New Prominence for Operational Due Diligence in Private Equity

New Prominence for Operational Due Diligence in Private Equity

Through the double-barreled approach of commercial due diligence and operational due diligence, private equity firms can improve their assessment of full potential.

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New Prominence for Operational Due Diligence in Private Equity

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Margin assessment rules when it comes to private equity deal success. Having observed the PE industry over decades, Bain & Company has identified a set of winning factors that highly correlate with deal success, as well as factors likely to undermine a deal. Margin assessment is the only factor that makes both lists. Funds that accurately assess margin improvement opportunities during due diligence and capture those opportunities after acquisition will be rewarded. On the flip side, unrealistic expectations for margin improvement in the deal thesis can spell disaster.

The practical route to accurately assessing and realizing the margin expansion opportunity starts with operational due diligence, combined with commercial due diligence. Together they provide a robust, realistic view of the target’s full potential. Whereas commercial due diligence provides a perspective on how fast the target company’s market will grow and whether the target could increase revenue faster or slower than the market, operational due diligence assesses the opportunity for the target to expand margins.

Most target companies have not reached full potential to improve operations or to enhance the top line. And there is nearly always opportunity if one knows where to look. Using benchmarks and expert perspectives, PE firms make a disciplined march through the target’s cost structure—beginning with procurement; moving through to manufacturing or service delivery; then customer service; and ending in selling, general and administrative expenses. In parallel, they can look for ways to optimize net working capital, real estate, inventory, capital expenditures and other components of the balance sheet.

Analysis of procurement, for instance, would undoubtedly uncover pockets of waste, which a new owner could address. The owner could reduce pricing with current vendors, consolidate vendors, reduce consumption internally, or reduce working capital by forward buying and by better managing inventory and accounts payable.

This is how Apollo reaped enormous value from its 2011 acquisition of a majority stake in Constellium, a producer of aluminum products. Apollo spotted an opportunity to buy an undermanaged asset during a down cycle of the aluminum market, having identified potential savings of €50 million in operating expenses in diligence. To capture the savings, Apollo undertook a deep transformation project to improve Constellium’s cost base, with an emphasis on procurement. At the time of acquisition, Constellium’s purchasing operated in silos, with each business unit having its own purchasing team and with very limited bulk purchasing. Apollo identified the major cost reduction opportunities by purchasing category, set cost reduction targets and measured progress, and it redesigned the purchasing organization while developing a new performance-oriented culture. By 2013, the aluminum market had recovered, and Apollo floated public shares on the New York Stock Exchange. At that exit, Apollo realized a very high multiple of money and internal rate of return (IRR) on the deal.

Although commercial due diligence and operational due diligence pursue different goals, they work best together, by developing an integrated view of the target’s full potential. If a private equity fund underestimates full potential, it will lose the deal in a highly competitive bidding environment. If it overestimates, the fund may win the auction, but the deal will not deliver the anticipated returns.

During uncertain economic times, the best way to reduce the risk of a deal is to attack baseline costs from year one. Through operational due diligence, a PE firm gets a head start on pursuing savings immediately after the deal closes, having already identified and sized up the biggest opportunities. Freed-up cash flow from expanding margins can be used to aggressively pay down debt and invest in the business strategy.

The interplay between the two streams of due diligence is where cost and growth converge, as the double-barreled approach gives PE funds a better understanding of how much capital could be freed up to reinvest. Until it’s clear where capital will come from, growth opportunities often don’t become feasible or even part of the senior management agenda.

Hugh MacArthur, Graham Elton, Daniel Haas and Suvir Varma are leaders of Bain & Company’s Private Equity practice.


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