Operational Due Diligence – The necessity to a successful M&A

Operational due diligence

In this blog, we shall discuss the importance of Operational Due Diligence in evaluating a target during acquisition. Besides, we will also enumerate the list of activities to perform effective due diligence.
Operational Due Diligence is an integral part of a Due Diligence phase. It involves understanding the target business operations and evaluate how aligned the target business is to the acquirer business.
Due Diligence activity varies with industry to industry, and specialists having strong knowledge of that industry perform operational due diligence. Sometimes Due diligence is conducted by Third-party consultants too.

1) What is Due Diligence?

• Operational Due Diligence is a comprehensive and complete study of the target company business operations to confirm if the business plan of the target company is realistic or not.
• Besides, it involves analyzing each function and structural processes of the target and identify any risks which would require the buyer to abort the deal or adjust the final purchase price. In an acquisition, the buyer is looking to maximize synergies and minimize the risks.
• Hence the acquirer will identify opportunities where the target can unlock value, improve performance, and increase the efficiency of cash flow. It involves analyzing target departments like Manufacturing, Supply chain, and Procurement, along with back-office functions like HR, IT, and Accounting.

2) Importance of Operational Due Diligence

• Conducting operational due diligence is essential to identify the risks in the target company. The due diligence team must have expertise in the target industry, understand its market trends, evaluate targets against its competitors, and have clarity on the technological trends influencing the target industry.
• Besides, the due diligence team needs to understand the target business operations to identify the value-added opportunities and identify improvements post-acquisition.
• It is necessary that the acquirer identifies all the risks and how to mitigate the risks. The acquirer should ensure that it does not discover any hidden issues post deal closure.

3) Objectives 

• The objectives of Operational due diligence is more than looking at the due diligence checklists to provide approval for the acquisition. It has to provide valuable information that justifies the proposed acquisition.
• Successful due diligence should identify the cost savings and opportunities to improve efficiencies in the target company. At the same time, it needs to identify the risks that can be deal killers or which would require the acquirer to renegotiate the final purchase price. The following objectives are:

1. Get a comprehensive understanding of target operations, cost structure, and CAPEX
2. Identify gaps in the target business operations and opportunities for improvement in cost savings
3. Prioritize costs savings on operational improvements and build an investment case to support purchase price negotiations
4. Get a clear understanding and develop a plan to identify value creation opportunities to maximize value addition.
5. Devise a process to track the plan progress and have a contingency plan.
6. Ensure that the identified synergies can be realized and sustained for a long period.
7. Ensure that there are no hidden issues/risks that might threaten the deal.
8. Use the operational due diligence review to come up with a realistic business plan and a post-acquisition integration plan to realize the synergies identified.

When to start 

• Operational Due Diligence is a costly and time-consuming process.It should start right after the Letter of Intent / Term sheet is signed between the target and the buyer.
• The term sheet specifies the initial purchase price, the deal structure and also should have exclusivity for the acquirer to conduct due diligence. If there is no exclusivity agreement, then more buyers would be evaluating the target.
• Operational Due Diligence should be done in parallel with Financial, Commercial and Legal Due diligence. The due diligence should be a particular activity, and sufficient resources allocated for this task.
• The outcome of the Operational due diligence should provide a realistic estimate of the final purchase price.

Methods of Due Diligence

• Operational due diligence would involve understanding the target business strategy, analyzing its departments, and back-office functions like HR, IT, and Accounting.
• Besides, it involves understanding the target industry, key drivers, and doing a competitor analysis.
• As the due diligence involves both internal and external research, operational due diligence needs to be performed by industry specialists that have a deep understanding.
• The due diligence should be done by independent consultants so that they can provide a neutral view of the due diligence process.

The outcome 

• Generally, an acquirer would perform integrated due diligence that includes financial, Operational, Commercial, and Legal DD. The outcome should provide the acquirer a holistic view of the target company, risks, and ways to mitigate the risks.
• Besides, the outcome should give confidence to the acquirer that synergies targets get achieved, and a post-acquisition integration plan can get managed.

The outcomes of the Operational Due Diligence would include:

1. Target operations risks assessment
2. Working capital assessment
3. Target Manufacturing, Supply chain, and Procurement assessment
4. Target evaluation of back-office functions like HR and IT
5. Sales and Marketing effectiveness

Conclusion

• Operational due diligence is essential to assess target operations to identify the underlying risks and value addition opportunities.
• The outcome of the due diligence provides the acquirer guidance on whether to abandon the deal or renegotiate the final purchase price.
• The due diligence exercise should provide a realistic business plan of the target, along with a post-acquisition integration plan to implement the synergies targets identified in the business plan.