An often-overlooked area during Mergers & Acquisitions (“M&A”) transactions is Operational Due Diligence (“ODD”). ODD is a critical component of the decision-making process, no matter the market or industry in which the buyer and seller operate. While there is no doubt that other areas of Due Diligence, such as Financial, Commercial, and HR, are just as critical, ODD focuses on the abilities of a company to operate and deliver value to its customers.
By investing time into the ODD process, key stakeholders can uncover deep insights into a company’s operational efficiencies, identify potential risks, find areas of improvement, and assess the proper steps for a successful Post-Merger Integration (“PMI”) after a transaction. ODD goes beyond the financials to scrutinize a company’s operational backbone and encompasses many different inputs and risk factors.
This article provides a primer to understanding ODD deeper; the areas and categories will likely need to be modified and adjusted depending on the industry or company. Still, it should provide a robust overview of what factors to consider during ODD and what red flags to watch out for.
This primer splits the ODD process splits into three key areas:
- Operational Excellence
- Key Partnerships
- Capital Assets
Operational Excellence
Operational Excellence represents the cornerstone of any thriving company. It focuses on delivering the highest-quality product or service while efficiently meeting the delivery timeline. At its core, Operational Excellence involves examining various facets of a company to successfully meet current and future customer demand while driving performance improvements across the board.
Each company operates differently, even within the same industries, so fully understanding these details may require modifications to the Operational Excellence area. What remains the same ensures that a company’s operations meet customer objectives, always aiming to exceed expectations.
Operational Excellence can be sorted into five broad categories:
1. Environmental Health & Safety:
Environmental Health & Safety (“EH&S”) is essential, blending regulatory compliance with a commitment to safeguarding workplace health and environmental stewardship. Robust EH&S controls and programs seek to reduce the risk of workplace accidents and environmental incidents while enhancing the company’s reputation and employee well-being. For any company, prioritizing EH&S can lead to cost savings through reduced liabilities, improved productivity, and maintaining a healthy workforce.
Evaluating and understanding a company’s EH&S practices and history is vital. Many countries’ labor regulation bodies increasingly focus on EH&S to protect workers. A company with a poor EH&S history may put future growth plans at significant risk!
🚩 Red Flags:
- Repeated history of regulatory and EH&S non-compliance.
- Frequent workplace accidents or incidents.
- Lack of EH&S training, awareness programs, or safety plans not being followed.
2. Research & Development:
The ability of a company’s Research & Development to execute efficiently from concept to commercialization is paramount. This ‘cradle-to-launch’ capability ensures that the innovation pipeline is filled with ideas that turn into market-ready products or services swiftly and effectively. This efficiency in execution reflects a company’s agility and responsiveness to market demands and technological advancements. A streamlined R&D process, which effectively moves from initial ideation through development, testing, and into successful market introduction, underpins a company’s ability to maintain relevance and competitive advantage in a rapidly changing landscape.
A thorough assessment of a company’s R&D activities illuminates its innovation potential, capacity for market leadership, and readiness to navigate future challenges, making it a crucial consideration during ODD.
🚩 Red Flags:
- Low R&D investment relative to industry peers.
- High project failure rates or low adoption of new R&D innovations in production.
- Outdated technology and processes operationally.
3. Production/Service Excellence:
Production/Service Excellence is a cornerstone in ensuring that products or services meet and hopefully exceed customer expectations in quality, reliability, and performance. Understanding the product/service delivery process, workforce utilization, quality control metrics, and capacity planning provides a solid understanding of a company’s performance compared to peers. This discipline is integral to maintaining competitive advantage, driving customer loyalty, and enhancing operational efficiency. Some industries, such as aerospace & defense, may have regulatory or industry quality requirements, such as AS9100, that must be maintained and followed. Continuous improvement is also paramount in verifying that a company continually improves itself when serving its customers.
Product/service delivery evaluation is a critical step in the ODD process. Many metrics, such as turnaround time (“TAT”), overall equipment effectiveness (“OEE”), service throughput times, and more, can be used to evaluate a company. The strength and consistency of its production or service delivery systems reveal much about its capacity for sustainable growth and its potential to adapt to market changes and challenges.
🚩 Red Flags:
- Inconsistent quality and delivery problems to customers or distributors.
- High dependencies on manual processes, relying heavily on human input.
- Limited flexibility in production/service capabilities or often switching weekly/monthly production/service plans due to customer “whiplashing.”
