Operational Due Diligence explained

Introduction

As M&A activity continues, it is key to understand within individual M&A processes how the target business has been affected by COVID-19, and what recovery measures have been taken, or are underway. A comprehensive consideration of these aspects is key, in valuing the risks and opportunities of a target business moving forward appropriately. This is where Operational Due Diligence (ODD) comes into play:

Operational Due Diligence is a bespoke, continuous and iterative process of formulating and testing the investment thesis, in order to co-create an actionable value creation plan. ODD is primarily forward looking and opportunity focused, it therefore complements the risk oriented types of due diligence, to maximize the return on M&A investments.

In this article we will dig deeper into the key components of the definition of ODD, and discuss the value in M&A processes. This article is in particular targeted at professionals involved in M&A, both at corporates and/ or private equity, as well as at professional service firms.

ODD objectives

The term due diligence is used by the M&A industry in a broad sense and can cover financial, legal, operational, commercial, tax, HR, IT, pension and technical engineering matters. The scope of a due diligence investigation varies, as many internal and external factors influence the depth and breadth of a due diligence. Due diligence findings are typically used to shape the following deal documents:

The objectives of an ODD are to:

• Assess the sustainability of the target’s operations into the future, without additional investment on top of management’s business plan
  
• Identify actions and investments needed, not seen or considered by target management, to accelerate value creation moving forward
• Advise the deal team on the strategic fit of the contemplated transaction
• As process, ODD should secure buy-in from all stakeholders for the planned change

Whereas financial (FDD), tax (TDD), and legal (LDD) due diligence provide the basis to assess the current economic value and inform the SPA to protect the price paid, ODD is more forward looking and answering the question “what are we going to do with it, when it is ours?”.

ODD is bespoke

As the primary objective of ODD is to provide input to the value creation plan, the scope is by definition bespoke, as each deal is unique. The scope will be tailored to the deal rationale, deal structure, industry and company specific operational risks. There is no standard approach for a ODD, whereas the approach of a financial due diligence or legal due diligence are relatively standard. ODD investigations typically answer one or more of the following three questions:

1. Are operations robust?
2. What are the operational upsides and what is the full potential of the target?
3. Which post-merger synergies can be expected?

ODD is continuous

ODD is a continuous process which does not stop at the end of the due diligence phase. ODD starts as part of the target selection phase and continues throughout the deal cycle, up to and including the first 100-days post-closing. Whereas FDD and LDD findings are key inputs for further negotiation and SPA drafting, continued processing of ODD findings in the value creation plan, as more access is granted, is key to secure buy-in from both target and divisional management.

ODD is iterative

The iterative character is embedded in the hypothesis based approach that is applied to ODDs, in answering the question “how can we best create value with the contemplated transaction?”. ODDs start with hypotheses, which are tested and reformulated until they can no longer be broken down. ODDs facilitate creativity, pull on multiple information sources and allow for interaction between stakeholders. The best results are achieved by an inductive and iterative process, focused on providing actionable insights, which are presented in a concise equity story.

ODD is a co-creation

Developing an effective value creation plan should be a co-creation and cannot be a report from an advisor to the acquirer. In testing the investment thesis, the ODD team needs to work closely with the management team responsible for implementing the plan post-closing. A proper value creation plan comprises:

• a prioritized set of value creation opportunities (synergies and stand-alone performance improvement initiatives), as well as.
• a plan for action, describing how to capture the upsides and to mitigate the execution risks.

ODD is forward looking

Commercial Due Diligence (CDD) assesses the attractiveness of the market the target operates in as well as the relative strengths of the target today compared to its competitors. Like FDD the as-is assessment of CDD provides important input for ODD to answer the question “what should we change in our operations to create more shareholder value?”. The translation of facts into an action plan is at the heart of ODD and provides its forward looking orientation. The forward looking element of ODD is more important than ever in the context of COVID-19.

ODD is opportunity focused

A balanced ODD helps acquirers to look at (i.e. COVID-19) risks through a different lens. When risks are well understood and managed, it can be an inspiration for opportunities to grow. Vice versa, when companies pursuit opportunities these will come with risks. ODD plays a role in seeing both sides of the coin. In the current competitive M&A market deal teams need to strike a balance between issue and risk based due diligence scoping and the identification and substantiation of upsides. ODD as part of the overall due diligence scope changes the lens from ‘due diligence to lose’ into ‘due diligence to win’.

ODD compared to other types of due diligence

The above definition urges a comparison of ODD with other types of due diligence, such as financial-, tax-, commercial and legal due diligence, which are focused on describing the existing economic value and on informing the Share Purchase Agreement (SPA):

The ODD process focuses on value creation

Based on the above description ODD includes: 1) the development of a value creation plan (incl. various (post COVID-19) scenarios), 2) an un-biased advise regarding the strategic fit of the transaction, and 3) an essential process step for obtaining buy-in from target management. The responsibility for conducting a robust ODD lies with the entity integrating or acquiring the target company, but cannot be performed without involvement from target management. External ODD advisors can provide additional specialized expertise and significantly increase the quality of operational analysis. However, they cannot replace the required ownership.

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