By Fernando Assens, Uday Kamat, and Jorge Mastellari of Argo, Inc. –
A midsized manufacturer with factories in Colorado and South Carolina went on the market. The data room offered a slim binder of operational information, which included a brief summary of a plan to transfer all production to the South Carolina facility. The anticipated result? $8 million in cost savings after two years.
Several buyers expressed interest, including a private equity firm working with an operational due diligence team. The team looked at the plan and was skeptical. An $8 million reduction in costs implied a huge cutback in people. How could that be accomplished without impacting production?
Rather than trusting the summary in the data room, the team requested an expert call with the company’s operational managers. They found that the transfer of operations and anticipated cost savings hinged on automating production at the South Carolina plant to drastically cut headcount, but the investment necessary to implement this automation was nowhere in the submitted budget. The plan was merely an idea, with nothing real to support the $8 million number — and no real reason to invest once those savings were no longer part of the picture.
The majority of buyers rely heavily on a data room put together by the seller (and the investment bankers working the transaction) to assess whether or not to invest in a company. Generally, operational information is limited to a single folder that provides lists of assets, equipment and employee numbers. And even these metrics may be misleading — companies don’t always measure the right things in the right ways.
Limiting operational data may be a prudent approach given the possibility that some will use the sale process as an opportunity to gain insights into competitor firms up for sale. But for private equity firms trying to determine if a company is worth, say, 9x EBITDA, this lack of information can prove dangerous. Operational improvement has become a critical component of generating returns and often determines whether or not an investment is successful.
In the past, operations were rarely considered or reviewed. But over the last several years, private equity firms have come to realize that improving operations is a necessary part of a successful investment strategy. A rapid increase in assets under management across the industry means more competition for targets and sales at higher multiples — without operational improvements leading to increased EBITDA, it’s difficult to exit at a price that justifies the amount invested in the company.
Getting the Right Information
Requesting and analyzing operational metrics as part of operational due diligence helps ensure that you don’t miss a great opportunity or expect to generate impossible returns. However, most mid-market private equity firms lack internal operational resources. An outside firm may be necessary to get the most important numbers, ask the right questions at the right time — and analyze the answers appropriately.
Let’s say a target company currently owned by an aluminum producer uses that raw material to manufacture highly specialized products for the aerospace industry. The company’s top operating metric? Tons of aluminum produced, just like the parent company. But that number is completely irrelevant to the value provided to clients, who place a premium on quality. An extra ton of aluminum precision parts won’t translate to more revenue if those parts don’t meet customer specifications.
Companies collect an enormous amount of operational information in weekly and monthly reports that often never make it to the data room but can be provided on request. The operating metrics to look for will vary from business to business and industry to industry, which is what makes operational due diligence a difficult process to perform well — your diligence resource needs to have a deep grasp of performance improvement, as well as sector expertise and experience working with similarly-sized companies with similar characteristics that may impact implementation (use of union labor, dependence on overseas plants, etc.).
For example, critical data for a multi-plant manufacturing company may include:
- Copies of Plant Management Reports for each plant: These are reports that management uses to monitor performance and are almost never included in the data room despite containing the most significant information — key performance metrics by area. The numbers themselves are important, but even more important are the type of numbers used. If the key metrics don’t make sense given the business (as with the aluminum manufacturer above), that’s a clear sign that the company’s operations are being mismanaged and that there’s a real opportunity for improvement.
… - Inventory data: This includes number of SKUs and inventory levels by month broken down in raw material, WIP, and finished goods — and may be as important to know as the company’s profits. A large amount of inventory often means a buyer will be able to quickly free up cash and reduce leverage post-close.
… - Layout and location of production departments: This allows you to analyze product flow and gives you an idea of how much indirect labor is wasted during the production process.
… - Scrap data: Try to get this information by product and machine and by shift, and be sure to ask the seller if scrap is included in the bill of materials (in which case it’s under-reported in the scrap report). More scrap means more waste, and more opportunities to increase efficiency.
… - Organizational chart: This should include number of employees by area by shift, and positions by department. Check how many levels of management are in place — typically, companies with more management layers tend to be less well-run — communication suffers, collaboration is more difficult, etc.
… - Overtime premium costs by area by month: If the company has very low or nonexistent overtime costs, it’s most likely overstaffed. Manufacturers generally experience seasonality and swings in demand. On the other hand, if the costs are continually high, that points to improper management and/or institutionalized overtime, which can be hard to eliminate as employees have come to expect it as part of their salary.
… - Expedited freight costs: High expedited freight costs are signs of production issues — something is preventing products from getting to the client on time. The next step is determining the root cause of the problem.
Along with looking over relevant operating metrics, an accurate assessment of a company’s operations requires touring the facilities — including any shipping docks, warehouses and distribution centers — for at least a couple of hours. If there are dozens of plants and the seller places a limit on the number of facilities you can access, your operational due diligence team will need to determine which ones will best serve as a representative sample to extrapolate the findings.
These tours should include conversations with managers who oversee production and can speak in detail about issues like labor productivity and equipment utilization. Again, companies don’t always measure the right things in the right ways, so a first-hand look at operations is an essential component of the diligence process.
Bidding Up
Picture a mid-size manufacturing company that went on the market and appeared to be doing quite well operationally. One private equity buyer looked at the information in the data room and saw a report that put the company’s machine utilization consistently in the low ninetieth percentile, making it a world-class firm. They estimated that only $1 million in additional EBITDA would be possible through operational improvement, and hesitated about making a bid.
