A Brief Introduction to Quality of Operations™ Service
An Essential Guide to: Operational Due Diligence and TriVista’s Quality of Operations™ Service
As all prospective investors recognize, there is a direct link between the way a business operates and its financial performance. EBITDA, cash, and revenue can all be attributed to underlying process flows and business operations, despite being financial, not operational, metrics. Good sales processes drive revenue, sound inventory and/or cost management processes control cash, and EBITDA is a function of selling a product or service more efficiently than it costs to make or deliver the product.
Despite this, middle-market investors historically have relied on traditional accounting due diligence procedures to help them understand earnings and financial performance – relying on Quality of Earnings (Q of E, or QOE) reports. Beginning in the early 2000s, however, the investment industry started to experience a paradigm shift – more attention was being paid to operations and value enhancement, as financial engineering on its own was not providing investors with the required returns.
Thus, conducting operational due diligence, is becoming an important, mainstream requirement prior to most transactions. The industry now values the operational due diligence as much, if not more than its financial counterpart, given its ability to create rather than measure shareholder value. TriVista Quality of Operations™ service is designed to focus on that key element for investors: value creation.
What Is the Quality Of Operations™ (QOO) Service?
Before delving into the details of operational due diligence and TriVista’s Quality of Operations service, it’s important to be familiar with the purpose and history of the QOE in order to demonstrate the relationship between them. First, there is no single definition of QOE, and there is no agreed-upon industry standard. Its roots trace back to the 1970s and ’80s, when it was developed by professional investors who needed a way to ascertain company valuations based on true earnings, not accounting anomalies. At that time, the industry lacked a universal, objective form of measurement.
Today, the general consensus is that the goal of the QOE is to allow the user to draw conclusions about current income and projections for the future. The Quality of Earnings can largely be summarized as the extent to which earnings and expenses are:
- Cash or non-cash
- Recurring or nonrecurring
- Based on precise measurement or estimates that are subject to change.
Essentially, the QOE helps to quantify and qualify historical earnings, while providing some insight into actual earnings and where potentially value-destroying activities are occurring. However, it does not show the true capabilities of the organization, nor does it determine how to harness its challenges and turn them into springboards for improvement.
Understanding the Quality Of Operations™ Service
Like the QOE, the term operational due diligence has no single, widely accepted meaning. Yet the longevity and near universal use of QOE in the marketplace has led to some accepted criteria. This is not yet the case with operational due diligence, but accepted standards are developing as the process evolves.
The goal of the operational due diligence is to allow the user to judge the current state of operational performance and understand the sustainability, predictability and certainty of an investment’s future performance, including its impact on and correlation to financial statements. Operational due diligence provides analysis into the degree to which operations are:
- Optimized for operational excellence
- Sustainable at current / planned capacity and margins
- Performing at/near/above benchmarks within an industry (in terms of inventory, cycle time, etc.)
- Efficiently deploying capital (working capital, human capital and intellectual capital)
- Supported by reliable fixed assets or at risk of unplanned capital expenditures
- Producing/delivering high quality products that meet known customer expectations
- Led by a competent leadership team focused on continuous improvement.
Over time, it has become apparent that the more detailed and disciplined the operational due diligence approach up front, the more successful the investor, since decision-making is executed against an investment thesis that is grounded in a realistic view of the organization’s capabilities and its prospects for operational improvement.
An example is one recent case in which advisers from TriVista, a mid market focused management consulting firm with offices throughout the United States, United Kingdom and China, employed TriVista’s Quality of Operations(TM) service to identify $2.5 million in EBITDA expansion opportunities and working capital improvement opportunities of $7.5 million for their client, a $700-million private equity fund evaluating a $100-million transaction.
TriVista’s team members in China and North America simultaneously assessed operational capabilities and weaknesses throughout the targeted organization. The Quality of Operations services included data room analysis, personal interviews, on-site observations and fact-checking to analyze key areas of operations, including:
- Operational leadership and management skill sets
- CapEx planning and future requirements
- Engineering and new product development
- S&OP and inventory management
- Sourcing and supply chain management
- Continuous improvement programs
- Capacity by site
TriVista’s global teams kept in close daily communications with investors, flagging critical risks that could jeopardize the transaction, and then collaboratively produced the key findings report, which synthesized post-close risks and prioritized improvements. The key element to achieving the upside potential – the company lacked a formal Enterprise Improvement Program.
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