Operational Due Diligence

Overview of Operational Due Diligence

A buyer/investor (acquiring company) carries out due diligence on the target company (seller company) before making the acquisition. Operational due diligence comes as a part of a fully-fledged due diligence package for the target company. In this form of due diligence, the buyer comes to know about the aspect of operational specifications of the target company. Every industry has its peculiar approach to carrying out operational due diligence.

A third-party management consultant performs operational due diligence. It is crucial that expert professionals perform this process, as knowledge and industry-specific experience are essential in carrying out operational due diligence. In operational due diligence, the target company's operational structures are evaluated from the buyer's perspective to check whether the operational structure can be synergised with that of the buyer’s. The operational due diligence report apprises the buyer about the existing bottlenecks and possible risks in the target company and whether such a merger or acquisition will complement the buyer’s internal operational apparatus or not. This exercise allows the buyer to make informed choices and adopt one or more of the following courses of actions:

• Reconsider the deal;
• Negotiate the Price of the Target Company; or
• Walk out of the deal without any negotiation.

The major objective of a buyer in a merger or acquisition deal is to gain from the advantages of the target company and make up for its own deficiencies.  A company enters into a merger transaction with another company to improve its overall performance and achieve economies of scale. Hence, it is beneficial for the company to conduct an operational due diligence exercise to understand the operational performance of the target company and to what extent such acquisition would be beneficial for buyer’s company.

What are the Objectives of Operational Due Diligence? 

Some of the main objectives of operational due diligence are:

• The analyses generated by the exercise allow the buyer to make better-informed decisions which in turn gives the buyer confidence to invest in the target company.

• Through operational due diligence, the operations of different departments of the target company are known.
• It provides a competitive advantage to the buyer because he understands the operations of the target company better and therefore in a better position to negotiate the deal.
• It measures the extent of risk present in the potential acquisition. Through this, the buyer will understand if the target company is performing well or not.
• Operational due diligence discloses to the buyer the internal issues/ deficiencies in the operations of the target company.
• Operations due diligence covers all the departments of the target company. Hence, the buyer gets to know about all the operational risks associated with the target company.
• Operational due diligence helps the parties to build a scalable and achievable business plan with well-defined goals and objectives. 

Areas of Operational Due Diligence

The main areas where operational due diligence focuses are as follows:

1. The finances of the Target Company.
2. The Goals, Objectives and Strategic Planning of the target Company.
3. Evaluating the Strategies of Operations.
4. Measuring the risks in different departments.
5. Mitigating the risks and monitoring future performance. 

1.     Finances of the Target Company

One of the most crucial pieces of information required by the buyer is the finances of the target company. This includes the following:

• Statement of Annual Accounts of the Company.
• Periodic Returns filed by the company.
• Statutory Reporting and Disclosures of Quarterly and Yearly audits by the company.
• Profit and Loss Information about the target company.
• Assets and Liability position of the company.
• Appointment of Auditors for the target company as per the Companies Act 2013.
• Consolidated financial statements of the target company.
• If the target company has any subsidiary, then financial statements and reviews of the subsidiary company must also be provided.

2.     Goals, Objectives, and Strategic Planning of the Target Company

A target that is performing well will have specific goals and objectives. The performance of the target company would be based on its strategies and goals. Therefore, every buyer wants to have a look into the following:

• Goals of the Company.
• Management objectives of the company.
• Information on previous objectives of the company. Report on objectives achieved by the target company so far.

3.     Evaluating the Strategies of Operations

Synchronization is the practical key to aligning all the strategies of the target with that of a buyer. To understand the target company's operational strategy, the buyer has to analyse and observe the current working environment of the target company. All the departments have to function properly to understand if there is efficient synchronization within the company or not. To evaluate the strategies of operations, Enterslice undertakes the following tasks:

• Observe and measure the coordination between the upper management and the lower management of the company.
• Understand the hierarchy of the organization.
• Find out whether the Accounting functions, Human Resource functions, and Supply chain functionsare working effectively within an organization or not.
• Analyse the Planning and Coordinationfunctions of the Company.

4.     Measuring the risks in different Departments

Risk analysis is a crucial element for an organization to develop. An organization needs to measure and evaluate the number of risks in all the departments. In operational due diligence, the buyer will have to evaluate the target company's cumulative risk. Through this, the buyer will understand if there are any operational inefficiencies in the target company. Apart from this, the buyer will have to consider the following risks in the target:

• IT Risks such as cybersecurity breaches and data threats.
• Regulatory Risks.
• Financial Risks.
• Operational Risks.
• Performance Risks.

