Pre-Acquisition Diligence: Our Experience of What to Look For

Optimize Future Profitability and Working Capital

If you are a Private Equity organization operating in the lower middle and middle market, you have likely encountered unique challenges post-acquisition within your portfolio companies — especially in areas relating to actual profitability, working capital, and post-acquisition profitability. As a business consulting firm with 2 decades of performance and process improvement consulting and solutions, we’ve uncovered a list of common setbacks/unknowns that were missed in the pre-acquisition phase which directly impacted working capital and future profitability.

Many of these operational risks were the root causes of what we had been called in to mitigate. Therefore, we suggest ensuring the following list of recommendations be included in your pre-acquisition process as they will directly influence future target decisions and negotiations. From our consulting experience, these areas are not getting enough attention:

1. Enhanced Operational Due Diligence

The quality and quantity of your operational diligence process in the pre-acquisition phase can’t be underestimated. You may have found that there is a tendency among due diligence practitioners to inflate future operational savings in order to secure post-acquisition consulting work. This often results in overly aggressive projections which, down the line, become unrealistic and deflate your investment potential.

To mitigate this:

Select a Reliable Diligence Partner: Whether choosing internal analysts, external contractors or subject matter experts, and/or consulting organizations, look for objectivity and accuracy, over optimistic projections. Make sure you get solid references and understand what and how they will be investigating your targets.
Invest in Comprehensive Diligence: Although thorough operational due diligence can be costly, it pays dividends by revealing genuine opportunities and identifying potential and often costly setbacks. You might also leverage AI tools to help make comprehensive due diligence more attainable and cost-effective.
Consider Accelerated Operational Due Diligence: Diving deep into the operational aspects of a target, without a massive financial undertaking is possible, especially with modern technologies. In-depth rapid assessments can detect higher risk late-stage surprises by unearthing hidden issues.

2. Company Culture and Effective Change Management

Change management plays such a critical role in successful acquisitions. Overlooking the human element can render even the best-laid plans ineffective. The ‘change readiness’ of your target is often overlooked and the penalties later post-acquisition can be orders of magnitude higher than the initial investment.

Key points for consideration include:

Understanding Cultural Impact Acquisitions often lead to significant cultural shifts within the portfolio organization – like it or not. Recognize the magnitude and pace of the required changes and plan together with the Portco that is achievable and sustainable.
Inclusive Planning: Involve those who will continue to be part of the organization post-acquisition in the ‘go forward’ planning. Ensure synergies are achievable through collaboration which requires both top-down and bottom-up engagement of stakeholders.
Stay Agreements and Board Appointments: Get creative with stay agreements and board appointments as there are finite thresholds for ‘change’ tolerance, beyond which you can lose key talent.

3. Physical Space Rationalization

A close-up of a person pointing at a blueprint

Description automatically generatedPre-acquisition diligence often neglects the importance of physical space requirements and supply chain assets. These components can significantly influence profitability and operational efficiency down the line, especially if rationalization / centralization is a future strategy.

To optimize physical space:

Assess Leases and Land Assets: Evaluate current leasing arrangements and land holdings comprehensively. Investigating lease agreements from an operational flexibility standpoint can prevent long-term constraints.
Future-Proof Contracts: If planning for future consolidations or liquidations, ensure vendor contract terms allow for flexibility. Long-term liabilities can hamper strategic moves down the line.
Supply Chain Maturity: Examine the maturity of the existing vendors and contract management systems, as well as the logistics infrastructure. Identifying weaknesses early on enables targeted improvements. You may find you don’t have the data available to make interventions down the line therefore catch this in advance.

4. Effective Cash and Working Capital Management

While financial due diligence is not our area of expertise, when working on portfolio companies we have witnessed setbacks caused by limited access to cash and effective working capital which is crucial given the current cost of debt and leverage constraints.

Strategies to include:

Cash Flow Sensitivity Analysis: Conduct a thorough pre-acquisition analysis of future cash flow management, including receivables, payables, and inventory levels. Don’t just rely on a DCF to determine valuation, assess the multiple layers of realistic pro formas to include the cost of debt.
Cash to Cash Cycle Data Integrity and Analysis: Are there data integrity challenges related to AP/AR cycles? Hidden non-value-added time and inefficiencies latent in this process are caught early in diligence which can help emphasize data infrastructure work that will be required from the start, versus an afterthought. Reducing this lead time can have a significant impact on cash.
Optimize Inventory Levels: Scrutinize current inventory management practices to uncover inefficiencies and opportunities for optimization down the road, especially in the context of immediate visibility and lean stock levels (for both ‘make to stock’, ‘make to order’ and hybrid environments).

5. Technological Integration and Synergies

Technological challenges often arise post-acquisition, particularly in organizations with diverse tech stacks resulting from multiple legacy systems and/or prior acquisitions.

Strategies to include:

Inventory Tech Stacks: Document and assess the current state of each portfolio company’s tech stack (core/corporate, franchises, subsidiaries, planned acquisitions, etc.). This prevents undesired surprises and enables realistic planning for future system integration.
Focus on Integration and Data Integrity: Prioritize conversations around integration and data integrity over merely choosing the optimal Saas solution / best-in-breed for each functional or departmental requirement.
Pre-empt Synergy Execution Delays: Consider potential data and integration issues that could delay synergy realization and address them urgently in the diligence phase. The immaturity of tech processes, and or inability to integrate through hubs and off-the-shelf API’s will become amplified and costly post-acquisition or when future stack changes are required.

6. Realistic Assessment of AI and Technology Competencies

Embrace generative AI but with cautious optimism. While AI can revolutionize operations, its deployment is often less mature than advertised, especially in the mid-market.

Actions to take:

Evaluate Actual vs. Stated Competencies: Deeply probe any claims of AI competencies as real-world effectiveness can often trail behind what was promoted. This also relates to tech departmental capabilities or individual capabilities which do not translate to organizational capabilities.
Plan for Incremental Integration: Be realistic about the support and education required for successful AI integration. Gradual deliberate adoption often yields better results than swift, sweeping changes, depending on the use case.

Closing Thoughts

The diligence phase of any acquisition will influence the future success of your acquisition as well as your PE firm’s track record. By addressing these identified diligence strategies — operational thoroughness, change management, physical asset evaluation, cash flow scrutiny, technological integration, and realistic AI assessment — you should be better prepared to capture the opportunities down the road.

Pre-acquisition planning is not just about identifying opportunities but also effectively laying the groundwork for successful implementation of initiatives post-acquisition. By embedding these strategies into your diligence processes, your PE firm can enhance the profitability, working capital management, and future valuation of your portfolio companies, setting the stage for sustained growth and robust returns on investment. Shape

Need Help?

If you want to improve your operational due diligence process and outcomes, The Poirier Group offers expert guidance and bespoke consulting services tailored to enhance your operational diligence processes and drive long-term success. We provide pre-acquisition consulting and value creation solutions with partial or full implementation as required depending on the capabilities and availability of in-house resources to meet your objectives and timelines.

With almost 2 decades of experience creating sustainable transformations, we have demonstrated our value in serving the highest good of the organizations we’re connected to.

Reach out if you have a question or want to share your latest opportunity. We’d be happy to have a look and begin the conversation.

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