Operational Due Diligence (ODD) is an increasingly important part of buying or selling a business. It is often used to understand the way that a business works, identify operational issues, and uncover value creation opportunities before any sale takes place.
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Whether you're an investment manager in one of the many private equity funds or just exploring alternative investments, the ODD process is an important thing to learn. In this guide we will explore the following topics:
ODD focuses on evaluating a target company's operations to assess operational risks and potential for value creation. Unlike financial due diligence, which examines financial statements and records, operational due diligence investigates how a business operates.
This is also different to commercial due diligence, which is generally focused on the market outlook and commercial strategy. The operational diligence process aims to provide a comprehensive understanding of the target company's operational infrastructure, ensuring long-term sustainability and growth.
In summary, the key objectives of ODD are to:
Next up, we'll look at the ODD process in more detail.
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Like many things in life, ODD comes down to a process. We have broken it up into five simple steps, as follows:
The process begins with an evaluation of key documents such as financial records, regulatory filings, and legal due diligence reports. This phase helps identify risk factors, potential operational risks, and regulatory compliance issues. If you are the seller, then start by looking at your internal data sources and reports, while buyers should look at files uploaded to the Virtual Data Room ('VDR').
This involves examining the target's operations, including the organizational structure, human capital, and operational processes. Assessing the target company's operations ensures a comprehensive understanding of its capabilities and limitations. One commonplace technique is to perform functional, headcount, and cost benchmarking - Learn more about benchmarks here.
Operational due diligence reviews delve deeper into operational infrastructure, IT systems, and data management practices. VDRs are often used to facilitate secure document sharing and data security during this phase.
Another great source of information is the management team. They have a lot of institutional knowledge, which can help with detailed reviews. If you're on the buy-side, then most investors will also appreciate your view on the strength of the leadership team as part of your ODD report.
A proper value creation plan is drafted based on findings, identifying value creation opportunities and actionable steps for implementation post-acquisition. This is often called "additional upside", which is usually not included in the valuation. It can come from changes to any part of the business, such as employees, IT, processes, or even the company structure.
Benchmarking has also proven to be very useful when it comes to value creation, such as quickly finding cost reduction opportunities in certain functions of a business - Get functional benchmarks for your ODD project here.
Post-closing, ongoing monitoring ensures that the investment manager can track operational improvements and mitigate potential risks effectively. This is an important step that will determine whether the value has been unlocked over the hold period of the investment.
In this section we outline the five key focus areas that will complete any ODD checklist, as follows:
The management team plays a vital role in a company's success. ODD evaluates the stability and competence of key personnel, as well as the organizational structure. This includes using benchmarks to assess headcount levels in each of the functions - Search for functional benchmarks here.
Assessing a target company's IT infrastructure and operational processes is essential for scalability and operational efficiency. The key questions to ask are:
ODD should also investigate regulatory filings, environmental regulations, and data security measures. Ensuring regulatory compliance minimizes investment risk and supports long-term business continuity. At a minimum, it's important to have a basic understanding of the regulatory environment and how the company interacts with it.
While not the primary focus, operational due diligence complements financial due diligence by examining financial performance, controls, and records. Any observations that may impact value should be noted and quantified as a financial adjustment, which ultimately impacts the purchase price paid by the buyer. This adjustment process helps to align operational insights with financial realities.
ODD includes evaluating a target company’s business continuity plans and risk management practices. These insights help in identifying potential risks and ensuring preparedness for unexpected challenges. With most investors holding on to a company for a period of at least five years, this mid to long term vision is an important one to understand.
Yes, this is briefly repeating the above section. We want to remind you that the operational due diligence checklist is an invaluable tool for structuring the diligence process. Per above, it includes:
Virtual data rooms enable secure sharing of sensitive information during the diligence phase. They improve collaboration between investment managers, fund managers, and the target company while maintaining data security. If you are a seller, prepare one for interested parties as soon as possible.
A diligence questionnaire helps gather targeted information about the target company's operations. It can include inquiries about financial statements, operational processes, and corporate governance practices. This will usually be answered by the leadership team, or those close to them at a minimum.
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Conducting operational due diligence often involves a few hurdles, such as:
Limited Access to Information: Delays in accessing key documents or incomplete data can slow down the diligence process. Move quickly on the sell-side, and maintain pressure on the buy-side.
Complexity of Target Companies: Larger organizations may require extensive operational due diligence reviews to assess all operational risks. Materiality is an important concept to remember, which is all about focusing on the things that impact value. Don't sweat the small stuff.
Coordination with Stakeholders: Ensuring cooperation between investment managers, fund managers, and the management team is critical. This is one thing that can kill any deal at any time. Management teams can often get frustrated with interested parties, while buyers may not trust management. It's important to find the balance and treat everyone with respect at all times.
In this short section, we will outline some best practices to follow:
Adopt a Structured Framework
Using an operational due diligence framework ensures that all aspects of the target business are evaluated comprehensively. Refer to the five step checklist outlined above.
Collaborate with the Management Team
Developing a value creation plan should involve the target company’s leadership. Their insights are invaluable for identifying value creation opportunities and addressing operational risks.
Leverage Technology
Utilize virtual data rooms and data management practices to streamline the diligence process and maintain data security.
Focus on Value Creation
Balance risk mitigation with the identification of operational improvements that enhance value creation.
Search for functional, cost and headcount benchmarks
For private equity firms, ODD is critical for acquiring target businesses. Fund managers often rely on this process to validate a company's business model, assess execution risks, and evaluate opportunities for value creation.
ODD is especially relevant in PE acquisitions because it informs strategic planning, including the development of a proper value creation plan. By identifying potential risks and conducting operational reviews, PE firms can confidently pursue investments that align with their goals.
Operational due diligence is a critical component of the due diligence process, providing insights into the target company's operations, operational risks, and value creation opportunities. Whether assessing investments for PE (or hedge funds), conducting operational due diligence ensures informed decision-making and sets the stage for long-term success.
By following best practices and leveraging tools like the ODD checklist, investment managers can navigate the complexities of the diligence phase with confidence. Through structured frameworks and respectful collaboration, operational due diligence does not only identify areas of risk but also unlocks potential value, making it indispensable for investors across industries.
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