Dsi papers series 1 paper 4 - nov 09


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Assessment of operational value and risk in mid-market acquisitions - value maximizing framework; balancing value, pace and risk

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Dsi papers series 1 paper 4 - nov 09

  1. 1. Diligence Services International The Shire, Chalk Road, Ifold, West Sussex, RH14 0UA, UK DRAFT FOUNDER DIRECTORS’ PAPERS SERIES 1 – VALUE AND RISK; THEIR ASSESSMENT AND MANAGEMENT PAPER 4 – BALANCING VALUE, PACE AND RISK (2): THE INTERPLAY OF VALUE, PACE AND RISK This is the last in a series of four brief papers which explores the assessment and management of operational value and risk in mid-market acquisitions. The paper will discuss:  A value maximising framework and;  Based on another DSI model which represents our practical approach to balancing value, pace and risk - consider in turn the interplay of: o Value with pace, o Value with risk, and o Pace with 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 3 of this series we discussed the sources of value and risk, example improvement areas, and implementation issues. We concluded that understanding how the sources of value and risk are accessed in a timely fashion, in the context of the investment objectives, is often harder than identifying them. This Paper 4 seeks to illuminate these accessibility and timeliness aspects of managing operational value and risk in mid-market acquisitions. Value maximising framework The following ‘Value maximising framework’ is intended to summarise the key drivers of and constraints to the release of business value to give context to the balancing of value, pace and risk. By way of explanation of the model: the free cash flow of a business, which of course needs to exceed its cost of capital before shareholder value-added becomes positive, can be seen as held in balance by opposing influences. These are constraints, which tend to limit business performance, and operational value drivers, which tend to improve it; the principal ones are indicated in the framework. It is our long and repeated experience that viewing and addressing both constraints and drivers should be done on a balanced, pan-functional basis or improvement progress will be distinctly sub-optimal. This is increasingly the case as successful exits more often involve the need to make substantial positive impact upon the functioning of operations, rapidly, in order to increase the value of the acquired asset. This has led us to evolve an www.dsiOps.com office@dsiOps.com
  2. 2. approach to the timely release of value and management of risk which is discussed in the remainder of this paper. Value maximising framework Constraints Lack of finance / Management team Sub-optimal strategy Inadequate processes, Culture & change financial awareness capability/capacity & core processes systems & measures capacity Shareholder value Free cash flow Operational value drivers + Cost of capital - Identifies key value drivers, value potential, constraints and risks © Diligence Services International Limited 2008 A model for balancing value, pace and risk We have developed the model below based on many years of experience working in operational aspects of M&A. Our working definition of operations being, as discussed in previous papers (mainly Paper 2): the people, processes and systems working to deliver a product or service to an end customer’. We also discussed in Paper 2 that Operations is a pan-functional activity and its performance and improvement therefore require perspective and cooperation across functions. Some of the other functional activities which impinge on operational processes do of course have varying degrees of relevance to and impact on overall performance than others, but taking a pan-functional approach to releasing business value and managing risk is fundamentally important. Otherwise accessing value at an appropriate pace will be much impaired. The ‘Balancing value, pace and risk’ model emphasises the importance of balance when addressing these three key dimensions because in practice a degree of ‘trade-off’ between them is inevitable. If, for example, it is believed that a cost benefit through substantial headcount reduction is possible as a means to increase value, there will be limitations on the pace at which this can be implemented and possibly major risk implications. Although of course much depends on the extent of over-resourcing and the Page 2 30/09/2009
  3. 3. sector concerned, an unplanned ‘knee-jerk’ approach to headcount reduction has often been seen to be very unwise indeed. Our approach – balancing, value, pace and risk Sources of value  Revenue stream growth  Cost element efficiency  Working capital efficiency  Asset efficiency Value Value - Pace Value - Risk  Identification of risks  Scope & scale of changes  Mitigation plans  Management capability  Design of financial impact model  Organisational capacity Creating  Levels of sensitivity Programme structure  value  Tolerance for risks  Impact timing assessment in operations Pace Risk 5 © Diligence Services International Limited 2008 Sometimes the pace and risk implications of intended improvement actions are far less obvious, but always exist to some extent. Appropriately tailored, detailed planning and on-going monitoring during implementation seldom fails to yield substantial payback in operational improvement initiatives to release business value; especially if it is started early in the due diligence process. We discussed the sources of value listed in the model in Paper 3 and the three aspects of the ‘creating value in operations’ triangle of forces are explored hereunder. Value - pace Some key sources of potential value are of course usually identified very early in the pre- deal process and pointed-to in vendor-provided and other sector information. However the magnitude and practicality of these opportunities will not always be as hoped and the appropriate starting point is therefore a high-level review to identify, scope, scale and prioritise all the actual key value opportunities that exist in the particular circumstances. Informed by this review, it is necessary to make an assessment of the management and broader organisational ability to cope with proposed improvements within the time available; critically, this should be in terms of both capability and capacity. Given that financiers are astute in selecting of management teams that they back, this is often more Page 3 30/09/2009
