The Ultimate Guide to Operational Due Diligence

What is Operational Due Diligence (ODD)?

ODD is the investigative analysis of the operations of a business conducted by a potential buyer. In the broadest terms, the operations of the business consist of how the business turns inputs into outputs. 

The role of ODD is to assess this process and its future sustainability for the buyer in an M&A transaction.

Operational Due Diligence and Private Equity

ODD is a central component of every private equity company’s acquisition process.

At a very high level, ODD is used to validate a company’s business plan. Every aspect of the target company’s operations is placed under a microscope to understand how it generates value, but more importantly, how the private equity company can implement operational changes to extract even more value post-acquisition and ultimately increase its valuation. 

There are a few different components to this analysis:

• Understanding the company’s cost and revenue drivers: This will help the general partner and investment managers understand the target company’s growth projections and plans for operational improvements in context. 
• Assessing operational efficiency: Assessing the operational efficiency of the target company is not only an exercise for finding the target company’s intrinsic value, it also helps to identify areas for improvement post-acquisition.
• Value of the company’s capital: Capital in this instance refers to human capital (the company’s people), intellectual capital (IP), and its physical capital (the company’s assets). Understanding how all three interact to generate value is a goal of the ODD process.

Objectives of Operational Due Diligence

The priorities of each part of the ODD process will depend to a large extent on the acquirer’s objectives and the industry. However, in general terms, the objectives will tend to fall under the following headings:

• Business Plan: The company business plan - or the ‘how it operates’ - is the main focus of ODD. Conducting a critical analysis of the business plan tends to come first and underpins the entire ODD process.
• Risk management: Private equity firms are nothing if not risk averse. Therefore, one of the tasks of their ODD is to identify risks and how they can be mitigated. Risks which cannot be mitigated can ultimately bring transactions down.
• Customer and Suppliers: Any company can be seen as a nexus of contracts with customers and suppliers. To that end, ODD assesses contract terms and dependency risks for both customers and suppliers.
• Management: Private equity firms typically evaluate management in every interaction. Two common questions are: ‘Can I work with these people?’ And ‘Are these people capable of executing the new strategy?’ Managers that don’t meet that criteria are let go post-transaction.
• Compliance and Regulation: Every company and industry is subject to a series of laws and regulations. By identifying the target company’s compliance with its regulatory landscape, an acquirer prevents legal problems and fines post-acquisition.

Operational Due Diligence Process and Framework

Ensuring an adequate framework is in place will give your team the structure needed to ensure they are conducting due diligence correctly. At Dealroom, our customers conduct thousands of ODD every year using our ODD process. Here is what it looks like:

1. Target Business Model
2. Human Capital
3. Intellectual Property
4. Long-Term Assets
5. Risks and Mitigating Factors
6. Technology and Systems
7. Legal and Compliance
8. Data and documentation

Below, we look at each of these in more detail:

1. Target Business Model

There is some misunderstanding of exactly what a ‘business model’ is, even among experienced investors. A company’s business model is how it generates cash flow. That’s an important distinction.

So, for example, if the company has an extremely long inventory cycle, it means significant amounts of its cash are tied up in its inventory for a long time - a concern for any investor.

The easier it is for the company to generate cash, all things being equal, the more attractive it will be for investors.

This is one of the main reasons why investors love SaaS platforms: they provide recurring (i.e. predictable) cash flow on a monthly basis, with very little marginal cost per new consumer.

Also, with no inventory, that cash can be put to more productive use.

2. Human Capital

Although a significant chunk of the due diligence process should be devoted to assessing the people and culture of a target company through HR due diligence and change management you also need to evaluate from a purely operational basis.

The integration teams' role is to assess the target company's employees' ability to carry out its daily operations successfully. The level of value added by individual employees can differ greatly. Key employees are those who provide the most value to the firm.

The integration team should ask questions such as:

• How engaged are key employees with the acquisition process?
• What would it take to make key employees more engaged with the process?
• Are there any insights from current employees that can contribute to the overall ODD process?

3. Intellectual property 

Acquiring intellectual property (IP) can often be a central motive behind an acquisition, enabling the acquirer to build a competitive moat. ODD assesses the value, ownership, and potential risks associated with the company’s IP assets. 