Another private equity firm decided to take a look, but rather than relying solely on the data room, conducted a rapid assessment of the target’s operations. They found that the company was generating its high utilization numbers by excluding downtime, changeovers and maintenance — if a machine was meant to run for 8 hours, but was down for 3 of those hours, the company measured its utilization for just the 5 hours that it was working. The operational due diligence team estimated that decreasing machine downtime and implementing other specific improvements would result in $7 million in additional EBITDA in less than 18 months, and the private equity firm bid up for exclusivity.
Walking Away
A company that used raw materials to manufacture industrial dyes included information in the data room around a continuous improvement project. The project focused on implementing a proprietary software tool — a production optimizer — across its 35 factories. The tool was already being used in one of the plants, and led to increased yields and a 7% reduction in raw material costs (a significant impact, given that these costs made up more than 40% of total expenses). By implementing the tool across the remaining 34 sites, the buyer could expect to increase EBITDA by tens of millions of dollars.
One private equity firm was interested in making a bid, but the operational due diligence team was wary — if the tool was so great, why was it only being used in one factory? Rather than trusting the plan in the data room, they asked to visit several different sites and talked to the plant managers. Half of them had never heard of the tool. The other half said the production optimizer only worked for a specific type of raw material, one that their plants — due to location and logistics — could only obtain at a premium to what they were currently using. It simply didn’t make sense for them to spend 20% more on the raw material required by the tool to then cut that cost by just 7%.
After taking a close look at all of the plant locations and their raw material costs, the team determined that the only plant where the optimization tool was cost-effective was the one already using it. The expected cost savings weren’t there, and the private equity firm walked away from the deal.
Building a Business Case for Investment
Private equity firms routinely perform a number of diligence processes — financial, tax, legal, commercial, environmental — to ensure that a company is what it says it is, and to mitigate any unpleasant surprises post-close. But that data may not offer much guidance when competing with other buyers for, say, a healthcare company going for 8x EBITDA. Can you justify the current price? Can you justify an even higher price and bid up for exclusivity? Or is it better to walk away despite the company being in a “hot” industry?
A hands-on, operational due diligence team with cross-industry experience helps ensure that private equity firms get the right numbers to make a smart business decision. Even when internal resources are available, an external diligence team often proves a valuable asset. Firms may have Operating Partners who are brilliant at developing strategies but lack expertise in working with employees at every level to implement necessary changes — and may therefore not anticipate potential issues that could derail their plans.
Firms have also started hiring former executives and CEOs in relevant industries to assess operations at target companies. But again, these executives may not be able to get to the required level of detail to accurately predict additional EBITDA generation via operational improvement, and may not have the skill sets to minutely plan out how these improvements would need to be implemented post-close. Plus, CEOs don’t come cheap — most midsize private equity firms that invest in multiple industries just don’t have the resources to be spending hundreds of thousands (or even millions) of dollars per year per industry CEO.
Any operational due diligence is better than none, but ideally the end product should be an accurate, detailed and actionable plan for implementing improvements post-close — including how much additional EBITDA each improvement will generate and the length of time it’ll take to see any results.
Developing such a plan requires going beyond the information made available in the data room, requesting key operational metrics, and closely observing the current state of operations at the target firm. Even more critically, it requires an informed analysis of this information that yields a quantifiable, comprehensive approach for unleashing value.
The Other Side of the Deal
When it comes time to exit an investment, you’ll want to include as little operational information in the data room as possible to prevent giving competitors a scoop. But to get the highest return — and to give buyers the confidence to bid up for exclusivity — consider getting the company’s operations assessed six months prior to exit.
At this point, it may seem as though it’s too late to do anything. But for private equity firms that have been busy focusing on other strategic initiatives — such as industry consolidation via multiple add-on acquisitions — rather than on operational improvement, six months is more than enough time to come up with a roadmap to increase efficiency and start the implementation process. One option is to conduct a pilot project at one site/unit, generate lots of results, and then couple these proof points with a realistic plan for how the process can be replicated across the rest of the firm. Another option is to develop a company-wide plan and garner enough results to serve as indicators for future progress. Either way, it’s entirely possible for a firm looking to exit a $200 million business to generate several more millions of dollars in real and potential value with only six months to go.
Conclusion
You can always tell when operational experts have been involved in the diligence process by looking at the amount of operational information in the data room at the end. If it’s just the original few sheets of paper in a folder, then the buyer may be counting on making improvements that are improbable, unexpectedly expensive to implement, or take years longer to achieve results than originally planned.
But if the folder has grown fat with reports and diagrams, and was supplemented by expert calls and factory tours, then there’s at least one potential buyer who knows exactly how much additional EBITDA can be generated each year by reorganizing and cleaning up that messy warehouse floor, or increasing the (accurately measured) “cube utilization” of that private trucking fleet, or implementing any of the other numerous possible improvements.
Regardless of whether that buyer bids up, walks away or invests at the asking price, the decision-making process will include a real, actionable operational assessment rather than being based on incomplete information and misleading metrics.
About the Authors
Fernando Assens is the CEO and co-founder of Argo. His work primarily focuses on Operational Due Diligence and performance improvement for private equity owned businesses.
Jorge Mastellari is an Executive Vice President at Argo. He manages international projects focusing on company-wide EBITDA and cash flow improvement initiatives, product portfolio and profitability analysis, design and delivery of Strategy Deployment programs. These projects generally involve multi-site Operational Transformations as well as turnarounds for portfolio companies.
Uday Kamat is a Director at Argo. He has helped improve operational performance at private equity holdings, particularly in Industrial and Transportation verticals. His specialization includes asset management, supply chain optimization and operational excellence.
Argo is a global operations consulting company dedicated to implementing lasting performance improvements with offices in Chicago, Brussels, Madrid and Toronto and an active presence in more than 20 countries (www.argoconsulting.com).
© 2013 PEPD • Private Equity’s Leading News Magazine • 6-3-13