Risks in a company can be analysed and measured as per the quality assessment methods. Quality assessment methods are used to understand the standards of the risk present with the target.

5.     Mitigating Risk and Monitoring Future Performance

Mitigation is required for any enterprise to avoid any risk. The buyer has to ensure that the target company has integrated mitigation protocols to mitigate any form of risk the target company might be exposed to. The organization can achieve this by implementing the following protocols. The buyer has to ensure that the target company has the following protocols:

• Ensure that there is a practical cybersecurity framework within an organisation. This framework will mitigate and remove all the cyber threats faced by the organization.
• Ensure that data protection protocols have been adhered to by the company. Compliance with GDPR (General Data Protection Regulation, 2018) and other global data protection laws has to be ensured. By doing this, the buyer ensures that no data breach occurs in the company.
• The buyer also has to ensure that the target company's financial systems are at an optimum level.
• Risk protocols implemented must be effectively monitored by the buyer. A protocol implemented must be monitored to check whether it synchronizes with the activities conducted by the buyer or not.

Elements of Operational Due Diligence

1.     Organizational Structure and Employees

While conducting operational due diligence, the buyer must ensure that there is proper coordination among all the departments of the target company. This includes checking the operations of all employees of the target company. The following factors must be taken into consideration by the buyer:

• Corporate and Employees’ values.
• Leadership Skills, Motivational Tactics and Managerial Aspects of the employees.
• The level of delegation of authority from management to lower managerial employees.
• Departmental classification of the organization.
• Growth Plans of the individual departments.
• Employment Criterion of the target company.
• The corporate culture followed by the company
• The organizational structure followed by the company, whether it is the matrix or the hierarchical organizational structure.
• All these have to be conducted by the buyer to ensure that the organizational values and work culture arefollowed by the target company.

2.     Software and IT Infrastructure

Software integration is crucial for the proper functioning of an organization. Coordination among different departments depends on the software used by an organization. The buyer must ensure that the target company has adequate IT infrastructure in place in order to protect its systems from any cyber threats and instances of data breaches. The buyer, here, has to ensure that:

• Adequate IT infrastructure is present in the company.
• Data Protection Protocols are being followed by the company.
• The target company has a cybersecurity framework in place.
• Systematic checks are carried out within the company at regular intervals.
• Recovery Management and Data Management Systems are present in the company.
• The company has implemented disaster management protocols too.   

3.     All the Assets and Related Costs of the Target company

Cost Asset Management is a key area that a business utilizes to understand its operational efficiency. The buyer has to check whether the target company has sufficient funds to meet its daily operational requirements. Apart from this, the buyer also has to ensure that the asset quality meets the optimum levels which include the following:

• Checking the number of assets owned by the company.
• Valuing the assets as per the international standards of valuation.
• Calculating depreciation on the assets of the target company.
• Assets would also include intangible assets of the company, such as trademarks, designs, and copyrights. The buyer must make sure that the value of such assets is not affected in any way, such as data breaches in the past or reputational loss to the company.

4.     Potential to develop

The potential for the development of the target company is measured by the buyer. The buyer has to ensure that the target has some scope to grow the company substantially. This, in turn, helps the buyer increase revenue and generate long-term gains for the company.

5.     Adaptability

By gauging the adaptability of the target company, the buyer develops a broad understanding of the scope of the target company to adapt to both external and internal changes taking place. Based on the strategy adopted by the target company, the buyer can have a scalability analysis. This further helps the buyer to understand if the target company can face risks in the market and accordingly make its way to deal with them. The common risks present in the market include technology risks, economic crises, and competition.

6.     Amount of Risk

There are different risks associated with the target company. There are certain business risks that the buyer will have to face after the conclusion of the said acquisition. Operational Due diligence is carried out to counter any form of risks that the target company might be exposed to. By conducting this, the buyer estimates the resilience of the target company and can rethink the purchase price to be given to the seller. The buyer must undertake a thorough analysis of the apparent risks the target company is susceptible to and act accordingly. 

Enterslice Benefits -Operational Due Diligence services

• We have years of experience in carrying out Operational due diligence services in assisting clients’ companiesin finding out any issues with the transaction.
• We have diverse teams of professionals comprising Chartered Accountants, IT professionals, lawyers, and company secretaries.
• We have extensive experience in handling matters related to mergers, taxation, and accounting matters in India.