Avoid Costly Mistakes with Operational Due Diligence

Five tips to successfully perform operational due diligence.

Ambrose Conroy 5a0cb60524ba5

Due diligence of operational issues, such as logistics, maintenance, human resources and capacity, often take a back seat to cross-checking financial metrics and legal issues. However, it can define the success or failure of a merger or acquisition.

Operational due diligence in manufacturing focuses on critical elements such as organization design, production capacity, efficiency, quality, warehousing and team capability. While it’s important to scrutinize finances to understand revenue forecasts, working capital needs and future cash flow, supply chain executives can’t ignore fundamental operational issues that can spoil an acquisition’s chances for success. Can the operations support the revenue projections? Will capacity be able to handle projected order volumes? What blind spots have been hidden by the selling company? Is the company structured to grow?

Numerous studies have declared that most acquisitions fail to meet their intended outcomes. The fail rate resides in the 70 to 90 percent range. With an estimated $2 trillion spent by companies on acquisitions each year, the volume of wasted money staggers the imagination.

What Ignored Due Diligence Looks Like

Due diligence can't be taken lightly. Consider one company we've worked with, which suffered last year from a lack of due diligence after several of its plants were put up for sale a few years ago. The acquisition team focused on the finances—and they looked great. Big order volumes were coming, suggesting outsized future profits and cash flow. The purchase price looked like a great deal. But operational issues—manufacturing capacity, warehouse space and maintenance—went largely ignored during the walk-through period.

Not surprisingly, it didn’t take long after the deal closed for problems to surface. In the first week, examples of deferred maintenance seemingly jumped out from behind the walls, requiring the executive team to prioritize a list of capital equipment that required maintenance, overhaul or replacement. What seemed like smooth sailing in all but one of the plants soon led to the realization that capacity was well short of the need. The standard 15 shifts a week weren’t enough to meet customer orders, and the largest plant had to resort to three shifts of overtime to accommodate multiple product launches. The executive team still didn't realize the coming meltdown.

Then two other plants launched products, and work tempo increased to 18 shifts per week to meet the demand with less capacity. Post-merger integration work halted as the team tried to figure out how to handle expectations at the plants. Inventory depleted and customer orders began to ship late—a double no-no in the supply chain process. As it looked into the capacity issue, the executive team discovered that the seller had been looking into outsourcing some assembly operations before the acquisition but had stopped in the belief the new owners had a plan in place to fix the problems. They didn’t.

The moral of this story? Additional internal and external capacity had to be added, external warehouse space needed to be acquired, and a different operation pattern was implemented. The losses that the largest plant incurred wiped out expected profits for multiple years. Numbers that looked great on paper were overshadowed by worn-out machines, disorganized warehouses, lack of processes and controls, and capacity shortages. Lack of operational due diligence prevented this tier-one supplier from achieving its merger and acquisition goals and minimized its chances for success.

Tips to Successfully Perform Operational Due Diligence

Fortunately for supply chain executives, several tactics can be deployed before a merger or acquisition to limit surprises and increase chances for achieving desired goals from the process. Here are five tips to successfully do operational due diligence:

1. Employ the right expertise. Manufacturing business executives need to do one of two things here: Hire the right talent internally or augment the team with external advisors who can assist. Often private equity and acquisitions professionals possess sharp financial skills but lack the experience to analyze the raw operations of a business. Those operations directly affect the numbers and drive profitability, so get advisors who can analyze this essential aspect.

2. Spend time at the site. Due diligence requires that the team spend time on site. How else can you understand what is really happening at the target business? The due diligence team needs to walk the shop floor, talk to employees and customers, observe the flow of materials, and note warehouse operations in addition to reviewing business data. It’s not enough to do a token walk-through and quickly depart the premises without having a keen sense of the operation’s quality.

3. Review historical data to understand efficiency. This tactic involves reviewing such things as equipment conditions, maintenance logs, spare parts, and detailed production numbers. Doing so gives a better overall picture of the operation’s efficiency and capacity. Instead of relying on management’s opinions, find out for yourself what’s going on behind the scenes.

4. Perform parallel diligence with legal and financial. Operational due diligence cannot be performed in isolation. It needs to tie in with financial and legal due diligence. The three pieces work together: Operational details add context to the financial numbers, the financials can guide the operations team in prioritizing its review, and the legal team can incorporate financial and operational findings into a sound share purchase agreement.

5. Forecast future integration costs. Operational due diligence helps determine the costs of the acquisition process and limit any unfortunate surprises that might cut into future profits. If the finance team forecasts amazing synergies, operational due diligence should confirm those views or challenge them prior to closing.

Manufacturing leaders performing operational due diligence should not make any intractable assumptions nor accept anything at face value. They should not be afraid to dig deep because proper due diligence increases the odds for a successful purchase. After all, there's only one chance to carefully analyze a target entity and make an acquisition work to your advantage.