Assessment and management of operational value and risk in mid-market acquisitions - defining operations, dovetailing financial and operational metrics

1. Diligence Services International
The Shire, Chalk Road, Ifold, West Sussex, RH14 0UA, UK
FOUNDER DIRECTORS’ PAPERS
SERIES 1 – VALUE AND RISK; THEIR ASSESSMENT AND MANAGEMENT
PAPER 2 – DEFINING ‘OPERATIONS’ AND EXPLORING METRICS
This is the second in a series of four brief papers which will explore the assessment and
management of operational value and risk in mid-market acquisitions. This paper will
consider:
 Defining ‘Operations’ and merging perceptions
 Dovetailing financial and operational metrics
Subsequent papers in the series will address:
 Balancing value, pace and risk (1) – Sources of value and risk
 Balancing value, pace and risk (2) – The interplay of value, pace and risk
You are cordially invited to contribute your comments on the subject matter of our
papers or thoughts and suggestions for future papers on operational aspects of
mid-market M&A.
In Paper 1 of this series we discussed the changing drivers and pressures on financiers,
management and the risk return equation; and bridging the worlds of finance/investment
and operations. We concluded that different perceptions of what comprises operations is
often somewhat of a barrier to developing a common view of the performance and
potential of a target business. This Paper 2 seeks to further develop a common
understanding amongst financiers and management of the nature of operations and how
its performance is measured and improved.
Defining ‘Operations’ and merging perceptions
We sometimes find that ‘Operations’ is perceived to be the same thing as
‘manufacturing’, or ‘production’. The reality is that all functions of business have an
element of operations, as implied by our working definition: the people, processes and
systems working to deliver a product or service to an end customer’. Of course some
functions are much more operationally intense and directly relevant to the delivery of the
product or service than others. But the key point is that Operations is a pan-functional
activity which lies at the heart of value creation and its performance and improvement
therefore require perspective and cooperation across functions.
This is important and helps to explain why functionally-focussed improvement activity or
risk and value analysis are typically much less effective than their cross-functional
equivalents. An additional factor here appears to be people’s functional backgrounds
www.dsiOps.com office@dsiOps.com

2. and training, which naturally tends to influence their comprehension of and approach to
such activity and may serve to reinforce functional silos somewhat.
We offer in the figure below an indication of the scope of Operations, which puts our
working definition of the term in context.
Scope of ‘Operations’
Executive
management
Accounting &
finance Research &
technology
Product &
service
development
Human processes Marketing
resources
Sourcing,
Selling &
production &
customer
customer
retention
Information service
processes
technology delivery Strategy
processes
Operations
‘The people, processes and systems working to deliver a product or service to
an end customer’
© Diligence Services International Limited 2008
The three conjoined circles at the centre of this model indicate the basic processes for value
delivery rather than simplistic functional definitions which are, in varying degrees, core to
Operations. Whilst all other functions, as represented by the outer ovals, of course have
relevance to Operations, some impinge more directly and are thus considered as within the its
‘scope’ for our purposes.
An example, which we will explore further in the second part of this brief paper, of how
improvement limitation can arise if a pan-functional perspective is not taken is in the area
of performance measurement. The type of performance metrics that individual managers
have an in-depth understanding of, and thus tend to favour in practice, often derives
largely from their functional specialisms. This can easily result in measurement
disconnects between operational value drivers and the financial outcomes which are
desired from the overall business/investment point of view.
Another aspect of investing in acquisitions where a more pan-functional perspective on
the business helps is in the pre-deal briefing of due diligence advisors. When taking our
place alongside financial, commercial and other functionally-orientated advisors we have
observed, and encouraged, potential for increased co-operation between parties, and
thus enhanced overall value-add for the commissioning investor, when viewing the target
Page 2 15/05/2009

