"Doing" Due Diligence Right

For an American like me, the Chinese language is a source of insights that unveils the reality in an often more precise way than English. In an economic downturn like the one the world is experiencing now, the Chinese word for crisis – consisting of one character for risk, and the other for opportunity – very well explains the reality of the current market. The environment obviously is putting lots of companies at risk, but at the same time the Chinese way of viewing the situation is a very accurate one. With the proper approach, tools and insights, the opportunities for Chinese companies can not be over estimated.

Right now, many multinational companies find themselves in a process of restructuring and consolidating their portfolios and are increasingly willing to sell divisions and units outside their core strength. Unattractive financials, second-in-class operations or a generally challenging market environment often makes selling these assets a sensible option. In many cases these business units have assets (i.e. patents, strong brands, and established sales channels), that could provide bigger opportunities and value to a Chinese acquirer than to an American ones.

The current times also offer unique opportunities to pick up acquisition targets at very good prices. Many sellers have limited choices today. Some have taken too much debt in the years when it seemed any investment seemed certain to give excellent returns and have to now sell assets to repay their creditors. For Chinese companies, who have not been hit by the recession as hard as American ones, this opens up a never before seen chance for foreign acquisitions. However, in times of severe economic stresses, when the future direction of the economy is not clear, it pays even more than usual for acquirers “doing” the due diligence right – or the opportunity will be over shadowed by unnecessary risks and ultimately lead to failed transactions and acquisitions where the buyer was unaware of the processes available to make a proper evaluation of a company – from every possible aspect.

Why Transactions Fail

We find that a majority of deals which are falling apart are doing so due to over-valuation, over-payment and over-leverage. What’s missing when new and previously undiscovered opportunities are arising is a temporary breather that allows both sides, especially the buyers, to perform thorough analysis and due diligence. Such a breather lets them figure out whether the impending transaction is a good one or one that will never justify the sales price.

Companies know that some transactions don't make good business sense. But in their rush to move forward and to put their capital to work, they often are overly focused on the close, and forget about due diligence. That oversight can lead to financial disaster. Due diligence, when done right, can differentiate those companies for which an infusion of capital makes sense, from companies where more capital will simply paper over deep-seated and fundamental deficiencies in their operations and finances.

“Doing” Due Diligence Right

Performing thorough transactional due diligence helps buyers (and sellers) identify weaknesses and gaps that can be remedied or explained, and that can be exploited for negotiating leverage. In other words, due diligence allows the buyer to find out everything that it needs to know before taking the plunge. This then allows the buyer to either withdraw from the deal or adjust the deal’s valuation and have any uncovered problems remedied in time before the deal goes ahead.

In a broader sense, due diligence is an important risk management tool, perhaps the most important, which explains why it is a critical process for companies about to make a transaction. A thorough due diligence process helps analyze and establish the difference between a good and bad deal. It also evaluates inherent risks and opportunities in a deal, and puts all the facts on the table.

Beyond the Financial Due Diligence

Traditionally, when companies consider the transaction due diligence process, they think of financial due diligence; i.e., the very critical audit performed by accounting firms of company financial statements, records and books, to determine whether the target company is financially viable, and whether the price that’s being paid is in the ballpark. Financial due diligence provides peace of mind by analyzing and validating all the financial assumptions being made. It also uses past business experience to form a view of the future and confirms that there are no “black holes.”

Though financial due diligence is critical, the due diligence process is still incomplete if that’s all one does. Though acquirers can employ financial engineering to shore up the books, companies still can’t grow without being operationally sound. We spend an inordinate amount of time looking at a potential acquisition's trouble spots, and those are often not visible in the financials. Operations and “qualitative” due diligence (i.e. tangible factors such as strategy, culture, risk profile, and company management) are all checked out thoroughly before we give our clients the go ahead. Of course, this does not lessen the importance of financial due diligence, but merely demonstrates that in today's hyper-competitive world, purchasers need to be careful in their assessments of all the facets of a company. To go beyond financial due diligence is especially critical when the buyer and the seller are from different countries and cultures. The operational processes and the common view of what is “best practice” might not be evaluated in the same way – something that increases the risk of failed transactions due to lack of understanding.

Priority Operations

A recent client assignment offers a perfect example of why companies should perform across the board due diligence (financial, operational and strategic) before moving forward on a transaction. We were recently engaged by a private equity firm to perform due diligence on a manufacturing company in the metals industry. The client was going to serve as a second lien lender in the transaction. Our financial due diligence revealed a balance sheet that was heavily leveraged, which was troubling, but we didn’t stop there.

