Deloitte special: Due diligence – Expert Comment

Kamal Mistry

The days of buying undervalued assets, sprucing them with up a proverbial fresh coat of paint, and quickly selling them at a profit are long gone. Generating the above-market returns private equity firms have historically delivered now requires more than just financial engineering. Private equity firms are spending more time in operational diligence, digging deeper into the operations of potential acquisitions. They’re increasingly prepared to make major operational changes to realize value.

While this approach can deliver bigger returns, it also carries bigger risks. For example, changes to the supply chain can significantly streamline costs, speed up delivery cycles, and improve margins, but replacing or upgrading the enterprise resource planning (ERP) infrastructure that supports the supply chain can be a long and costly effort. Factories or plants that seem underutilized can be targets for improvement or closure, but running afoul of local labor laws or works councils can bring added costs and reputational harm.

More than any time in the past decade, general partners are carefully evaluating the implications – both positive and negative – of the changes they think are needed to generate the return investors have come to expect. And yet, many aren’t going nearly far enough. Deal teams faced with constrained time frames and exclusivity windows for options often stay focused on financial and accounting diligence at the expense of commercial and operational diligence. In Deloitte’s experience, skimping on this crucial aspect of deal-making can turn a simple fixer-upper into a money pit.

While timing will always be a constraint facing the industry, private equity firms can drive rapid operational improvements simply by focusing on areas that most commonly deliver value or trip up investors.

Commercial diligence

In the past, a rising stock market lifted all boats. It’s true that market leaders earned greater returns for their investors, but even laggards could generally turn a profit. Now it’s much harder to spot an attractive target in an increasingly competitive and sophisticated market where buyers have funds and are accustomed to financial leverage.

When one is found, it’s tempting to jump at the chance and lock up a deal before anyone else. But there are some fundamental questions that need to be considered first, and that’s where commercial diligence comes into play. Commercial diligence looks at key aspects of the target company’s market:

• What’s the size of the market, and where is it projected to grow?
• Who are the key competitors, suppliers, and customers?
• What competitive advantage do market leaders have, and how does the target company match up?
• Are there any new entrants to worry about or ones likely to crop up?
• Are there potential upside opportunities that the business may not be taking advantage of, or possible downside risks that could jeopardize the near term or ongoing value of the deal?

Understanding answers to these questions can help private equity firms find potential pitfalls – or confirm the target’s appeal by spotting alternative ways to deliver value.

Operational diligence

Where commercial due diligence seeks to obtain a comprehensive picture of the company’s market, operational due diligence uncovers the company-specific capabilities that help the business compete or the weaknesses that are getting in the way.

Operational diligence typically covers key functional areas of the target company, including sales, marketing, operations, finance, HR, and technology. When conducting commercial diligence, you want to make sure your team is assessing each of these areas to identify gaps in the company’s ability to support future growth, as well as the level of investment that might be needed to maintain or improve performance. This analysis can flag operational or technology issues that have the potential to become a drag on investment or uncover complexities below the surface that need to be addressed.

One of the most common issues Deloitte sees during operational diligence is with the existing technology infrastructure. As highlighted earlier, we encourage private equity firms to look closely at the ERP systems that are critical to efficient operations. Much like a home’s electrical wiring, an older ERP system may need to be replaced or upgraded if it’s not well integrated, requires a lot of manual workarounds, or simply no longer supports the needs of the business. As these costs can be significant, they need to be factored in to the due diligence process.

Supply chains are another key area: they offer great potential to improve margins by consolidating suppliers, negotiating better prices, streamlining delivery and shipping, and better managing inventories. But given the complex relationships and logistics that support supply chains, it’s not always as easy to spot the risks, particularly when the business crosses borders and oceans. A thorough review of the company’s quality control systems and processes can help spot red flags, identify opportunities for better margins, and find areas where different sourcing approaches could drive savings.

Diligent risk-taking

The pressure on PE firms to conduct deeper due diligence isn’t likely to lessen soon. Merger activity is expected to stay strong in this sector, as evidenced by 87 percent of M&A professionals surveyed in Deloitte’s 2016 M&A Trends report who expect deal activity to meet or beat 2015’s record pace. But survey respondents also see risks ahead, with global uncertainty cited as the top concern that could slow down the pace of deal-making and depress valuations.

In the face of this uncertainty, it’s not surprising that the survey also uncovered growing concern about deals not delivering on expectations. Fifty-six percent of the private equity firms surveyed said that more than half of completed transactions had not returned expected value, primarily due to gaps in execution and integration of deals. These are precisely the kinds of issues that effective commercial and operational diligence can head off.

In an uncertain and competitive environment, it’s probably a given that private equity firms will find themselves looking at deals more on the margin. Even there, the challenge will be moving quickly. Given short time frames, they may be tempted to focus more on the financial and accounting due diligence that reaped rewards in the past. But in an environment of increased competition and diminished returns, giving more attention to commercial and operational due diligence can protect investments, arm firms with a competitive edge, and generate the returns investors have come to expect.

Three steps to creating value

1. Review portfolio to define which customers or pieces of business generate value for the company. The private equity manager’s goal is to extract value from the portfolio company in the least capital-intensive manner possible. This means figuring out how to redeploy or eliminate non-productive capital, whether fixed assets or working capital.

2. Use data & analytics to document and improve performance. At present, private equity as a whole lags behind its mutual fund and hedge fund counterparts in the use of data. This leaves space for fast movers in private equity to gain a competitive advantage. The accuracy of the data received from the portfolio companies, and how well it is leveraged for strategic decision making, are important aspects of operational efficiency, especially at a time when holding periods are lengthening.

3. Consider what may be outsourced to full-service providers. While private equity firms have already increased the level of their back-office outsourcing, processes that support the front office may follow. Firms may want to improve allocation of their expensive in-house talent and resources by outsourcing components of initial due diligence, operational due diligence, and growth strategy formation processes for the portfolio company. The broader the range of services offered by the outsourced provider, the better, as this may help to lower the cost of operations across the board.

This article is sponsored by Deloitte. It was published in the September supplement with pfm magazine.