  4. 4. about the latter than the former. Nevertheless, we are often asked for our view on the ability of the management team from the operations perspective, and frequently there are gaps in the capability of the team that have already been identified and need to be filled through the time consuming and inherently risky business of recruitment. Not being realistic about what the management team can achieve within the time before exit is a common source of disappointment, which can be reduced by assessment and planning. As to the broader organisational capability and capacity, this is sometimes assumed to be adequate on the basis that senior management is there partly to ensure that it is. However, putting these in place is usually another task, additive to and competing with the various improvement initiatives being heaped on their plate during an already very demanding period. There are of course multiple facets to the broader organisational competence - falling into the general and interacting categories of people, processes and systems - some of which are much less apparent than others and well worth understanding early-on. Once an understanding of the value potential opportunities and management and organisational resources is available, it becomes feasible to design an appropriate improvement programme structure. In practice this is a reiterative process and benefits from input and feedback from various involved parties. Assessing the expected timing of financial and organisational impacts resulting from key improvement initiatives is an important aspect of the reiteration process leading to a viable programme of operational performance improvement. Using this approach, collapsing the overall elapsed time required by optimising parallel activity without creating overload can also be achieved. Value – risk The key risks of proposed value-releasing improvements will often have presented themselves, in part at least, during the review process thus far. However a more comprehensive assessment of risks and plans for their mitigation and management will be required. Also the levels of tolerance and sensitivity, in terms of both risks and financial outcomes, implied by the proposed initiatives should be well understood up- front. In planning operational improvement and controlling the value-risk aspects, the programme length, costs, benefits, other financial impacts, risks, sensitivity and tolerances are all clearly inter-related. Primarily for this reason we have devised a high- level financial impact tool which can be used to scenario-model the financial outcomes of proposed operational changes, typically over a 3-year timeframe, and bridge the operational and financial perspectives. Although the modelling is carried out at a high level, the tool is supported by shorter-term plans and cost/benefit, risk and sensitivity analyses that involve a method of working through proposed changes in significant detail where appropriate and beneficial. In financial terms, the tool models at a high-level the delta financial impact of key operational changes on the base metrics of a given year, as an adjunct to diligence and restructuring planning. It is based on a limited set of key opening financial metrics as available and considers the impact of proposed operational changes upon them. It does not forecast the resultant metrics as at the end of each year in the planning timeframe but the model output can be converted to populate the ‘operational lines’ in a corporate finance or similar model. The tool simplifies, makes clearer to the mind, promotes Page 4 30/09/2009
  5. 5. discussion and facilitates inputs from multiple parties if appropriate. It looks at financial outcomes of operational root causes and strips out potentially confusing factors such as financing, tax, inflation, etc. A manageable number of scenarios can be reiterated and modelled relatively quickly and the tool also provides a basis for monitoring, course correction and re-evaluation Pace - risk The classic manifestation of problems in the pace-risk area is of course what is often referred to as ‘initiative overload’, which can occur very readily especially in these times of excessive extraneous complications such as problems in the economy, increasing regulatory burdens and political change. Beyond avoiding potential problems by dealing with the foregoing factors in the manner suggested, an effective continuous monitoring and course correction review process can certainly pay off. The DSI tool referred to above is one way of providing a sound basis for overseeing operational/financial progress in this way. In conclusion Striking a balance between value, pace and risk may sometimes expose the fact that operational change cannot realistically be brought-about as quickly as first hoped based on the original deal rationale. However the good news is that there are often other compensating ways to improve beyond those that are immediately obvious. Starting-out with a realistic operational improvement plan that still gets close enough to the desired outcome can, observably, substantially raise the possibility of success and avoid a great deal of turnaround effort and cost later in the investment cycle. We very much hope that this series of DSI founders’ papers on assessing and managing value and risk in mid-market M&A has been of value to you and stimulated thought on how the success rate of these deals really can be increased. Although this paper is the last in our Founders’ series, we will be continuing to publish occasional articles and supporting case studies primarily about operational aspects of mid-market M&A. We will of course continue to welcome your feedback and requests for papers on particular aspects of interest to you. 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 2009 Page 5 30/09/2009