A major part of our due diligence of the metals company was operational. For example, BBK operations professionals toured the plant facilities and reviewed the operational metrics and manufacturing techniques that the company used. What we found was typical. This was a company that claimed to be using lean manufacturing techniques, but in reality, some of their manufacturing employees didn’t understand the principles of lean manufacturing, and had to rely on charts and graphs hanging throughout the plant. This gave us and our client, the private equity firm, a major reason to reconsider the acquisition, because the proposed aggressive productivity improvements and cost savings were supposed to rely on the lean manufacturing process. Unfortunately, it was clear by our operational due diligence that the company was not quite ready for such productivity improvements nor cost savings.

Next up was the qualitative due diligence process. We performed individual assessments of the company’s management team, interviewing the Chairman, CEO, CFO, and Vice Presidents of HR, Technology and the plant managers. No stone was (or ever is) left unturned. We analyzed their backgrounds and industry experience and tapped our network to get references. Every member of the team was given a grade, from A to F, and at the end of the day, our intense analysis indicated that the management team didn’t make the grade. BBK’s experience and network within the industry and the market made it possible for us to make this conclusion. Knowledge about the local market and local ways of doing business is imperative when assessing managerial skills, allowing the acquiring company to make a decision based on objective rather than subjective factors.

After further assessment of the target’s risks and growth opportunities, we compiled all the evidence from our due diligence process and concluded that our private equity client should seriously reconsider the transaction. We encouraged them to take a long, hard look at the pricing of the transaction, particularly given the risks, which we thought were substantial. The target had a mediocre management team, charged with implementing a difficult strategic plan with cost reductions, which was based on an incomplete rollout of lean manufacturing techniques. Coupled that with a balance sheet that was highly leveraged, and the chances of success were slim.

Having reached that downbeat conclusion, there was still a window of opportunity, which hinged on the target company considering additional pricing options on the loan. However, our client never got the chance to offer the metals manufacturer a second chance. In this highly competitive deal environment, it is not difficult to find a white knight, and that’s exactly what happened. But this time, there was no happy ending, except for our client. Before the target company had a chance to offer additional pricing options on the loan, the investment banker who brokered the deal found another private equity firm to provide the capital. To our knowledge, the second PE firm did not perform any due diligence and was only basing their investment decision on a report from other advisors within the main equity group. In their rush to get the deal done, the second PE firm put risk management aside, and they soon found themselves in the middle of a transaction gone bad. Sixty days after the second PE firm moved in, the deal died.

Bad Deals Gone Good

Due diligence doesn’t always produce thumbs up or thumbs down decisions. There is a lot of gray area, and that’s where operational expertise can determine the difference between a deal worth pursuing and a deal that should be turned down. However, not only can operational due diligence tell you when to step away from deals that others might rush into, it can tell you to move forward with deals that others run away from. We have been part of turnaround situations where, because of our operational due diligence, we were able to recognize value that wasn’t apparent until the company was evaluated from all aspects in the due diligence process.

For example, several years ago, BBK was brought in to manage a brake coatings plant that we had just brought out of bankruptcy. Under normal circumstances, most companies would have walked away from the company. The factory had half-installed equipment and a high scrap rate that exceeded 50%. The factory produced coatings that would more often than not corrode the steel in brake components they were meant to protect. It was an enormous challenge, but because of our operational expertise, we recognized the turnaround potential.

Three months later, new equipment had been installed and was up and running. Within 18 months, we had redesigned and retrofitted much of the plant, and extraordinarily, had reduced the scrap rate to seven parts per million. Production rates continued to climb and labor costs were slashed, and by the time we sold the company it was designated a world class supplier by one of their key customers. Without our expertise in operational due diligence, we would never have seen the potential in the company’s production line, and the turnaround, and subsequent value creation, would never have happened. Though the previous owners may have tried to turn things around financially, they may not have had the operational expertise to figure out how to turn the company around.

As a conclusion, the current financial climate creates many chances for Chinese companies who are looking to acquire abroad. With the proper due diligence processes, not only can bad deals be avoided, but also unlikely deals can be discovered and profitable and strategic deals made. As long as Chinese firms take a structured approach when acquiring, we are confident that the opportunities will be greater than the risks – something that not only will benefit the Chinese acquiring companies but in the long run also the sellers, the employees and the economy as a whole.

About the author: Duane Bolinger, Gasgoo's columnist, is Managing Director of BBK Consulting Co., Ltd. of Asia Pacific. Prior to BBK, Bolinger's senior roles with automotive companies have included Managing Director of ASIA Pacific, Corporate Finance Director, Business Line Executive, and Director of Strategic Planning for General Motors Worldwide Purchasing and Production Control.