The defensibility and strength of a company’s IP portfolio is often crucial for determining its potential for innovation and long-term growth. Questions to ask here include:

• Are all IP assets legally protected and properly documented?
• Are there any ongoing IP disputes or challenges?
• How critical are those IP assets, if at all, to the company’s competitive advantage?

4. Long-Term Assets

Long-term assets are assets, both tangible and intangible, owned by a company and expected to be used for more than one year. Tangible assets are things like property, inventory and equipment (PP&E) while intangible assets (intellectual property) are things that contribute to a company’s future worth, like, copyrights, patents and customer lists. 

Given how important long-term assets are for a company's day-to-day activities, it's crucial to thoroughly analyze them during the ODD process. Some things to think about here include:

• Have the long-term assets been properly accounted for on the target company balance sheet?
• What is the status of the financial leases held by the target company for its long-term assets?
• How does the operational efficiency of the company’s long-term assets compare to the industry standard?

5. Risks and Mitigating Factors

What is due diligence if not a means to identify and mitigate risks? Operating risks are arguably the biggest a company faces in a transaction after financial risks. The list here is potentially endless but some questions that should be asked include:

• What factors could prevent the company from continuing to operate at its current capacity when the transaction closes?
• Is there anything in the target company’s current operations that conflicts with how our business operates?
• How have the target company’s operations evolved over the past five years and how do they compare with the industry’s best-in-class?
• Is there any way that we could quickly and cost effectively improve this company’s operations in a short period of time?

6. Technology and Systems

Every modern company is to a greater or lesser extent, a technology company. ODD aims to evaluate the effectiveness, safety, and scalability of the target company’s IT infrastructure. In addition to identifying outdated systems or compatibility issues with existing IT infrastructure, this can identify early cybersecurity vulnerabilities. Questions that need to be asked here include:

• Are the current IT systems scalable in line with growth projections?
• What are the company’s cybersecurity risks and how are they being managed?
• How well do the IT systems support current operational needs?

7. Legal and Compliance

It goes without saying that a target company should adhere to all relevant laws, regulations, and industry standards. ODD in this area includes reviewing contracts, licenses, employment law compliance, environmental regulations, and any ongoing legal proceedings. 

The risks here are often less obvious and require detailed analysis from a seasoned legal expert. They will seek to address questions such as:

• Are there any ongoing or potential legal issues?
• How robust are the company’s internal compliance policies and procedures?

8. Data and Documentation

Data and documentation refer to anywhere the target company records transaction and information. This includes everything from financial records and operational reports to customer and employee data. 

A company can only effectively track its own performance and identify areas for improvement through the maintenance of good data management practices. Furthermore, a lack of transparency in this area signals a red flag for potential acquirers. They will ask questions such as: 

• Have several years of tax and financial records been maintained?
• How is sensitive data managed and protected?
• Are data management practices aligned with industry standards?

1. Initial assessment of the target company operations

1. How well do the operations of the target company fit with those of the buyer?
2. What synergies/conflicts exist between the buyer and the target company?
3. Are there any ‘quick wins’ that can generate value?
4. What kind of (capital) investment will be required to bring the target company operations to the desired level?
5. How sustainable are the operations? (i.e. are they running near capacity, using old technology, too expensive to be sustainable, etc.)

2. Document review

1. Check internal procedures
2. Check company compliance 
3. Check relevant licenses and subscriptions
4. Conduct review of technology underpinning operations
5. Conduct review of intellectual property (if applicable)
6. Benchmark KPIs of the operation against industry competitors

3. On-site visit 

1. Make an overall assessment of the company’s as-is operations (“if we were to buy this company today, what would change in these operations?”)
2. In what condition is the factory/office/logistics center and its technology/equipment/machinery?
3. Interview operations managers
4. Interview relevant players upstream and downstream in the supply chain (e.g. suppliers, distributors, service providers, etc.)
5. Are there any backlogs or bottle becks immediately apparent at the target company site?
6. How easy would planned performance improve strategy be to implement given the current operations?
7. Assess the culture at the on-site operations. Is it structured or ad hoc? Is there one manager or is everybody making autonomous decisions? Are there any health and safety issues that need to be addressed?

4. Projections

1. Use information gathered until now to make projections about the value added that your company can bring. Can it generate more value from the same machinery/technology? Is there any value in having this extra capacity?
2. Work with commercial and finance teams to build a budget based on the operations of the target company.
3. Work with the finance team to estimate synergies that could be generated from a merger or acquisition with the target company