Nov 10 ‘23 17 min read
There are numerous operational risks organizations have to deal with today — from employee conduct and employee error to business processes and controls. For example, the primary operational threats for banks, as reported by 75% of survey participants, are related to cyber risk and data security concerns.
That’s why operational due diligence in M&A and other corporate transactions is a must. It helps identify and assess operational risks and determine measures to take to mitigate them.
The article explores the importance of operational due diligence, compares it to other due diligence types, and provides a comprehensive operational due diligence checklist.
What is operational due diligence?
Operational due diligence (ODD) is a form of due diligence focused on examining a target company’s business model and operational aspects to assess its suitability for the acquiring party.
The key objectives of operational diligence are:
- Operational risk assessment. Evaluate the sustainability of the target company’s operations and determine if the business can thrive without extra investments.
- Value creation. Identify actions and investments that can potentially increase the business value but that haven’t been considered by the current management team.
While financial, tax, and legal due diligence help assess the current value of a company and mitigate the execution risks, operational due diligence is forward-looking, opportunity-focused, and oriented towards creating value in the future. It answers the question “What operational improvements can we make to enhance shareholder value?”
Also, while the approach to other types of due diligence is relatively standard, the scope of ODD is always customized to fit the deal structure, industry, and specific operational risks of the company. Moreover, the ODD process doesn’t conclude before negotiations — it extends up to the deal closing.
In short, ODD is different from other due diligence types by:
|– Financial due diligence|
– Legal due diligence
– Commercial due diligence
– Environmental due diligence
|Operational due diligence|
|Objective||To project value||To create value|
|Focus||On risks||On opportunities|
The outcome of operational due diligence should be an actionable value-creation plan. Note that it’s important for a plan to be a co-creation of an ODD team and a management team, not just a due diligence report from an advisor. A plan should contain:
- A list of value-creation opportunities
- An action plan describing how to seize these opportunities while minimizing the risks associated with the transaction
Note: ODD isn’t limited to M&A transactions only. Real estate investment and private equity operational due diligence is also essential. That’s why investment experts and hedge fund administrators must examine all potential operational risks when making recommendations. Lehman Brothers’ collapse still remains a reminder of its importance.
Importance of operational due diligence
“A company can seize extraordinary opportunities only if it is very good at the ordinary operations”, Marcel Telles, a Brazilian investor and businessman.
Indeed, strong everyday operations make a business resilient and efficient. And operational due diligence helps ensure the company you’re going to invest in will be able to support your future growth.
More precisely, the importance of the operational due diligence process lies within:
- Synergy assessment. ODD helps determine whether synergies between the acquiring and target companies are possible and whether the transaction is really worth the effort.
- Operational efficiency. ODD can identify opportunities for operational improvements within the target business, leading to increased operational efficiency and potentially higher returns on investment.
- Risk mitigation. ODD helps identify risks associated with the target’s operational processes, such as compliance issues and inadequate internal controls. Identifying these risks early in due diligence allows acquirers to develop strategies to mitigate them, reducing the chances of post-acquisition problems.
- Legal and regulatory compliance. ODD can uncover any non-compliance issues, helping avoid potential legal disputes and liabilities.
- Integration planning. ODD helps acquirers understand the operational differences between their own organization and the target company. This is critical for creating an effective integration plan and minimizing disruptions to day-to-day operations. You can also use our post-acquisition integration checklist to ensure an effective integration process.
- Pricing adjustment. The findings of ODD can influence the overall business valuation and terms of the M&A deal. If significant operational risks are identified, the acquirer may negotiate a lower purchase price or adjust the deal structure in accordance with these risks.
Drawing on our own experience, operational due diligence is an absolute must for all organizations planning transactions as it helps them make informed decisions about whether to proceed with an investment.
Operational due diligence (ODD) checklist
The depth and scope of due diligence may vary depending on a specific transaction and the industry in which the business operates. However, you can use the operational due diligence (ODD) checklist provided below as a starting point and tailor it to your needs.
|Checklist tasks||Objectives||What to review|
|1. Analyze operational efficiency||To clearly understand how the target operates and whether its operations align with industry best practices.||
– Standard operating procedures (SOPs)
– Manuals or guides that outline specific operational processes
– Audit procedures
|2. Assess the internal control system||To identify and mitigate operational risks like chain disruptions or cybersecurity vulnerabilities.||– Policies and procedures that cover financial controls, data security, access control, and other critical areas|
|3. Evaluate the strategic planning and risk management process||To ensure the organization’s strategies and risk mitigation measures are well-defined and capable of addressing and mitigating risks.||
– Strategic business plan
– Risk management and insurance policies
– Risk assessment reports
|4. Investigate the target’s legal compliance and identify potential legal risks||To ensure the business adheres to relevant laws and functions within legal boundaries.||
– Legal structure
– Corporate governance
– Regulatory compliance
– Intellectual property rights
|5. Assess the company’s financial health||To conduct a thorough analysis of the company’s financial stability and ensure the accuracy and reliability of financial reporting||
– Audited financial statements, such as balance sheets, income statements, and cash flow statements
– Audited financial reports
– Debt agreements
– Tax returns
|6. Check the performance indicators and business continuity plan||To evaluate if the target company has well-defined objectives and a resilient strategy to address unexpected disruptions.||
– A business strategy
– Business continuity and disaster recovery plans
– Emergency response protocols
|7. Conduct technology stack assessment and digital asset verification||To assess the IT infrastructure, data management practices, cybersecurity measures, and IT governance.||
– Data governance policies and procedures
– Records of security assessments, penetration tests, and vulnerability scans
– IT security audits and reports
– Incident logs and reports
|8. Conduct supply chain and vendor assessment||To ensure the organization adheres to clear procurement processes and has transparent relationships with vendors.||
– Vendor and supplier contracts
– Service level agreements (SLAs)
– Vendor invoices and payments
– Supplier performance reports
|9. Review the human resources practices||To gain valuable insights on human capital and evaluate whether the target has effective HR policies in place.||
– Human resources policies, including hiring, training, performance management, employee benefits
– Employment contracts
– Employment agreements
– Retention strategies
|10. Evaluate health, safety, and environmental practices||To assess whether the target complies with relevant environmental regulations and implements necessary strategies to ensure the well-being of its employees and minimize potential environmental risks.||
– Environmental impact assessments, including emissions data, waste management, and resource consumption
– Safety inspections and audits
– Incident reports
– Emergency response plans
Operational due diligence framework
An operational due diligence framework is a structured approach that outlines the key due diligence process steps. Frameworks vary but typically include the following components.