4. Business Process Management:
While related to Production/Service Excellence, Business Process Management (“BPM”) is important across all company areas and departments. Clear, documented processes ensure consistency across the company while allowing others to identify improvement opportunities. By adopting strong BPM practices, a company can achieve scale and growth that are much more manageable.
Investigating a company’s BPM practices helps understand its scaleability and growth orientation. During ODD, understanding how processes are documented, maintained, and improved helps bridge the gap between what is already in place and what needs to be done to realize value.
🚩 Red Flags:
- Absent or lack of standardized processes and instructions across the company.
- Poor or inconsistent process documentation, leading to long training times and onboarding.
- Resistance to process improvements or slow to change despite clear value propositions.
5. Inventory Management:
While highly dependent on a company’s industry, managing inventory well requires balancing operational efficiency and market responsiveness. This discipline involves overseeing and controlling inventory levels, ensuring the right amount of products or materials is available at the right time without incurring excessive costs or resource wastage. Effective inventory management strategies are essential for minimizing holding costs, optimizing stock levels, and ensuring timely fulfillment of customer orders. Moreover, ineffective Inventory Management can tie up cash in working capital, which may occur during Financial Due Diligence.
In the broader scope of ODD, a thorough examination of a company’s inventory management practices offers insights into its operational efficiency, supply chain resilience, and ability to adapt to fluctuations in demand. Understanding how a company manages its inventory is crucial when assessing its Operational Excellence and long-term growth potential.
🚩 Red Flags:
- Frequent shortages or piling up of inventory in one or more company areas.
- High levels of obsolete inventory that cannot be sold or disposed of efficiently.
- Inefficient inventory turnover when compared to industry benchmarks.
Evaluating these five categories will help M&A professionals paint a clear picture of HOW a company operates internally, highlighting strengths and, just as significant, critical improvements needed for sustainable growth and PMI.
Key Partnerships
Much of Operational Excellence focuses on a company’s internal operations. On the other hand, Key Partnerships concentrate on relationships with outside parties before the product or service is delivered to customers. These Partnerships, encompassing suppliers, farmouts, and distribution channels, form a company’s backbone. They are necessary for maintaining a seamless flow of goods and services from inception to delivery, ensuring that a company can respond dynamically to market opportunities and challenges.
Whether Partners deliver goods or services, they can be invaluable growth stakeholders for a company’s success or be nightmares that prevent profitability. For example, Long-Term Agreements (“LTAs”) can provide stability in pricing and delivery but could create problems when price escalations or exclusivity clauses come into play. During ODD, examining contract agreements, pricing, and the relationships between these Partners and a company can help M&A professionals understand and manage supply chain and distribution risks.
Key Partnerships are separated into two categories:
1. Suppliers and Farmouts:
To begin value creation, a company likely uses tangible or intangible inputs from suppliers and Farmouts. In this article, we define each as:
- Suppliers – Entities that provide inputs (goods or services) upstream in the value chain.
- Farmouts – Entities that provide goods or services on a company’s products or services by sending out during the value creation process and receiving the product or service back versus upstream as an input.
These entities are not merely external resources but integral to the fabric of a company’s operations, directly impacting the quality, cost, and timeliness of the end product or service. Nurturing collaborative relationships with suppliers and farmouts leads to consistent, quality supply, aiding a company in delivering its products or services to its customers. Managing these relationships requires a strategic approach, emphasizing both cost-efficiency and the long-term value these providers bring.
ODD involves a rigorous evaluation of suppliers and farmouts, focusing on assessing the alignment with a company’s quality expectations, ethical standards, and strategic objectives, including examination of a supplier’s or farmout’s capacity for innovation, responsiveness to changes in demand, and ability to manage risks, such as supply chain disruptions or fluctuations in material or service quality.
🚩 Red Flags:
- Overreliance on a single supplier or farmout for a critical input or service.
- Lack of supplier diversity and geographic concentration.
- Poor performance, price, and quality issues with one or more suppliers.
2. Distribution:
Distribution is a critical pillar, the lifeline connecting a company’s products or services with its customers through another entity or to end customers. This intricate network, comprising logistics, warehousing, and transportation, ensures that the final products or services reach customers efficiently, reliably, and cost-effectively. In today’s globalized economy, the agility and resilience of a company’s distribution channels can significantly influence its ability to meet customer demands, adapt to market changes, and maintain competitive advantage.
During ODD, the evaluation of Distribution uncovers the effectiveness of these channels, assessing their capacity for scalability, adaptability to technological advancements, and alignment with the company, with an increasing focus on Environmental, Social, and Governance (ESG) goals.
