What operational due diligence checks that financial and legal DD miss

• Alistair Maxwell says operational due diligence grew out of private equity investment theses that promised returns, such as 24%, that were never usually achieved.
• Jackie Kitching says commercial, financial and legal due diligence look at the business as it stands, while operational due diligence asks whether the combined business will work.
• Maxwell argues a synergy is only worth chasing once you have assessed how hard the change is to make and how ready the business is for it.
• RSM splits a target into a business model (markets, propositions, customers, channels) and an operating model (processes, technology, structure, people, incentives) and reviews both together.
• On a carve-out, Maxwell says the seller should check the remaining business is right-sized, with the right support at the right cost.
• After close, the review tracks whether the returns in the investment thesis are actually being delivered.

Private equity deals used to come with investment theses promising a 24% return, says Alistair Maxwell, chief operating officer of RSM South Africa, and that never usually occurred. Operational due diligence, in his account, came out of that history: out of asking why deals were not achieving the goals set at the start of the transaction (around 6:24). In this short webinar, Maxwell and his colleague Jackie Kitching of the accounting and advisory firm set out what that review covers and where it sits next to the diligence most deal teams already commission.

“Historically deals would be done specifically in the private equity space and they'd have these investment theses that said we'd get a 24% return that never usually occurred.”

Alistair Maxwell, Chief Operating Officer, RSM South Africa

Kitching, who heads corporate finance at RSM South Africa, starts with the familiar three. Commercial due diligence looks at the markets the business will work in, the assumptions around them and the key drivers. Financial due diligence covers the historical financial statements, performance, assets and liabilities, cash flows and synergies. Legal due diligence starts with the shape of the deal, a sale of business or a sale of shares, then moves to commercial contracts with change of control clauses, regulatory compliance and tax risk.

“The main focus is primarily in terms of getting the deal done and what is the best way to get the deal done, but in truth you then have a deal that is done, you have two businesses that are now coming together and they need to then be viable into the future.”

Jackie Kitching, Head of Corporate Finance, RSM South Africa

Her point is what those three leave out. They look at the businesses as they stand at that point in time, Kitching says, and the main focus is getting the deal done. Then you have two businesses coming together that need to be viable into the future. That, in her words, is where operational due diligence comes into play, because it is forward-looking (around 4:15).

“Very often I've seen deals where people have gone through and said, well, there's a synergy here, but they haven't really understood the risk and reward factor or the difficulty in getting a change made.”

Alistair Maxwell, Chief Operating Officer, RSM South Africa

Maxwell's definition is RSM's own: a forward-looking perspective that actively manages a transaction to help it achieve its investment thesis and create additional value, with credible plans and evidence of sustainability. He splits the deal value chain into four parts: investment thesis, valuation, sale and purchase agreement, integration planning. Operational work sits at the first and the last. On the thesis side it asks why the deal is strategic, how sustainable future operations are, and which actions and investments can accelerate value creation from the start.

“It allows you to monitor key initiatives post deal to ensure that those benefits are achieved and that the investment thesis doesn't become a document in a file somewhere that we just look at and go, that was great, but we didn't really get there.”

Alistair Maxwell, Chief Operating Officer, RSM South Africa

Synergies are where he is sharpest. Maxwell says he has often seen deals where people spotted a synergy but had not understood the risk and reward or the difficulty in getting a change made (around 9:37). Operational due diligence, he says, assesses the implementation complexity of a change and how ready the business is for it. A change may carry a lot of value. If the risk to the business is very high, it might not be worth making that specific saving.

To structure the work, Maxwell breaks any business into a business model and an operating model (around 11:00). The business model is markets, propositions and brands, customers and channels. The operating model is core processes, technology, organisational structure, people and culture, and measures and incentives. The most value, he says, comes from looking at both at the same time. His business model questions include where you want to play in your market's value chain and, ultimately, what you want to be famous for.

