How buyout managers can identify opportunities and actions to accelerate improvements in EBITDA and working capital.
Operational due diligence provides private equity investors with insight and guidance on EBITDA and working capital opportunities. By conducting what we call operational diligence pre-acquisition, buyout managers can identify the opportunities and actions to accelerate improvements in EBITDA and free up working capital.
Conducting Operational Diligence
An operational diligence review takes between one to four weeks depending on the size of the company, complexity of operations and the depth of the assessment desired.
The standard operational diligence assessments consist of four phases:
- Phase 1: Review available financial and performance data collected to date; prepare additional information requirements; and conduct on-site review.
- Phase 2: Collect additional financial and performance data; conduct follow-up interviews by telephone; begin analysis of operations and performance versus best practices and benchmarks; and review initial observations and next steps with buyout managers.
- Phase 3: Conduct additional on-site reviews as needed; complete analyses versus best practices and benchmarks; develop first-cut report of financial opportunity; and review with buyout managers.
- Phase 4: Refine financial estimates and develop projected timing and resourcing required; complete and submit formal report to buyout managers; and conduct review either on-site or by teleconference.
Final documentation includes a report on operational capabilities; assessment of the leadership and organization; and detailed descriptions of financial opportunities, including high and low estimates for each.
Two Operational Diligence Case Studies, Different Outcomes
A couple of case studies will illustrate why operational diligence should be conducted after a letter of intent (LOI) is signed.
CASE 1
In the first case, we performed an assessment for a Private Equity client in the process of acquiring a mid-size, single-site pharmaceutical company. The firm’s operations were well organized and maintained, but our initial review and analysis indicated some strong upside in equipment efficiency and certain supply-chain activities. After additional on-site reviews and researching their competitors’ and industry best-in-class performance, we identified specific opportunities to increase EBITDA by nearly a third and free up between $14 million and $20 million in working capital.
We realized about $13 million in working capital and $1.4 million in EBITDA improvements. We were engaged to work with the management team and, since closing on the acquisition a little over a year ago.
CASE 2
In the second case, we did an assessment for a client looking at a consumer packaged goods company. This company’s products were in a fast-growing and highly profitable market niche. The assessment again identified significant opportunities in both EBITDA and working capital. However, two significant risks were uncovered.
First, while the industry was lightly regulated, that was likely to change during the next five years—something we learned in our discussions with trade groups and regulatory officials. As a result, the company would require sizable capital outlays to comply with anticipated facilities requirements.
We also called out recruiting and retention and the caliber of operations management in general. The location of production operations was ideal for raw materials supply, but the community was remote and offered few amenities. Turnover in line supervision was very high. For these and other issues, our client eventually terminated the buyout.
First, while the industry was lightly regulated, that was likely to change during the next five years—something we learned in our discussions with trade groups and regulatory officials. As a result, the company would require sizable capital outlays to comply with anticipated facilities requirements. We also called out recruiting and retention and the caliber of operations management in general. The location of production operations was ideal for raw materials supply, but the community was remote and offered few amenities. Turnover in line supervision was very high. For these and other issues, our client eventually terminated the buyout.
Has the impact of financial engineering and leveraging on PE investor returns become muted?
In the current environment, it may, at best, be on hiatus. However, building value through organic growth and value chain efficiency is not a new strategy for the Private Equity industry. Perhaps it is more prominent today than pre-2007. We believe that a robust assessment of financial opportunities helps buyout managers set expectations and make more informed decisions on acquisitions. We advise clients to set the tone early by setting 90-day, six-month and 12-month performance goals and delivery plans.
