1. Identifying operational risks in the target company
While operational due diligence typically identifies potential risks, known as red flags, in the internal value chain for each business function, it is advisable to focus on selected, often critical areas.
For global value chains, one focus is on assessing the resilience of supply chains and the effectiveness of the target company’s purchasing organization:
- In which countries do critical class A suppliers have their own production sites and will these countries be affected by tariffs in the future?
- How high is the dependency on one or a few suppliers and are there alternative suppliers on the global market that can be qualified at short notice?
- How professional is the supplier management in the purchasing organization? How are key class A and B suppliers managed?
- How good has their delivery and on-time performance been so far?
Further questions arise for companies with production sites in the USA, Canada, Mexico and China: What is the assessment regarding possible risks associated with the imposition of import duties? Are there any alternative sources of supply?
In order to identify possible starting points for further cost-cutting potential, a parallel assessment is made regarding how successful purchasing has been in recent years in fending off price increases by suppliers and reducing purchasing costs, particularly after the temporary cost increases that commonly occurred during the COVID-19 pandemic.
An assessment of the professionalism of the purchasing organization is also important:
- How is purchasing organized (e.g., assigned to strategic buyers by procurement groups)?
- What training, professional experience and (technical) skills do the employees have?
- How are savings in purchasing measured? Is a distinction made between cost reduction and cost avoidance? Is there perhaps even a dedicated purchasing controlling role to keep track of purchasing success?
- How are the incentive systems for employees in purchasing structured?
- Is the purchasing organization sufficiently staffed or are there vacancies in key positions?
Risk assessment for global companies takes a holistic view of the network of operational locations:
- Where does the target company have its own production sites and to which sites of its own customers does it deliver? How complex are the resulting supply chains?
- How does the operational footprint affect the target company’s cost base?
Across all industries, we are seeing companies weighing the prospect of building up their own production locations in the US. Moreover, production capacities are being relocated from Eastern Europe to North Africa due to significant cost increases in the former. Industries with high energy requirements (e.g., the chemical industry) are shying away from building expanding production capacities in Central Europe and are shifting to regions with lower energy costs. In view of these and other trends, it is important to assess how the operational footprint has evolved and what strategy the target company is pursuing.
Finally, historical and planned capital expenditures (CapEx) are being scrutinized. After years of limited availability of materials and spare parts as well as delivery delays, the question for manufacturing companies is often whether the necessary investments in replacement and expansion were made in the past – or whether they had to be postponed and have resulted in investment backlogs today.
Caution is also advised when assessing the investments required over the business plan period. If management estimates the financing requirements for new machines on the basis of historical prices for previously purchased equipment, this underestimates investment requirements as significant price increases are sometimes not taken into account, or parts from that time are either no longer available today or can only be replaced by more expensive successor products. Another consideration is that historical prices only take into account the underlying technical specifications, which means that technological advances with significant benefits for the production process, for example, cannot be priced in. Furthermore, equipment that was deliberately specified to be cost-effective in periods of crisis may distort estimates of future investment requirements.
2. Assessing the scalability of the organization and operational processes in the target company
After several years of moderate demand, many companies are currently planning for ambitious growth targets, which can usually only be achieved with an optimally positioned organization and highly scalable production, delivery and warehousing processes. At the same time, many manufacturing companies have restructured their workforces to adapt to the changed situation, avoided filling vacancies externally or temporarily shut down production lines.
Operational due diligence generally assesses the availability of personnel; currently, the focus is on the following main questions:
- In the event of rising demand, how can more workers be recruited and trained on short notice so that production can be ramped up again quickly?
- Is it possible to cover the ramp-up of production and peaks in demand through both outsourcing and hiring temporary workers on a short-term basis?
- Is there a risk that the company will lose valuable expertise due to the departure of experienced workers? And how quickly can this knowledge be rebuilt internally if necessary?
- What options are there to deploy employees more flexibly within the company, for example by training plant operators on several production lines to enable more flexible scheduling?
Site visits are essential when estimating the lead time for restarting decommissioned production lines. In addition to the direct dialog with the Chief Operations Officer (COO) and Production Manager, this enables a more precise assessment of the situation on site:
- How long was production down and how were the necessary maintenance and servicing measures carried out over this period?
- How long will necessary cleaning and, if necessary, renovation measures take before production can resume?
- Is it necessary to invest in replacement machinery and how long does it take to procure and install the required equipment?
- Are technological upgrades a viable option when purchasing new machinery and equipment in order to, for example, achieve a higher degree of automation in production?
In addition, further thought should be given to identifying potential bottlenecks throughout the value chain:
- Are the existing capacities in production, warehousing and logistics sufficient to implement the business plan envisioned by management?
- Is there sufficient free capacity to enable further growth?
- Can capacity peaks be balanced out by shifting production volumes between multiple locations of the target company? And if so, how are products or customers prioritized and what are the costs involved?
- Can external storage capacity be rented at short notice near the production site?
These and other questions are best discussed after a site visit has been conducted to gain a detailed understanding of production processes, bottlenecks, capacity, utilization in production and of the warehouse, as well as key performance indicators.
3. Quantifying value creation potential to boost operational performance
After years of high material and personnel cost inflation, the cost base of the target company often harbors significant potential for optimization. Management teams and investors recognize this and often initiate comprehensive cost-cutting packages prior to a sale in order to improve EBITDA margins in the short term.
Operational due diligence then takes a closer look:
- How robust are the planning assumptions made and how ambitious are the savings targets?
- Were the packages of measures developed pre-crisis, but not consistently implemented and just revamped for the purpose of the sale process? Are they therefore based on an outdated cost base (baseline) and outdated assumptions?
- Is the proposed timeframe for implementing the measures realistic?
- What one-off costs will be incurred during implementation, such as for external consulting?
It is important to assess whether the measures are merely incremental improvements with potential savings of two to four percent per year through traditional value-adding levers, or whether transformative changes to the target company can make a real difference and significantly reduce the cost base over the long term, for example by relocating production, outsourcing support functions, or automating processes with AI. And can a pre-crisis cost level be reached and possibly even lowered through such measures?
Operational due diligence also assesses the target company’s working capital management. In recent years, many companies have built up additional safety stocks of raw materials in order to prevent production losses caused by delays at their own suppliers. Moreover, manufacturing companies sometimes store large inventories of finished products – the result of overestimated demand or canceled orders from customers, some of which have gone bankrupt. The potential to free up liquid funds in the short term by reducing inventories is examined in the due diligence phase. There is also the question as to whether the build-up of unnecessary safety stock can be avoided in the long term through optimized production and sales planning – accompanied by tighter monitoring of suppliers in order to anticipate failures at an early stage – with individual risk and opportunity assessments.