🚩 Red Flags:
- Inefficient distribution networks leading to prolonged delivery times and high costs.
- Lack of flexibility or other options in distribution networks and channels.
- Poor integration with logistics/distribution providers, leading to miscommunication and poor visibility for the company.
Keeping open, collaborative communication with these partners helps build a solid foundation for growth. During ODD, evaluating external parties and how they interact with the company provides clarity both upstream, midstream, and downstream.
Capital Assets
Capital Assets represent a company’s operational foundation, representing significant investments in property, plant, and equipment (“PP&E”) or other fixed assets that enable production, service delivery, and revenue generation. This area encompasses everything from manufacturing facilities and machinery to office buildings and technological infrastructure, depending on the company’s industry and offerings structure. Effective management of Capital Assets indicates a company’s foresight in planning for growth, resilience in maintaining operational continuity, and efficiency in allocating capital expenditures (“CapEx”), including considerations such as the adaptability of facilities to future technological advancements, the sustainability of production equipment to meet evolving market demands, and the strategic location of real estate for distribution efficiency.
During ODD, assessing a company’s capital assets goes beyond evaluating their current value or condition. It involves understanding how these assets are acquired, maintained, and optimized to support the company’s long-term strategic goals, operational efficiency, and delivery of products or services.
Capital Assets are separated into two categories:
1. CapEx/PP&E:
The management of CapEx on PP&E and other investments underpins the ability of a company to deliver products or services and sustain growth over the long term. These investments are not merely financial commitments but pivotal decisions that influence a company’s operational efficiency, competitiveness, and ability to innovate. Effective management involves a comprehensive strategy encompassing the acquisition of physical assets and their maintenance, depreciation, and lifecycle management. This view ensures that each investment is justified by its expected contribution to operational capacity and aligned with a company’s broader strategic goals.
ODD scrutinizes a company’s CapEx planning and execution processes, evaluating how well past and current investments align with long-term strategic objectives, enhance operational efficiency, and contribute to sustainable competitive advantage. The goal is to ensure that capital is spent wisely and contributes to a company’s enduring resilience and agility.
🚩 Red Flags:
- Idle or underutilized assets throughout a facility or network.
- Deferred/little maintenance expenditures or high maintenance costs compared to asset values.
- CapEx on PP&E or other assets that don’t appear to align with a company’s core growth objectives.
2. Facilities & Real Estate:
The strategic management of Facilities & Real Estate is a critical component of a company’s operational framework, directly impacting its ability to deliver products and services while also accommodating future growth. Even with the rise of remote working arrangements, tangible goods need to be made somewhere; this aspect of Capital Assets goes beyond mere location or physical attributes; it encompasses the thoughtful planning, utilization, and optimization of spaces to support operational objectives and strategic ambitions. Adequate management involves maximizing the use of current spaces and planning for long-term needs, ensuring that investments in or leasing of property align with the company’s vision for growth, market expansion, and sustainability goals.
ODD seeks to assess a company’s Facilities and Real Estate strategy, focusing on how well these assets support operational goals and sustainability ambitions. The aim is to gauge whether a company’s management of these assets enhances operational performance and positions the company for future success and resilience.
🚩 Red Flags:
- Inadequate space for expansion or large amounts of empty space.
- High real estate costs relative to the market area.
- Poor stewardship of the land and facilities, also related to EH&S concerns.
It is crucial to analyze and understand Capital Assets and how they provide a firm foundation for a company to deliver goods or services to customers efficiently. Many of these Capital Assets don’t come cheap; verifying how they provide value to a company is vital during ODD.
Conclusion
Operational Due Diligence is an essential, though often underestimated, component of the Mergers & Acquisitions process, providing a comprehensive assessment of a company’s operational backbone. This primer endeavors to illuminate the multifaceted nature of ODD, spanning Operational Excellence, Key Partnerships, and Capital Assets. By delving deep into these areas, ODD enables investors, stakeholders, and corporate leaders to uncover invaluable insights into a company’s operational efficiencies, identify potential risks, and pinpoint areas ripe for improvement. Such thorough evaluation is indispensable for ensuring a smooth PMI and laying the groundwork for sustainable growth and competitive advantage in an ever-evolving business landscape.
As businesses continue to navigate the complexities of global markets and technological advancements, the role of ODD in informing strategic decision-making and investment cannot be overstated. This holistic approach to ODD ensures that strategic M&A investments are made with a clear understanding of their potential to enhance operational efficiency, foster innovation, and drive long-term value creation.