process.

Although most middle market companies larger than $25-30MM in annual revenue have some level of enterprise systems including Enterprise Resource Management (ERP) applications, data availability and data quality remain an issue in middle market companies. In many of our diligence engagements, we find that companies are “data rich and information poor,” and FortéOne analysts may need to spend considerable time getting access to data, cleansing it, and reformatting the data to make it usable.

Data access and analysis prior to the on-site visits allows Diligence team members to begin assessing an enterprise’s operational performance and risks. Issues are then identified based upon (i) the team’s experience compared to our internal best practices and (ii) industry databases including the process framework provided by the American Productivity and Quality Center, or APQC (www.apqc.org). With these reference standards, we compare the operational findings/risks and observations against similar size companies within the same industry vertical. This approach has two advantages over the traditional “company walkthrough”—it identifies at the onset the operational areas that need a deep dive, and it enables fact-based findings that can quantify both changes required and EBITDA impact of the recommended operational changes. Although this initial data analysis is important, it does not replace the need for one-on-one (in person or via video) discussions with the key personnel as the diligence progresses.

Information Technology

Because people, process, and technology work closely together in today’s operating environments, Information Technology diligence is a critical component of Operations Diligence. Today, all companies are “in the IT business” and the quality and scalability of an acquisition are contingent upon its information technology capabilities and infrastructure. For middle market companies with outdated systems, IT Diligence must be completed with the recognition that system changes, and especially ERP installations, can be disruptive and that other, less disruptive options may well be the best option in the near term. Technology changes need to improve the business, not grind it to a halt. The use of the Information Technology Laboratories (ITL) (www.axelos.com) best practices model is a guide to evaluate information technology capabilities and risk, but our recommendations also take into account the capacity of the company for change and strategic objectives that must be supported through IT.

Financial Impact

Like a pre-purchase home inspection, the findings and recommendations of Operations Diligence often impact the purchase process and terms of the sale for the investor group. In addition, knowing what areas of the operational and information technology infrastructure need additional investment allows the buyer to include these expenditures in their pre-purchase financial models, and in their lender discussions. In many situations, these investments are material and full disclosure prior to the acquisition is critical to build confidence and investor support.

FortéOne personnel have conducted hundreds of operational assessments in a wide variety of industries. Our comprehensive diligence process, conducted by experienced operating executives, provides business investors with an accurate and objective understanding of business sustainability, potential for growth, and (where needed) the changes and investment required to achieve their investment thesis. If you are considering a business acquisition, please contact us to discuss how we can assist.