Contents:
• What is Operational Due Diligence (ODD)?
• Objectives of ODD
• ODD Framework
• Why ODD must be linked directly to the Value Creation Plan (VCP)
When exercising judgement on potential private equity (PE) investments, investors have traditionally placed priority on the financial, legal, and tax due diligence processes and the purchase price at which managers should look to acquire companies. This process remains critical, but in heated bidding environments and rising valuations, additional levels of due diligence need to be performed in order to find hidden sources of value.
Operational Due Diligence (ODD) is well-positioned to identify hidden value drivers as well as chart a path to value creation that assesses the range of EBITDA-impacting benefits available, time to implement, and the contribution to the investment’s IRR. The ODD process seeks to determine the overall current performance of the core business operations, compared with the potential level that could be reached within the investment lifecycle.
In this article, we will dig deeper into the key components of the definition of ODD, provide a basic framework for conducting effective due diligence, and for deciphering how this type of pre-acquisition operational analysis can play a vital role in informing significant value drivers in a PE investment.
What is Operational Due Diligence (ODD)?
Operational Due Diligence is a tailored and continuous investigative analysis into the operations of a target business, helping to establish the company in question's future sustainability for a buyer, alongside an actionable VCP.
ODD is primarily future-oriented and opportunity-focused, complementing a managed-risk approach to maximize ROI. In the broadest sense, ODD seeks to answer the question, “When this is ours, how will we make it work?”
The objectives of ODD are to:
Determine the sustainability of the target company's operations into the future, without the need for additional investment on top of management's current business plan.
Establish fresh action points and investments needed to accelerate short and long-term value creation.
Consult and advise the deal team on the strategic fit of the proposed transaction.
Operational Due Diligence Framework:
Integrating ODD into the overall due diligence process is an important step towards providing input to the value creation plan, with a clear link to IRR contributions, and ensuring that every investment is thoroughly vetted before a commitment is made. In most cases, the ODD personnel and procedure should be carried out independently of the investment teams and coordinated in parallel with the investment due diligence process. This helps to ensure that input from the ODD process is clearly and conspicuously incorporated into the investment recommendation.
Each deal is unique, making the scope of every ODD procedure tailored to the deal rationale, structure, industry, and company-specific operational risks. A bespoke ODD process that manages to define an applicable plan for significantly increasing the EBITDA of the organization in question, will make a substantial contribution to the private equity’s decision to acquire the company.
A strong operational due diligence process should look something like the following:
Phase One: Getting to know the organization
Phase one aims to study the organization’s primary activities and identify its key contribution to revenue and expenses. This phase helps to define the objectives and scope of the diagnostic process.
Tools and methods used in the 1st stage:
Cost structure and working capital analysis – identify operating segments with high costs or inefficient cash management for the project’s focus.
Internal benchmarking – identify “best in class” in different categories and examine the implications of bringing others to this level.
Business model & process analysis - how easy is it for the organization to generate cash flow?
Phase Two: Exploring the organization’s business environment and its operational and business processes
The second stage focuses mainly on learning the business environment, current market share, growth potential and competitors’ behaviour.
Tools and methods used in the 2nd stage:
Market analysis – market share, market demand trends, competitors analysis.
Organizational structure analysis.
Deal room document review and analysis.
Inventory and procurement management.
Trends – category trends, price trends.
Sales – sales processes, sales policy – SFE*, Customer segmentation, SKU rationalization (volume & profit), returns volume and policies.
Human capital - to what extent does the target company’s people contribute to successfully carrying out its operations? (I.e. What are they doing to develop leaders throughout every level of their organisation? Are they running consistent leadership assessments?)
How sustainable are the operations? (i.e. are they running near capacity, using old technology, too expensive to be sustainable, long-term asset dependency, etc.)
Phase Three: Performing an analysis of the core activities
The 3rd phase is a thorough analysis of the core activities in the organization, in order to identify potential savings, opportunities for improving efficiency and required investments.
Procurement:
Strategic sourcing (e.g., vendor and SKU fragmentation, unleveraged spend, contracts assessments)
Inventory levels (e.g., turnover, and slow-moving analysis)
Examination of contracts with subcontractors and suppliers
System process & data analytics (e.g., purchase order management and spend reporting)
Manufacturing:
Manufacturing processes
Value stream mapping
Capacity Model
Bottlenecks identification
Manpower standardization – organisational structure & manager-employees ratio
Operational excellence (OPEX)
Logistics:
Haulage & distribution efficiency (scheduling methodology)
Driver payment methods
Trucks maintenance
Loading and unloading processes
Quality:
Waste
QA infrastructure and processes
Quality control procedures
Process Improvement Events (e.g., LEAN, Kaizen, Six Sigma)
Tools and methods used in the 3rd stage include; on-site visits, SME interviews, and finalized value drivers.
Phase Four: Projections
Use information gathered until now to make projections about the value added that you can bring - are there any ‘quick wins’ that can generate value?
Work with commercial and finance teams to build a budget based on the operations of the target company.
What kind of (capital) investment will be required to bring the target company operations to the desired level?
Operational Due Diligence is a Continuous Process:
Post-investment ODD monitoring efforts are crucial to mitigate future risks and hold all parties accountable for continuous operational improvement. This is executed by linking ODD outputs into the 100-day post-close plan, and subsequently further linked into the overall long-term operational improvement plan that is to be executed within the holding term. The level of monitoring that is carried out should be established through the use of a structured and standardized pre-investment risk assessment (often referred to as ‘risk-based monitoring’).
Whereas FDD and LDD findings are key inputs for purchase terms, continued processing of ODD findings help to evaluate how the initial risks and opportunities discovered in the assessment phase are being remedied and operationalized, respectively. In tandem, it is expected that the drivers identified will also enable management of emergent opportunities as well as risks, which would therefore set up the business for continued growth.
Continued ODD monitoring will play a decisive role in:
The continuous prioritisation of value creation opportunities.
A regularly updated plan for action, setting out how to maximize upside chasing while mitigating execution risks. The translation of data and facts (acquired through ODD) into an action plan, is at the heart of ODD and provides its forward-looking orientation.
Opportunity management: when risks are well understood, continuously managed, and kept on top of, it can be an inspiration for opportunities to grow.
Closing Remarks:
Traditionally, acquisitions have relied upon financial, legal, and perhaps commercial due diligence to estimate an organization’s potential over the short and long term.
In the current macroeconomic climate, private equity firms looking to acquire a company should prioritize ODD in search of reliable value drivers that can provide material contributions to the investment’s IRR.
Simply put, ODD is a thorough investigation of the target’s business, what it does, how well it does it, and how it can be improved upon.