On the operating side the question is whether the right people are in the right roles and staffing is at an optimum point. That cuts both ways, Maxwell says. A buyer may need to beef up HR, IT, finance or the sales force. A seller that has carved out part of a business needs to check the rest is right-sized, with the right levels of support at the right cost points. After the deal, he asks whether the operating model is still fit for purpose, or whether you are hammering a square peg into a round hole (around 17:03).

The case for doing all this comes back to the thesis document. Maxwell wants the review to keep monitoring key initiatives after the deal, so the investment thesis doesn't become a document in a file somewhere that people look at and call great, without ever getting there. He does not knock the other workstreams: commercial answers why the board is doing the deal, financial and legal make sure the numbers and the structure are right. What operational due diligence adds, he says, is a credible independent assessment of management's plans.

Financial and legal diligence test the numbers and the contracts, but nobody in that process owns the question of whether the synergies can actually be delivered. If you want that answered, put operational questions on the request list early, so the data room holds the process, systems and staffing documents that can answer them.

0:02 good morning everyone my name is Jackie kitchen I'm a head of corporate finance at RSM South Africa I'm joined this morning by Aleister Maxwell who's our chief operating officer so welcome and thank you for taking the time to join us this morning the topic of this morning's webinar is the importance of the operational due diligence and I think what we what what I'm going to do is to just kick off and just talk about a due diligence in in general and what is the due diligence and then Alistair will take us through the importance of the operational due diligence so if we talk about due diligence I think Alexander lejo summarized it quite nicely when he said that the basic function of any due diligence is to assess the benefits and liabilities of an acquisition by ancurring into all the relevant aspects of the past present and predictable future of the business to be

1:05 purchased because in essence what a due diligence is is the Gathering of information and data and then analyzing that in order to make an informed decision about a particular transaction so so that that I think just summarizes it quite nicely in in terms of what the due diligence process is if we if we look to to the different aspects of a due diligence we've essentially categorized it at this stage into to three fundamental aspects that or components of the due diligence process I think the the the first the first part would be the commercial due diligence and essentially from a commercial due diligence perspective you need to consider the markets in which you are going to be you're going to be working what are the assumptions around those markets

2:07 what are the key drivers so that's in essence what you look at when you're looking is this particular transaction commercially viable we then move on to the financial side of things so we look at the financial due diligence and this in essence focuses on all the financial information so it looks at your your historical Financial financial statements that looks at the performance of the of the business the target it assesses the assets and liabilities you look at both past and pres past present and potentially future cash flows you look at potential synergies cost savings or or in truth any additional costs that would need to be incurred as as part of this process and then the third Focus point in terms of the due diligence would be the legal sound of things now the legal sound of things takes on a number of of different shapes and forms because it you know

3:11 it's quite a broad area that needs to be covered from a legal perspective but I think the the first focal point in terms of the legal legal due diligence would be to access well well what is the shape of this transaction so is this transaction going to be potentially a sale of business a sale of shares or or doesn't need to take some other shape or form that needs to be fleshed out so that would be the first aspect from a from a from a legal DD side we then look at we would then look at things like commercial contracts you know what sort of contracts are are part of of the the business are the the Clauses in those contracts that would need to be negotiated if there's a change of control in terms of the the businesses the other aspects of of the legal due diligence would be to look at compliance so is is a particular Target complying with all the legislative aspects of of the particular industry in which they

4:15 operate and that then also goes and and talks to for example from a tax perspective are there risks involved from a tax perspective in terms of non-compliance and and the lag so so I think in in summary those are all the different aspects of of the due diligence process and and in essence they look they look at risks they look at synergies they look at all of those types of things in terms of the businesses as they stand at this point in time so the main focus is primarily in terms of getting the deal done and what is the best way to give the deal done but in truth you know you you then have a deal that is done you have two businesses that are now coming together and they need to then be viable into the future and I think that that in essence is where the the operational due diligence comes into play because that in essence is forward-looking so how do we make this this combined

5:20 business or entity work going into the future so I'm going to hand you over to Alistair now and he's going to take us through the the process is in terms of an operational due diligence and why we believe it to be an important part of the due diligence process thanks Jackie morning everybody Jackie spoke about what usually happens around traditional views of a due diligence and that it's more focused on the here and now and what's happened historically but then how do we actually bring in that more forward-focused view a little bit more rigor and visibility of forward projections into a merger or an acquisition but also more importantly how do we make sure that we can bring in actually attaining the investment case that's been put forward this is where an operational due diligence has come from is historically

