Operational Due Diligence Explained: Definition, Framework, and Checklist

read
131reads

Operational due diligence is essential for the M&A process —  38% of corporate dealmakers and 36% of private equity managers attribute deal success to effective operational due diligence.

In this article, we dwell on the operational due diligence basics, its objectives, and its framework. Additionally, we provide an example of an ODD checklist and suggest several virtual data room providers that can essentially improve the ODD process.

What is operational due diligence?

Operational due diligence (ODD) is the type of due diligence that focuses on the investigation of the target’s operations and business model to ensure it’s worth an investment and can potentially bring expected post-merger synergies.  

The operational due diligence process typically involves examining various operational components such as processes, systems, controls, and management practices to understand how well the target business is managed and to identify any potential operational risks that could impact its performance or value.

The role of operational due diligence in private equity and M&A is essential. It helps deal-makers and investment managers in private equity funds and hedge funds assess the target’s operations prior to the transaction and project its value-creation opportunities. This, in turn, allows for the understanding of whether to step into the transaction or walk away.

“Historically, operational due diligence had a narrow remit — it was focused on the quality of assets as opposed to being value-focused. Today, we’ve moved toward a more expansive and cohesive approach that considers, for example, how you can best integrate components of digital, commercial, technology, HR, and operational value creation together to come up with a plan that improves the potential for the asset.” says Neil McFerran, EY.

Main objectives of operational due diligence

By conducting operational due diligence, deal-makers and fund managers typically pursue the following goals: 

  • Assessing the target’s sustainability into the future. The key objective of the ODD is to assess the target’s value-creation potential in the future on the basis of the review of current operations. Operational due diligence reviews the target’s current operational processes and projects the outputs they can bring to the buyer after the transaction.
  • Investment risk identification. ODD aims to identify and assess operational risks within a target company or fund. These risks can include regulatory compliance, financial controls, operational efficiency, cybersecurity, and business continuity planning.
  • Operational risk management. Effective operational due diligence, if performed by the sell-side before the buyer’s, allows for identifying potential risks and pitfalls, such as compliance or legal issues, and timely addressing them. This significantly minimizes the chances of the buyer finding problematic areas during their ODD, which accelerates the transaction.
  • Operational efficiency assessment. ODD seeks to understand the effectiveness of the target’s operations. This includes evaluating processes, procedures, technology systems, and organizational structure to identify areas for improvement.
  • Verifying business continuity. This implies ensuring that the business has effective contingency plans and disaster recovery measures in place to mitigate potential disruptions to its operations, such as natural disasters, economic downturns, or technological failures.
  • Compliance assessment. This is about assessing whether the target complies with relevant laws, regulations, and industry standards. This includes evaluation adherence to regulatory requirements, such as anti-money laundering (AML) and know-your-customer (KYC) regulations. 
  • Extra actions identification. This is about the actions and investments that are not seen or considered by the target company but are needed to accelerate the value creation moving forward.

How ODD differs from other due diligence types

Operational due diligence is the part of the due diligence process that includes other types of due diligence as well. Let’s take a look at how ODD differs from other types, specifically financial and legal.

AspectOperational DDFinancial DDLegal DD
PerspectiveForward-lookingPresent- and backward-lookingPresent- and backward-looking
FocusOpportunity-focusedRisk-focusedRisk-focused
ObjectiveCreate valueProtect valueProtect value
ProcessOngoing monitoringFinishedFinished
OutcomeActionable value creation planFinancial risks and value drivers definedLegal risks and potential liabilities defined

Operational due diligence framework 

Operational due diligence should answer the two main questions:

  1. What are the target’s operational upsides and full potential?
  2. What post-merger synergies are expected?
  3. What will we do with the target’s operations, when it’s ours?

As a result of ODD, a proper value creation plan is drafted. It comprises a prioritized set of value-creation opportunities and a plan of action that describes how to mitigate the execution risks and capture upsides.

Now, let’s briefly review the most common areas of the operational due diligence framework:

  • Financial position and business model
  • People and organization
  • Business continuity and disaster recovery
  • Operational infrastructure
  • Legal and regulatory compliance

Financial position and business model 

Assessing the current financial position of the company as well as its business model is one of the key objectives of ODD before investments. It implies scrutinizing the target’s financial health and evaluating factors like revenue streams, profitability, debt levels, and cash flow dynamics. 

Knowing these and understanding the business model helps project the company’s ability to generate sustainable returns and weather economic downturns.

People and organization

The way human capital operates within the company significantly impacts the overall company’s performance. What’s more, 42% of dealmakers attribute deal success to management work and commitment. That’s why it’s an integral part of ODD.

Source: Statista

Operational due diligence examines the competence and stability of the management team, organizational structure, and human resource policies. The buyer (or fund managers) analyzes key personnel, their qualifications, turnover rates, and the effectiveness of internal controls to ensure the company has the talent and leadership necessary for success. 

