Green Peak

Does your new investment have a ‘scary basement’? Organizational Due Diligence is the secret to creating value in M&A.

John thought he had done everything right. This was his third investment as a Principal and he followed the FirmVest playbook to a “T”. His Quality of Earnings opinion was solid, critical legal questions had been resolved, and the market diligence supported a bullish case on demand accelerating faster than expected.  The management team said all the right things during diligence, and the background checks and references came back quite clean for a company of this size. Yes, the technology was a little dated, but the CIO had a clear plan for updating the right systems. So why, six months after successfully wooing the sellers and winning the bid, was Sarah calling him into her office and challenging his underlying investment thesis? Why was the CEO clearly beginning to avoid him, and why was John spending half his week on a connecting flight far away from his family?  This portfolio company was quickly becoming the bane of his existence. What did he miss during diligence and how had this all gone so wrong?

If you’ve been an investor for any period of time, you know this scenario well. Perhaps it has even happened to… your friend? It’s why you invest substantial time and money in diligence to reduce knowable risk as much as possible. As an investor, you also know how critical having the right team in place is for the success of your investment.  The right CEO, surrounded by high performing talent, can work their way out of most situations where mediocre leaders would fail.  Yet, think about your last investment committee presentation; what percent of the diligence was dedicated to the quality of the management team, and the next layer of the organization? Did you effectively evaluate the talent and performance management programs to ensure they were incentivizing the right behaviors?  Are you sure that the org chart is aligned to the strategy and set up to scale the company as rapidly as your bull case on revenues? If you’re like most investors, the answer is probably not.  We find that the average investment committee document has a couple of pages at most dedicated to these critical people issues while the vast majority are focused elsewhere.  Yet, the organizational issues are just as likely to undermine your investment as the market dynamics are.  You wouldn’t buy a house without hiring someone to conduct a thorough home inspection.  So why take such a risk on a multi-million-dollar investment? 

“John” took that risk; he justified it because he was afraid of losing the deal if management was pushed too hard about the quality of the people on their team.  He also didn’t know where to turn; his firm had always relied on networked references and management team meetings to gauge the quality of the team.  Unfortunately, the risk he bought came to fruition.  The company he invested in had a CEO who was not prepared to lead the organization through the next phase.  This CEO actually hadn’t been actively driving the firm for the prior two years; he had all-but-retired and much of the organization was being run by a President who was pushing orders out the door and papering over substantial quality concerns.  The organization was tired, disengaged, and largely working to the letter of their contracts and job requirements.  All of this could have been identified during diligence, but it doesn’t show up in the “tried and true” methods.  Especially when the CEO is a savvy individual, battle-tested by prior investment rounds and well prepared for the meetings.

At Green Peak, we believe that performing an effective organizational due diligence is more important now than ever before.  Gone are the days where returns were mostly a result of financial engineering or even operational excellence. Deal valuations are soaring as a smaller number of deals are being chased by an ever-growing pool of money.  Many of these deals are for companies that have already been owned by a professional investor, and the low hanging fruit has been picked clean, from operational improvements to bolt-on acquisitions to sales force effectiveness.  New tools are required in order to create value, and undoubtedly managerial talent and the supporting infrastructure will be a critical part of the value creation roadmap.

Having conducted over 130 Organizational Audits and Reviews, we have learned a lot about creating the blueprint for scalability and identifying blockages to growth.  Our approach begins with a thorough understanding of the investment thesis:  what is the core rationale supporting this investment and, more importantly, what will the company need to do differently to achieve the goals? From this, we conduct a series of interviews with the critical leaders who will be responsible for leading the company in its next phase of growth.  We seek to answer four fundamental questions:

  • What is great about the company?  What are the foundational pillars that have fueled success to date and will be required in the future?  (Spoiler alert:  avoid changes that accidentally knock these out!)
  • What is missing from the company if it is to be successful in reaching its goals in three to five years?  What are the functions, capabilities, and organizational needs that must be strengthened to support a far larger organization?
  • Where is the company’s talent or organization infrastructure ill prepared to scale?  How might that undermine the investment thesis and how can we mitigate those risks?
  • How should the company phase those organization and talent investments?  Too much too early can be as detrimental to growth as too little too late.

These questions, and the sub-questions we use to unlock the answers, result in a clear fact-base that management and the new board can use to build a meaningful “First 100 Days” plan and ongoing org blueprint.  These two parties can be fully aligned on the state of the company today and therefore the steps needed to achieve success.  On average, our clients report advancing the value creation agenda by 6-9 months as a result of knowing this fact base in the first days of the new partnership vs.  ‘tripping on hidden land mines’ over the first year.  And by eliminating those 6-9 months of wasted time, their investments can be realized on a faster trajectory. 

What types of issues will organizational due diligence uncover?

First, know that the example that befell “John” was not conjured out of thin air.  It represents an actual outcome but the circumstances described are an amalgamation from two other diligence projects we conducted. 

In another example, a regular client was under time pressure to close a deal, and already knew that the target company had some problems. But, rather than do a detailed assessment before closing, they decided to buy the company, do their own deep dive, and call Green Peak later if needed.  Within a month of closing the deal, the “CEO Successor” quit, the COO clamored for the CEO job, and the head of HR was finally honest with the deal team about “the real story” behind the company’s dysfunction. In all, the series of events led to a 10% reduction in EBITDA.  When we arrived, we uncovered a massively fractured team, broken operations, and a toxic culture. It took an entirely new executive team to right the ship and get things running smoothly, and far more time, money, and energy to accomplish all this after the deal closed. Eighteen months later, the organization is beginning to turn the corner but much time has been lost. 

There are many other examples, and there is no easy set of “the five questions to ask during diligence” no matter how catchy that title might be.  Findings range from deep familial and other undisclosed personal relationships within the team, compensation programs with perverse incentives, companies presented as one unified organization that are little more than financially beholden to a corporate center, etc.  All of these challenges would certainly have been uncovered after the deal was concluded, but at a major cost of both time and relationship alignment.  Importantly, when these types of issues arise post-close, the trust between management and the board is broken.  The issues can be fixed, but the trust is substantially harder to rebuild and leads to tense if not tumultuous dynamics within the board room. This is certainly not the right way to begin a three to five year relationship!

Organizational Due Diligence is more important than ever if private equity firms plan to maximize the value of return on their investments. Make no mistake, there is a price associated with a thorough inspection. But, it is a small upfront price to pay, and it could potentially save millions in time, energy, capital outlays, lost productivity, and of course the lost equity value of a bad investment. Just ask our numerous investor clients -- our blueprint for continued scalability is worth its weight in gold. 

By Craig della Penna and Andy Caine