6:24 deals would be done specifically in the private Equity space and they'd have these investment Theses that said we'd get a 24 return that never usually occurred and operational due diligence came from that historic background as to why were we not achieving those goals that we put in place at the start of the transaction so at RSM we Define an operational due diligence as a forward-looking perspective that actively manages a transaction and achieves it to help it achieve its investment thesis as well as creating additional value it describes and evaluates the business from an operational perspective and provides credible plans with evidence of sustainability that that that's a nice slogan but how does that actually work in in progress right in in real life sorry forgive me if you look at the typical value chain of of any deal any merger acquisition they're fall into four main areas the

7:29 investment thesis the valuation the sale and purchase agreement and then the integration planning but now how do we bring it that we bring that forward focus and that rigor in yeah it's it's very easy to see that if we're talking about bringing rigor into a merger in an acquisition what have we spoke about in the previous slide that the primary focus area would be to spend more time on the investment thesis and the integration planning and these do form the core areas for an operational due diligence but what are their main objectives if we just look at the investment thesis side of of the transaction how do we review it the underlying market and economic factors associated with the deal why is this deal strategic what what what's the drivers behind that there could be numerous reasons as to why we're doing a deal whether it's on

8:32 the buy or the sell side how do we assess very excuse me the sustainability of future operations can we identify actions and Investments That accelerate value creation right now at the start that can go into the investment basis that will allow you to try and identify value to the transaction and the other main focus of operational due diligence is to advise the deal team on the Strategic fit of a transaction now this can happen even before you've entered into a deal and then there's a proactive piece to this is if you've really understood internally your own company that could then say Oh based on INX five to ten year strategy we should be looking at an acquisition in this kind of Market if we then go down and look at from the back end of the deal the integration of planning operational due diligence focuses on driving the integration planning

9:37 process identifying short and long-term value creation goals and projects it considers and this is quite important both the past and potential future information in assessing risk and reward very often I've seen deals where people have gone through and said well there's a Synergy here but they haven't really understood the risk and reward factor or the the difficulty in getting a change made and that's what an operational due diligence allows you to do is to assess the implementation complexity of making a change in a business and how ready you are for it so you might get a lot of value from doing a certain change but if the risk is very high to the business it might not be worth making that specific saving or that that specific focus in the integration planning the other main area of an odd it allows you to monitor key initiatives post deal to ensure that those benefits are

10:43 achieved and that the investment thesis doesn't become a document on in in a file somewhere that we just look at and go that was great but we didn't really get there and then the other advantage that it has is it gives you the space to identify additional synergies and changes operationally in a business post the deal to make sure that you can unlock potentially more value that does sit there now the first question I usually get asked after this is Alice that's great but how do you increase value great it's a great question and this is how we would look at it if we take any business we can break it down as a combination of business model and an operating model and this for me I like to break that down into a further eight eight additional areas if we look if we look

11:46 at it so we can see in the green there that the business model is made up of I for me I I classify it as your markets your propositions and your Brands your customers and your channels your operating model will break that down into five key areas your core business processes your technology your organizational structure your people and culture and your measures and incentives how are you making sure that you're achieving your goals now an operational due diligence focuses on both of these simultaneously we can do one or the other but the most value comes from looking at both of these at the same time from a business model perspective these are the key five key questions for me that need to be answered in if you're doing an operational due diligence what does a winning business model look like in the future for us how what is the sustained the sustainable advantage that we will get as a result of this transaction how

12:49 would it be achieved where do we want to play in the value chain of our Market ultimately what do you want to be famous for that that's a core view that goes to the strategy of a deal what platforms do you can you develop and prioritize how do you change your go to market strategy does it does this augment it does it give you a new potential customer base where are we sitting there and then that leads to the last Point how do you actually maximize Revenue in your share of the customer's wallet so all of those form a key focus of an operational due diligence if we then so that that drives the top line but there's another part of the equation that that's the bottom line the operating model an opera an odds Focus there is what are the core capabilities and requirements that we need in place to achieve this

