Operational due diligence

Operational due diligence is an inseparable part of any due diligence (DD) process. It is very important to understand the operations of the target company to see how they fit into the structure of the buyer’s enterprise. Operational due diligence is the process by which a potential buyer reviews the operational aspects of a target company during mergers and acquisitions. The approach for operational due diligence varies by industry. An operational due diligence review is often performed by a third party, such as a professional services firm. The process itself needs to be executed by specialists and professionals who understand the industry and have a background in it.

Here is an overview of the operational due diligence process:

• What is operational due diligence?
• The importance of operational due diligence
• The objectives of operational due diligence
• When to start operational due diligence
• Methods of conducting operational due diligence
• The outcome from operational due diligence

What is operational due diligence?

Operational due diligence is a comprehensive and complete review of the main operations of the target company and its primary task is to ascertain if the business plan of this company is realistic and achievable or not. Next, the operational due diligence review will explore and examine the operational functions and structural processes in the target business and will also try to define whether there are serious operational risks that the potential buyer should consider regarding accepting or aborting the deal or renegotiating the price. Whether it is a merger or acquisition, the investor is looking to maximize returns and benefit from synergies. Therefore, the target company must improve its operations – unlock value, seize opportunities, minimize risks, and maximize the efficiency of cash flow throughout the investment lifecycle. In order to achieve this, the buyer should analyze functional and departmental processes, including manufacturing operations, supply chain, and distribution channels, the potential for performance improvement, procurement, working capital risks, information technology, as well as back-office operations such as finance, accounting, and human resources. 

The importance of operational due diligence

The operational analysis of the target is crucial. A buyer needs to recognize and understand which risks exist in the company. The key to understanding a business the investor is going to merge with or acquire is having deep industry knowledge and the capacity to evaluate the competitive landscape and the technological trends along the industry’s value chain. In this case, it is essential to conduct proper due diligence for the purpose of ensuring that the nature and level of risk involved in the potential deal are fully understood so that there are no hidden problems that might threaten the deal or, even the stability of the investor’s business. Besides market opportunities, the target’s operational improvement potential is of major importance in a successful acquisition. Very often, not inspecting the company’s operations can break even the most promising acquisitions. Deals that appear initially attractive often fail because of internal and structural inefficiencies that remain unnoticed during the pre-purchase commercial and operational due diligence. Therefore, the buyer should be aware of the target’s risks across the whole business.

The objectives of operational due diligence

The due diligence process is much more than a standard checklist of procedures with the aim of providing approval for a proposed acquisition. When done properly, an operational due diligence review provides valuable information to support the proposed acquisition. In order to save the cost of a bad acquisition, the investor should assess the full potential for operational savings and efficiency improvements as well to identify and quantify potential risks of the target company. Operational due diligence should be conducted with the following objectives:

• Get a comprehensive understanding of a target’s operations and risks, including the cost base and CAPEX requirements
• Identify performance gaps and potential improvement opportunities, e.g., cost reduction and or revenue enhancement
• Know how to evaluate and prioritize the potential savings from operational improvements and based on that to form the investment case and conduct purchase price negotiations
• Get a clear understanding of how to develop and implement a plan to create maximum value and how to prioritize value creation opportunities
• Know how to assess progress, completion, and contingency plans
• Determine if the expected synergies can be realized and remain sustainable in the future
• Check that there are no hidden problems that might threaten the deal or, even the stability of the investor’s business
• Use the operational due diligence review to create an achievable business plan and to prepare the post-acquisition integration plan

When to start operational due diligence

Operational due diligence can vary case-by-case and can be a costly and time-consuming exercise. Therefore, it is important to determine when the process should start. In general, it is recommended to start after the negotiations are open and a letter of intent (LOI) has been provided and signed, i.e., it should start simultaneously with legal and financial due diligence. It is also important for the buyer to know how many other potential investors have performed due diligence on the selected target. This is crucial information because if there are too many, the buyer takes an elevated risk that he will not end up as the final buyer and will have wasted his time and investment in the due diligence process. Hence, it is important to have exclusivity and an agreed letter of intent including the price and other conditions. Once an LOI has been drafted that describes the structure of the deal, operational due diligence should begin. Adequate time and resources should be allocated to the operational due diligence process as the outcome of the review can provide valuable information regarding a realistic purchase price.

Methods of operational due diligence

Operational due diligence can be performed by several diverse methods. The most common methods are to investigate, analyze and assess the following aspects of target operations and business strategy and conditions: product management and logistics processes, IT and business processes, store locations, online channels, functional and departmental processes, and back-office operations. In addition to the operational due diligence methods, there are other aspects of the process connected with the terms and practices of commercial due diligence. Its objectives include analyzing the market in which the business operates and assessing the industry and market conditions: state of the industry, competitive landscape, supply chain dynamics, market trends, and stability of demand and customer behavior. The most effective methods for commercial due diligence include conducting interviews with industry experts, independent primary and secondary market research, analysis of competitors using wide-ranging research techniques, along with detailed industry knowledge and expertise, as well as internal and external research. In general, there is no ideal case for operational and commercial due diligence. It always depends on the acquisition’s target, the investor’s budget, and the quality of desired information. It is important that the operational due diligence is conducted by independent advisers or specialists that give an independent assessment and opinion. This is important in order to have an operational due diligence outcome that gives a fair, open and objective opinion.

The outcome from operational due diligence

The outcome generated from operational due diligence is different and depends on the buyer’s assignment. In general, it is good to have an integrated DD process covering operational and commercial due diligence, and even financial DD. This is because the investor needs to confirm whether the target company is as viable as its business plan might suggest, to explore the potential for adding value and synergy that could be gained from the target company and to successfully manage the post-acquisition integration. This more integrated approach enables the buyer to gain a more coherent idea of the direction of the company, a holistic view of the transaction opportunity, and the potential for growth and development of the acquired business. Here are some of the integrated outcomes of the operational and commercial due diligence process:

• Target’s operational risk assessment
• Business and strategic plan review
• Operational and financial planning
• Working capital assessment
• Manufacturing and operations evaluation
• Supply chain operations assessment
• Procurement and supply review
• Technology capability, risk, and process capacity planning
• Sales and marketing effectiveness assessment
• Merger and acquisition planning
• Human resources assessment

Information about the process of operational due diligence

Contact us for free consultation and feedback on your operational due diligence plans. We can discuss how the operational due diligence process can be conducted. We are ready to give you independent feedback about how to organize your operational due diligence process in your industry or country of choice.