The pre-sign diligence phase is a critical point in the deal process, which if used properly can generate significant value for the investor. The majority of private equity firms leverage this phase to validate the firm’s financials, conduct strategic diligence, and required legal diligence. However, with the access provided to the company and management team, an increasing number of investors and their operating teams can also get a head-start on their value creation plan with a focus on execution. In addition, proper diligence may also uncover value items which can work as negotiating levers to offset the purchase price.
There are three key outcomes the team can develop to better support the investors:
Focus on Value Creation Execution
Beyond red flag analysis and validation of cost structure, operational diligence should provide an informed and executable value creation plan across the entire P&L. The output should identify discrete time-phased initiatives that will unlock run-rate and one-time improvement. The plan should be focused on the “how to” not just the “what.” Topline value creation planning are not usually as scripted or focused on execution due to uncertainty. However, the elements of the topline growth thesis should be understood and incorporated into planning to ensure EBITDA expansion initiatives are aligned with the growth ambitions of the investor.
Identify your Working Hypotheses for the Target Operating Model
When you are conducting the pre-deal diligence, the operational diligence team should identify potential fit-for-purpose target operating structures to support the deal thesis, revenue plans, and resourcing that will fit within the proposed cost envelope. This is a critical task as it will help to inform your views on the required skillsets of the management team, support the validation of the existing leadership team, and help define the incentive structures required for the leadership team. It is also helpful to understand what key hires may be required prior to deal close, as this stand-up may require equity funding.
Identify Value Levers
One-time costs and costs to achieve savings are a typical output of this phase of diligence. The teams should develop a working budget with detailed line items of expenses that the company should incur. As there will be some uncertainty that remains, it is typically advisable to put in place a buffer in your financial plans for unforeseen expenses and execution mis-steps. The one-time costs will typically fall between 75% to 125% of the run-rate improvement identified in the value creation plan. In some situations, we have seen these costs leveraged as offsets or elements of the deal negotiations.
Driving toward these three key outcomes will support your engagement with management in the pre-close planning phase of the deal and provide the investors with an informed view of value creation priorities as the asset enters your portfolio.