13:51 do we have the right people in the right roles is everything where it needs to be what are the initial synergies that we've identified as part of this transaction what do we need to have in place to make sure that they are realized are they still fit for purpose when we look at a pre-transaction versus post-transaction are there any gaps in our organization is our staffing level at an Optimum point this is important for both on both the buy and a sell side transaction if we've brought in an acquisition do we have to beef up our HR RIT our finance teams our sales force equally important on a sell side if we've carved a piece of a business out have we planned to right-size the rest of the business that we've still got the right levels of support at the right cost points in the business

14:55 how do you fully understand and mitigate your risks now risks move all the time whether it's pre-deal during deal post deal and this gives you it allows you to have a single view around the deal from a risk perspective and then it it almost forces you to make achievable short and long-term growth objectives that are transparent because you've had to take into account both the operating model and the business model at the same time so how does that actually work now I'm going to break this up into two into two areas pre-investments and post Investments so pre-investment have we really understood the market do we know what's happening both externally in the market broader economy as a whole the sector the industry as well as internally within their own in our own business what are the initial assessments for

15:59 your top line synergies what's the growth rate you're going to try to achieve is this is this is it growth is it an increase in market share are we doing this for a competitive advantage or Dax is a new market what are those initial risks and where do we identify the potential areas of overlap in a transaction as well as operational synergies are we going to be able to maximize cost or Revenue through this and the other very important part that's pre-investment is reviewing the current operating model I see I've missed that word up there apologies are we going to be able to put everything in place now what do we have put in place now to help a deal get over the line or what has to put in place now to make sure that a post deal merger is successful if we then look at it on the other side and go all right post investment are we actively monitoring what was required from the investment thesis and

17:03 that we're actually delivering on the returns that we said we would achieve for the transaction do we need to review the operating model is it still fit for purpose or are we hammering a square peg and a round hole and trying to make it work those are real questions that have operational impacts to the business and then the last part which is that I enjoy the most in doing this work is where do we find additional operating synergies all those opportunities for cost Improvement are we being as efficient and as or as effective as we need to be were the initial pieces of operational Improvement cost savings cost reductions pre-investment are they still fit for purpose now after the deal or should those be revised the great thing about this is it's not a buy or a sell side thing it's done on both sides of the transaction as I mentioned earlier

18:06 but now if we were to bring all of this together and say all right well what does this this actually mean from an overall due diligence perspective I'm not saying that there's anything wrong with what's currently happening but I'm saying this is the ability to have more richness that can come into a Deal Pro into the deal strategy so if we look at where where things sit not you've got the commercial due diligence that focuses on the external factors what impacts future performance what answers it answers those critical questions at a board level why are we doing a deal financial and legal that focuses on making sure that the numbers are right focuses on the historic performance and makes it of an affordable deal what are we going to be paying the legal due diligence make sure that everything is structured correctly what an operational due diligence brings is it describes the business

19:09 operationally and it gives a credible independent assessment of management plans the evidences the sustainability of your operation and the potential to start to mitigate futurists and quantify additional upsides both before the deal and after the deal so for us at RSM we see this as more of a an odd adding to a holistic deal strategy that it's not just one each piece is individually as important but if we take everything all four parts of a due diligence together that's a real deal strategy that has the ability to unlock real value in an organization both pre-deal or post deal and whether we can really get value out of it Jax anything you'd like to add from your side

20:11 no I don't think so Alistair I think I think the main the main point I think which has come across quite quite clearly in in what what you've taken us through is that it needs to be to have a meaningful deal ultimately we need to have a holistic strategy that takes into into account all the different aspects in order to make the deal a success in in essence going forward and I think that's that's a very important message from from what you've said and bringing it together on on this particular slide right and everyone then thanks very much that that brings our this webinar to an end this recording will be sent up to you as soon as it's ready and where there are questions we'll we'll answer each of those directly to you individually thanks very much