“The Game of Hide-and-Seek” Mar 8th, 2013
-Dean Cantrill
What could possible go wrong? Your M&A due diligence team just wrapped up their assessments of a multiple site manufacturing business, and your ready to complete the acquisition. Your experienced Executive team walked a few of the factories, kicking tires and filling out your company’s due diligence check list. All seems in order. Your financial team and legal team thoroughly analyzed reports and documents looking for abnormalities and liabilities. All have been identified and accounted for in your offer.
Fast forward to post acquisition…
“We’re not delivering the profit and cash promised in the board paper. We keep reducing direct employees and consolidating facilities, but the profit and cash position doesn’t improve. Now, to make matters worse, we’re losing market share and revenue, sales teams are reducing price to save the deals they have, further exacerbating the financial performance problem.” WHAT HAPPENED?
If this hasn’t happed to you, keep up the good work. But for the rest of us, let’s talk about Operational Due Diligence and how adding this expertise to your M&A due diligence team will help identify and eliminate many of these risks early in the process. Best of all, let’s explore how these issues can be converted into untapped financial benefits others don’t see.
The Cause
I call it the adult version of “Hide-and-Seek”. Why would a manufacturing company offer up all their hidden issues during the due diligence process? It’s human nature to answer only the questions being asked. “When asked for the time, tell them what time it is, not how the watch was made”. In many cases, the individuals being interviewed won’t even know these issues exist. The target employees who know where the issues are hiding, aren’t normally anxious to share, nor included in the process.
What kind of Issues?
The example above is real. Our team assessed a post acquisition, multi-site manufacturing company that started a revenue death spiral because the Private Equity firm that invested in this company didn’t properly assess the current state operations before making significant structural changes to the business. Some of these changes seemed logical on the surface, but the results were catastrophic. The basic strategy was to beef up the business front end and reduce operating costs through significant head count reductions. The balance of indirect cost to direct labor became so skewed, that you could have eliminated every penny of direct labor cost and the product still wouldn’t be profitable.
The revenue death spiral happened like this; 1) Drastic reductions in the direct labor force lowered moral, competency, capacity, 2) Quality and on-time deliver suffers, 3) Customer satisfaction drops quickly, 4) Sales force lowers price of product to win back customers, 4) Low margin, rush orders dominate manufacturing worsening the customer satisfaction issue, 5) Profits fall and more direct employees let go, …
The hidden operational problems in this scenario included:
1) No Sales, Inventory, and Operational Planning process in place linking the Sales Force to the manufacturing sites 2) Faulty order entry process, labor intensive, redundancy, and human errors that propagate to the shop floor. 3) No cross training for critical employees 4) No ability to balance direct labor shift to shift, day to day 5) High absentee rates in direct workforce causing quality and deliver issues 6) Production Planning driving up lead-times by the way orders are moved to the shop floor amplified by random machine set-up times. 7) Etc., Etc., Etc.
This example highlights several of the hidden issues and risks that should be identified during Due Diligence. It’s safe to say that traditional financial due diligence will have difficulties identifying delivery, quality, cost, safety, supply chain, and warranty issues hidden deeply in the operational infrastructure of the business.
How can this be converted to upside financial benefit?
Let’s assume you now have the insight of a proper Operational Assessment during due diligence. In addition to the legal and financial results, you now have a list of significant Operational Opportunities that have been identified. Your team will have the ability to articulate operational weaknesses hidden in the target business that can be used when negotiating the sell price. When executed properly, you also have solid projections for upside potential in revenue, cash and profit that will be obtainable by implementing proven Operational Excellence techniques and processes. Once fully implemented, the business will have a sustainable operational excellence culture to help drive revenue, profit and cash growth.
How does this differ from traditional Private Equity oversight?
The key to protecting your business from operational risk and unlocking this financial upside starts with the execution of a proven assessment methodology by skilled assessors. Driven by the assessment, a clear and executable project plan will be designed and implemented by experienced Toyota Production System practitioners. The business culture transforms through a continuous improvement mindset targeting World-Class performance from the front office to the shop floor.
How can you protect yourself from the game of operational Hide-and Seek?
Start by included an Operational Excellence advisory to the Due Diligence team who has the experience to assess the business by asking the right questions and analyze the data to expose these operational risks that will surely reveal themselves after the change of control.
What credentials should an experienced Operational Excellence Advisory have?
For starters, a track record of delivering successful operational performance in similar operating environments. Secondly, a proven methodology to assess, diagnose and develop an operational excellence plan for transforming the target into a world-class manufacturer. The assessment should expose cash, profit and growth risks quickly, providing a clear picture of the potential, the cause, and the solution.
No more hide-and-seek. It all starts with during the due diligence process, reducing operational risk while unlocking sustainable financial upside.