Business continuity and disaster recovery

This aspect focuses on the company’s readiness to withstand and recover from unforeseen events such as natural disasters, cyber-attacks, or operational disruptions. An acquiring company or fund managers review contingency plans, IT infrastructure resilience, data backup systems, and insurance coverage to assess the company’s ability to maintain operations during crises.

Operational infrastructure

This area evaluates the efficiency and reliability of the company’s operational processes, including production facilities, supply chain management, and technology systems. 

ODD reviews such factors as capacity utilization, maintenance practices, vendor relationships, and the level of automation to identify potential weaknesses or areas for improvement.

Legal and regulatory compliance 

It’s essential to ensure the target company adheres to relevant laws, regulations, and industry standards before proceeding with the transaction. 

Operational due diligence investigates the target’s compliance with labor laws, environmental regulations, intellectual property rights, and contractual obligations to mitigate legal risks and potential liabilities that could impact the company’s operations or reputation.

Operational due diligence checklist

Let’s look at what an operational due diligence questionnaire or checklist can look like. 

Note: This is just an illustrative example. You can tailor it to your business needs and use it when you conduct operational due diligence in your case.

AreaChecklist ItemsKey documents to review
Financial position and business modelReview financial statements for accuracy
Assess revenue sources and profitability
Evaluate business model for sustainability
Analyze financial projections
Financial statements (income statement, balance sheet, cash flow statement)
Business plans
Financial forecasts
Budget reports
People and organizationReview organizational structure and key personnel
Assess employee morale and turnover rates
Evaluate talent acquisition and retention strategies
Review succession plans
Organizational charts
Employee handbook
HR policies and procedures
Employee satisfaction surveys
Succession plans
Business continuity and disaster recoveryReview business continuity plans and disaster recovery procedures
Assess the resilience of critical systems
Identify potential risks to business operations
Evaluate insurance coverage
Business continuity plans
Disaster recovery plans
Risk assessment reports
Insurance policies
IT infrastructure documentation
Operational infrastructureEvaluate operational processes and workflows
Assess the scalability of infrastructure
Review technology systems and IT infrastructure
Identify weaknesses in operational systems
Standard operating procedures (SOPs)
IT infrastructure documentation
Technology vendor contracts
Process maps
Legal and regulatory complianceReview licenses, permits, and regulatory filings
Assess compliance with laws and regulations
Evaluate any legal issues or regulatory actions
Confirm contractual obligations
Business licenses
Permits
Regulatory filings
Contracts
Legal correspondence
Compliance policies and procedures

Improve the ODD process with virtual data rooms

Modern dealmakers and investment managers improve the operational due diligence process by using virtual data rooms (VDRs).

Virtual data rooms offer a variety of dedicated features that enable secure and efficient data sharing which is essential for the due diligence process. Virtual data room vendors provide their clients with a highly secure cloud space for sensitive data sharing and enable effective collaboration for both deal sides.

If you’re searching for a VDR provider for your business needs, consider the following industry leaders:

  • iDeals. iDeals is a VDR provider with 15+ years of experience that takes customer service as a top priority. Eight levels of granular access controls, 24/7 in-app live chat support, customizable branding, desktop app synchronization, and advanced Q&A workflows offered by iDeals grant their clients a pleasant yet highly secure experience.
  • Ansarada. Ansarada improves the client experience and deal flow with dedicated AI-based tools. What’s more, such features as four levels of granular access controls, built-in redaction, and remote wipe ensure data safety, while the dedicated Deal Workflow tool enables multiple project management.
  • Datasite. Datasite is a reliable data room provider with more than 50 years of experience that targets various business needs: from mergers and acquisitions to project management. Datasite helps accelerate business deals with such dedicated products as Datasite Diligence, Datasite Acquire, Datasite Prepare, and Datasite Outreach.

Note: Visit our main page for more of the top virtual data room solutions.

Summing up

Let’s briefly summarize the main points from the article:

  • Operational due diligence is the investigation of the target’s business model and operation to ensure it’s worth investing in and can potentially bring expected post-merger synergies.
  • The main objective of ODD is to identify how the target’s current operations can foster value creation in the future and whether there are any risks and pitfalls that can hinder the deal’s success.
  • The main difference between ODD and other due diligence types is that it’s forward-looking and opportunity-focused, while other DD types are present- or backward-looking and risk-focused.

Author

Ronald Hernandez

Founder, CEO at dataroom-providers.org

Data room selection & optimization expert with 10+ years of helping companies collaborate more securely on sensitive documents.

Recommended for you

Due Diligence
120reads
Customer Due Diligence: Types, Stages, and Requirements
read
We use cookies on our website to ensure the best user experience. By clicking "Agree" you are letting us use cookies according to our cookie policy. Learn more