The Case for Sell Side Operational Due Diligence

Author: GAVIN FIELDEN | April 16, 2018

While most private equity firms perform buy side operational due diligence, there is a strong case that many mid-market investors can increase enterprise value by conducting sell side operational due diligence.

Sell side operational due diligence is catching on, and for good reason. The process can:

Identify key risks that may come to light in the buy side due diligence
Qualify and quantify areas for improvement, and associated savings
Boost enterprise value
Decrease the likelihood of surprises that can stall or kill a deal
Accelerate the transaction timeline
Lessen risk for both buyers and sellers
Reduce management time supporting buyer diligence
Reduce the number of potential competitors touring your facilities

Perhaps most importantly, it gives sellers more control over the story they want to communicate, not only about where the company stands today but where it can go in the future. In short, sell side operational due diligence increases both buyer confidence and equity value.

When conducted by a reputable 3^rd party firm with relevant industry and functional expertise, it can lead to added credibility with prospective buyers, and keep more buyers at the table further into a sale process. Prospective buyers will have increased confidence that projected improvements and savings are attainable, when management teams have a well-defined operational plan developed with the help of outside experts.

Increasing Company Value

Clearly identified projects that increase EBITDA can increase the value of the business and the multiple that the buyer pays at close.

To get an understanding for how sell side operational due diligence works, and how it can impact a sale, let’s look at an example. A private equity firm engaged an experienced diligence firm to evaluate a $200 million equipment manufacturer. The goal was to examine the company’s operational processes and protocols and identify areas to trim costs and improve quality.

The diligence team made multiple site visits and communicated extensively with the C-suite to ensure that current improvement plans were evaluated, and that newly formed recommendations were fully vetted and prioritized. The sell side operations diligence team worked in an expedited fashion to evaluate all operational aspects of the company, including supply chain processes, inventory practices, continuous improvement activities, and opportunities to expand revenue and optimize overhead.

The result was a plan that identified:

A consolidation of manufacturing and distribution sites resulting in $4M+ in potential savings

A 2% reduction in annual sourcing and procurement spend resulting in a $1.6M EBITDA impact
Opportunities to drive standardization, and sharing of best practices
Projects to improve labor costs by 5% and expanded capacity, lessening the burden on hiring additional operators

The private equity investors were extremely pleased with the results as the sell side due diligence work paid for itself several times. Moreover, prospective buyers could quickly understand where the business was going, and what benefits they could realize as management implemented their improvement plans.

What to Expect

Sell side operational due diligence can be conducted at any time leading up to a sale but has the most impact when completed 3 to 9 months beforehand. This gives management time to act on the intelligence provided, implement some of the improvements, and have some necessary improvements in place before the Confidential Information Memorandum (CIM) is released to prospective buyers.

For example, many companies that have been built as part of a roll-up may not be fully integrated or may have excess capacity at some of their legacy plants. A sell side operational due diligence analysis will be able to qualify and quantify the opportunity associated with plant consolidation and further integration. The existing owner may choose to start implementing some improvements pre-sale, while other future improvements (and their respective savings opportunities) can be carefully articulated and documented. This critical information can be shared with prospective buyers, demonstrating the potential value that can be unlocked in the coming months and years.

Hiring an experienced diligence team is key. In most cases, a diligence can be conducted in a matter of a few weeks. The team will know what processes to examine, how to evaluate these processes and how to best communicate future improvements to all involved, from management to prospective buyers.

It is important to use an outside entity that has established credibility with potential buyers. Experienced diligence teams run a multi-phase evaluation process, starting with a preliminary report that identifies weaknesses and opportunities. As the process continues, that report is refined until it becomes a blueprint for company improvements, both current and future—a document that can be shared at sale to increase credibility, transparency and value.

Of course, management buy-in and participation is crucial. The diligence team will be visiting the company often and communicating extensively with the Board of Directors, the C-suite, and relevant Senior managers with all agreeing on a sell side strategy and a process to get there. Without buy-in from management, the process may not produce the desired outcome.

Savvy private equity investors understand the value of sell side operational due diligence. It provides a clear operational strategy that brings life to the financial narrative and greatly increases confidence when negotiating with knowledgeable buyers. The evaluation can also identify problems that might arise at inopportune moments, such as during the transaction. Overall, sell side operational due diligence arms the seller with information and a solid plan for improvement, which can directly increase the value of the company for greater returns and an accelerated transaction timeline.

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