3. more along the lines set out above. One reason for this is that each diligence
‘specialism’ has significant interface issues which affect the others, and ensuring that
these are addressed properly (which is not always the case) increases the chances that
the due diligence process will make the most of the one-off opportunity to understand
the target and decide what, potentially, to do with the asset post-deal.
One example of these diligence interface issues is understanding customer demands
and business growth potential, as determined by commercial due diligence, and then
proceeding to ensure that operations is in (or can be in, at acceptable pace) a condition
to deliver upon them. Another is communicating effectively the financial implications of
proposed operational restructuring and other factors to the holders of the investment
financial model. Whether that is the financial advisors or the investment sponsor direct.
Building a more common perspective of Operations based on the above scope and
definition can certainly help investment success in practice. This applies both in the
identification of potential investment value and risk, and in the nitty-gritty of operational
performance improvement. As already mentioned, a specific example of where a shared
perspective adds value is in the dovetailing of financial and operational metrics.
Dovetailing financial and operational metrics
In carrying out both due diligence and restructuring planning pre-deal and supporting
performance improvement post-deal, we often find that measurement and improvement
targeting disconnects exist between the operational drivers of and constraints to value
and the financial outcomes being sought. When this is the case, the disconnection is
invariably a significant contributor to financial under-performance and thus represents an
opportunity to increase business value.
When making the reconnection, it helps to focus first on the financial outcomes targeted
and then align the operational metrics accordingly. In doing so each factor of the
business operations that drives operational value and each that constrains it should be
considered in turn. However viewing and addressing both drivers and constraints should
be done on a pan-functional basis or improvement progress will be distinctly sub-optimal.
The following table illustrates the point by way of an actual, and not untypical, case
where the target business had multiple manufacturing facilities and sales offices.
Generic Financial ‘Process’ measure
operational value Key issue ‘outcome’ / improvement
driver measure targets
Cost of sales by Limited, inconsistent
Improving Poor individual
individual and not shared
productive asset production plant
manufacturing production KPIs and
utilisation performance
country targets
Value of RM, WIP
Optimising working High inventory No other measure
and FG by
capital levels or specific targets
individual country
Optimising
Fragmented order No measure or
product/service SG&A % revenues
fulfilment processes target
delivery
Page 3 15/05/2009

4. Under previous owners the business was federally and functionally organised and there
was virtually no cooperation and improvement activity either across sites or across
functions within sites. As a result there was little or no measurement or target setting
aimed at addressing key issues which involved multiple functions and represented
substantial opportunity to add value and drive financial outcomes in the desired
direction.
All of this was of course an opportunity for the acquiring private equity house and the
restructuring plans developed pre-deal while due diligence was being carried out
included actions to reorganise the business and manage its performance with an
emphasis on pan-group and cross-functional cooperation. Post-acquisition, operational
metrics were audited in detail and new measures and targets introduced which aligned
with the financial outcomes required by the exit plan, with emphasis on EBITDA and
cash flow improvement generally.
This example serves to illustrate that by understanding the sources of value and risk
which exist in the particular circumstances involved when planning improvement /
restructuring initiatives, metrics can be designed that dovetail with the financial outcomes
sought and greatly aid their achievement. In our next paper, due to be published in
August 2009, we will explore further the sources of operational value and risk which
determine in significant part the potential shareholder value of acquisition investments.
Our next paper in this series about operational value and risk in mid-market M&A
is due to be published in August 2009. In that paper we will explore the balancing
of value, pace and risk (part 1 of 2), and in particular the sources of value and risk.
Contact
Ian Hackett Simon Jones
+44 (0)7710 306943 +44 (0)7802 304622
ian.hackett@dsiOps.com simon.jones@dsiOps.com
Note
This paper is one of a series written, either individually or jointly, by the two founder
directors of Diligence Services International Limited. It is copyright material and intended
for the sole purpose of being of benefit and general interest to our present, past and future
clients. The material should not be used by any other party or for any other purpose.
© Diligence Services International Limited 2008
Page 4 15/05/2009