Due Diligence: Looking for the Pony…

My dad grew up on a ranch in Western Montana and he was always sharing a simple story that would add perspective to the situations we face in life. One day many decades ago I was with him as he worked with his horses and we talked about the challenges I was facing at that time. In response, he shared the following story he had heard as a younger man:

A boy was walking with his Grandpa one day as they headed out to his barn. Several times the boy mentioned the smell of the horse manure and he was fascinated by the size of the large piles of the smelly stuff that had been scraped out of the barn and piled up outside. The Grandpa thought nothing of it until several hours later, when the boy somehow disappeared and they could not find him.

They looked all over to no avail until the Grandpa thought to look out by the barn where they had been earlier. When he walked around the corner he was astonished to see the young man had a shovel and was busily digging in the pile of manure. Relieved he had found him, the puzzled Grandpa walked up to him and said, “We were worried when we could not find you. What are you doing out here by yourself?”

The boy kept digging and without looking up he exclaimed, “With a pile of horsesh*t this big, there has to be a pony in here somewhere!” Needless to say the Grandpa got a chuckle out of the young man’s excitement as he searched to find his treasure, a pony!

This story certainly shows that when we all are faced with the troubles of life it is important that we keep a positive outlook during those trials. Since the early 1980’s I have chosen to be someone that seeks out opportunities to fix big problems facing businesses, first as a business leader and then later as a consultant. In order to maintain my sanity as a turnaround leader, I have to keep a positive outlook as I lead the difficult process of discovery as well as the often difficult improvement implementations.

In the process used by our team, we would typically lead a due diligence effort on all the major operations and processes in the business. We were often overwhelmed by the immensity of the task as we dug our way through all of Operations to find the problems so we could implement changes. On many of those occasions, I have shared my Dad’s story with the staff so they could gain a positive and perhaps humorous perspective as we searched to “find the pony” under the huge pile of horsesh*t we were digging through!

Due Diligence

In my varied roles as a turnaround leader, I have led many improvement efforts on companies that were part of a Private Equity’s portfolio. In almost all of those projects, we would typically find that the problems that we were hired to fix had been there prior to the purchase of the company and would have been discoverable had those issues been looked for.

You may ask how that is possible. In those projects, what we found was that the dealmakers who had purchased the businesses were incredibly smart when it came to financial analysis and structuring deals. We also quickly recognized we were not in their league in the financial due diligence and analysis process; they were far smarter than us in that regard and we gained a lot for respect for their knowledge.

However, in their due diligence process, those same financial wizards were not able to recognize common Manufacturing Operations-related issues – both human and process related – that could create future problems with quality, customer service, cash generation, margins and profitability in that same business. Those intricacies of Manufacturing Operations were outside their bandwidth of understanding where in this case we were the experts. Looking back I believe that had they understood the presence of these issues in their original due diligence process that they would have either valued the company differently or may not have gone through with their acquisition altogether.

In support of my comments, I have listed below typical problems that were below their radar during the initial due diligence process that ended up later creating a profound negative impact in the performance of those respective businesses:

  1. Product Costing Errors: Inaccurate product costing would drive margin, profitability, and even inventory valuation problems when there was a major change in sales mix.
  2. Product Design Issues: Design issues created product quality and performance problems leading to rework, field quality costs, poor service levels and lower profitability.
  3. Operational Process Issues: Process design and management disciplines would lead to lower efficiencies, extended lead times, greater inventories/cash needs and low margins.
  4. Capacity Imbalances: Created delivery and operational inefficiencies leading to extended lead-times, higher inventories/cash needs and lower profitability.
  5. Supply Chain Process Issues: Poor processes and user disciplines yielded higher supplier prices, labor inefficiencies, high inventory levels /cash needs, and delivery delays with all leading to lower margins and profitability.

When the fallout from these issues finally manifested themselves, their financial impacts were very large and often exceeded the annual operating income of that business. As stated earlier, these issues existed within those respective companies long before the acquisition but were not visible to anyone that did not have an extensive understanding of Manufacturing Operations. Fortunately, when asked to help, our group was always able to identify the underlying causes of the performance issues and then implement corrective actions to once again get the business profitable.

Operational Due Diligence

If a business is being considered for purchase, it is typical that those interested parties will perform financial due diligence and look at specific areas of the financial reports and audits for certain processes and ratios as well as their historical trends. A good financial analyst can apply their skills in the review of most any business and get a thorough understanding of its financial health and history.

However, Operational due diligence has its own unique discovery and evaluation processes and there are fewer absolute ratios to benchmark against. The understanding is more relational between the many varied inputs and responses within the more complex environment. For example, some performance ratios that are good for one industry, such as capital equipment manufacturing, are totally inappropriate for the food processing industry where materials and components have a very short shelf life that are sometimes measured in hours. However, a skilled Operational Due Diligence Analyst can review those processes within that industry, and given those other process constraints, quickly determine whether those processes are healthy and in control and can therefore still render a meaningful judgement.

Finding the Pony

The growth of Private Equity firms has exploded and grown exponentially from a few dozen in the 1980’s to now thousands. In this light, there are many more professional investment groups in the market trying to find that right business opportunity for their investors.

Given my experiences, I offer that the way for these firms to get a broader view of the health and value of each business opportunity is to partner with experts in the Operational Due Diligence process. If they do this, they will be able to obtain unique viewpoints on the businesses under consideration. Those perspectives will include opportunities for  significant upside as well as awareness of those problems that could become troublesome in the future and that could diminish the value of their acquisition.

Undoubtedly, this added perspective would help the Private Equity firms make better initial purchase decisions as well as understand additional performance enhancements for their portfolio businesses once purchased. With this approach, the firms will be much more successful in “finding that pony” among all of their possibilities.

 

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Posted in Blog Post, Case Study - Mergers and Acquisitions, Case Study - Restructuring Businesses and Case Study - Selling Businesses

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