Every type of due diligence starts with a planning phase which includes:
- Objectives definition. Begin by clearly defining the objectives of the ODD, including what aspects of the target company’s operations you need to evaluate (operational efficiency, financial performance, legal compliance, etc).
- Stakeholder identification and team formation. Identify key stakeholders, including internal teams, external advisors, and potential investors. Also, create a dedicated due diligence team with the required expertise in finance, legal, IT, and industry-specific knowledge.
- Document collection. Gather all relevant documents, reports, and data related to the target company’s operations, such as financial statements, contracts, and operational records. It’s crucial to pay special attention to data quality to ensure the accuracy and reliability of the collected information.
- Timeframe setting. Establish a clear timeframe for the entire due diligence process, including specific deadlines for different stages.
2. Execution and review
The next phase includes:
- Document review. Conduct a thorough review of the gathered documents to gain insights into the target company’s operational efficiency. Prioritize and first focus on key documents, such as financial records, contracts, and regulatory compliance, as they provide critical insights into the target company’s operations.
- On-site visits. If necessary, arrange physical site visits to verify the condition of significant assets, such as real estate, equipment, and inventory.
- Meetings and interviews. Meet with the target company’s management and employees to gather additional insights into operations, challenges, and strategies. Encourage open dialogue by asking open-ended questions (prepared in advance).
- Market research. In some cases, market research can be a relevant component of operational due diligence, especially when the target company’s operations are influenced by market trends and customer behavior.
- Data analysis. Analyze the collected data to assess the company’s operational and financial performance and risk factors. Compare the target’s performance with industry benchmarks and competitors to identify areas of strengths and weaknesses. Apply investment analysis techniques to calculate key metrics like return on investment (ROI) and net present value (NPV).
3. Assessment and recommendations
Here’s what to do during the last stage:
- ODD report. Compile all the information, findings, and evaluations into a comprehensive report. The report should summarize key observations, outline risks and opportunities, and provide recommendations for improvement.
- Communication. Share the report with relevant stakeholders, including investors and management, discuss concerns or issues, and plan how you can address them.
- Ongoing monitoring. To ensure all recommended improvements are implemented, establish ongoing monitoring and track the target’s progress in addressing operational concerns.
Tools and software for operational due diligence
Based on our experience, operational due diligence software can help companies greatly during corporate transactions. One of the software solutions businesses opt for today is a virtual data room — a secure online repository for document storage, management, and sharing.
Virtual data rooms bring numerous benefits for companies conducting due diligence, such as:
- Time savings. Advanced document management and communication tools save time by reducing the need for manual tasks and in-person meetings. The software also allows users to access M&A transaction documents in one centralized platform, so there’s no need to waste time searching for files through multiple sources.
- Cost efficiency. Using VDRs can be cost-effective in comparison to maintaining physical data rooms as there are no expenses associated with physical storage, printing, or transportation of documents.
- Advanced security. Data rooms are equipped with advanced security features, such as multi-factor authentication, dynamic watermarks, and data encryption. These measures provide a high level of protection for confidential documents, ensuring that only authorized individuals can access, view, or modify them.
- Accessibility. Data rooms provide the possibility to access documents from anywhere, at any time, through both web-based platforms and mobile apps. This allows deal-makers to collaborate and make informed decisions even while on the move.
- Analytics. Virtual data rooms offer audit trail and reporting features, which make it really easy to track and record user activity — what documents they viewed, printed, or downloaded. This helps to maintain internal compliance and avoid potential audit or litigation risks.
Operational due diligence should be a key component of any corporate transaction as without it organizations risk failing to create the expected synergies. Here’s what to know about it:
- Operational due diligence investigates a target company’s operational aspects to ensure it’s a good fit for the buyer.
- The key objectives of operational diligence are operational risk assessment and value creation.
- A well-structured ODD process involves planning, document review, on-site visits, interviews, data analysis, and ultimately results in a comprehensive report with recommendations for improvement.
Virtual data rooms are valuable tools for conducting ODD, offering secure and efficient document management and communication, and reducing the time and cost of the transaction.