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Operational Due Diligence: an M&A necessity

19 Jul 2017
The process of Due Diligence (DD) is essential for investors to make informed decisions. Originally, DD primarily focused on financial, tax and legal audits complemented with a commercial review. However, over the past years, we see a growing importance of the operational aspect. If done right, I think an Operational Due Diligence (ODD) can provide the much sought ‘inside view’ and add real value to both the seller and buyer.

Before we dive into the process of ODD, let’s take a look at the developments that led to the growing importance of the operational aspects of acquisitions.

Smaller margin of error

In the wake of the global financial crisis and Eurozone crisis, central banks have resorted to lowering key interest rates and applying forms of quantitative easing to stimulate spending and industry investments. Capital has become cheap, at least for now.

At the same time, these crises reminded us that overall economic growth could no longer be taken for granted. Dwindling growth indices have plunged and are now stabilising, but the new reality is one with a higher financial risk.

On top of this all, the tumultuous geopolitical stage of the past two years has resulted in a more protectionist attitude towards cross-border M&A activities. While domestic controls halt Chinese investors, US protectionist policy leaves investors looking at Europe. Although options to truly intervene in deal-making might be limited, the UK is considering a ‘public interest test’ for foreign takeovers (following the example of France).

This all being said, 95% of Dutch CFO’s expect the M&A market to grow this year. The combination – more risk and less potential for growth – makes acquirers more demanding and critical in their M&A decisions. As the margin of error has become smaller, it is essential to know the ins and outs of a company before the acquisition. Hence the growing importance of ODD.

What makes a good ODD?

With M3, I have worked ODDs for both strategic buyers as well as financial buyers and the sell-side. Regardless of the perspective, some factors stand out as vital to success.

Apply industry expertise
For an outstanding ODD, industry focus is essential. Previously, the operational part of a DD was only one small piece of the complete DD, often dismissed with ticking a few bullet points from a checklist. Currently, an overall operational check-up is no longer sufficient, as industry-specific differences are crucial to getting an insight into the true health of the business. This requires that the team performing the ODD’s has extensive industry knowledge and experience.

Include a deep dive
The time allowed for an ODD is usually in the range of a few weeks. Needless to say, a detailed analysis of all business processes is not possible. However, many aspects can only be assessed when digging deep and interacting with the target company on multiple levels. Are presented improvements realistic and sustainable? Do stories match across the ranks? More importantly, do stories match the data? In short: don’t take management’s word for it (or for that matter, management reporting). This is more significant than you might expect. Therefore, always include 1 or 2 deep-dives in the ODD approach. An excellent example of such a deep-dive is determining the right inventory levels based on POS data and then matching this with actual levels.

Focus on operational improvements
As stated before, quickly increasing a company’s bottom line is usually more straightforward through increasing efficiency than through growing revenue. When achieved, the realised cash flow can be invested to obtain revenue growth. Therefore, keep an extra eye on other opportunities and validate with the target company’s staff. In my experience, there are always hidden gems in the supply chain that can be more effectively and efficiently managed. Discovering these out-of-sight options is essential for M&A’s to become successful.

ODD in the future

Going forward, although the trends that have sparked the rise of ODD are now stabilising somewhat, I am convinced that it is here to stay. And also, no surprise here, true expertise delivers the most value.

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