The Black Hole in the Due-Dilligence Audit – Taking the Guesswork Out of Acquisitions

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The Black Hole in the Due-Dilligence Audit – Taking the Guesswork Out of Acquisitions

Vowyar - Tom Fitzgerald

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www.ManagementConsultants.comThe Black Hole in the Due-Dilligence Audit – Taking the Guesswork Out of AcquisitionsBy Tom FitzGerald He knew, with a metaphysical certainty, that it was FitzGerald Associates necessary to look deeper, look into the soul of the company. Not just evaluate the CEO and senior man-agers one by one, or even those in the next layer So critical to a company’s performance is its down. The appraisal had to look at something else.Operating Dynamic, its Will to Compete, that During the recession, during the cutbacks, and the improving it by just 20% improves the bottom downsizing, and the survivor-guilt of farewells, had line by 42% comparable to a capital investment the intrinsic courage of the company-as-a-whole been damaged? Had its competitive spirit been erod-of 70%*.ed? For Harry knew that this corporate spirit was the real cause and foundation of performance Yet, it is never measured in a due-diligence. – not strategy, not tactics, not financials. Not even the CEO.Harry’s stomach sent him the signal first. A twinge, a Would it be strong enough? Would they be able to mere twinge. renew it, transform it, if that were needed? But Harry’s was a large stomach, a faithful stomach. The failure rate for all acquisitions had been run-One he had lived with a long and trusted time, one ning between 60% and 80% for decades. It would he listened to when it spoke. And now it had. A be higher because of the recession. Harry had seen ...

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The Black Hole in the Due-Dilligence Audit – Taking the Guesswork Out of Acquisitions

By Tom FitzGerald FitzGerald Associates

So critical to a company’s performance is its Operating Dynamic, itsWill to Compete, that improving it by just 20% improves the bottom line by 42% comparable to a capital investment of 70%*.

Yet, it is never measured in a due-diligence.

Harry’s stomach sent him the signal first. A twinge, a mere twinge.

But Harry’s was a large stomach, a faithful stomach. One he had lived with a long and trusted time, one he listened to when it spoke. And now it had. A twinge, a mere twinge. But he had heard.

Harry was managing partner of Greycor Capital. His job was to oversee the purchase, care and nurtur-ing of acquisitions. He had held this job a long and trusted time, longer than he had his stomach, almost. And he was good. He knew he was good.

The recession was ebbing. There were signs of re-covery. And now was the time he had been waiting for. They were again in the market for a company of the right industry, the right size. He had one in mind. They had the money. With the competition still running scared, they had the opportunity. They had the will – at least Harry had. It was time for a due-diligence.

So they looked. Looked deep and long with a due-diligence that was thorough and careful. Into every aspect of the company that custom and tradition al-lowed. Into the financials, into the operations. He used all the lists and tricks and techniques he knew.

But now, looking at the findings his stomach was speaking. It was just a twinge, a mere twinge. Every-thing looked good; but his stomach was speaking. And he listened.

He knew, with a metaphysical certainty, that it was necessary to look deeper, look into the soul of the company. Not just evaluate the CEO and senior man-agers one by one, or even those in the next layer down. The appraisal had to look at something else.

During the recession, during the cutbacks, and the downsizing, and the survivor-guilt of farewells, had the intrinsic courage of the company-as-a-whole been damaged? Had its competitive spirit been erod-ed? For Harry knew that this corporate spirit was the real cause and foundation of corporate performance – not strategy, not tactics, not financials. Not even the CEO.

Would it be strong enough? Would they be able to renew it, transform it, if that were needed?

The failure rate for all acquisitions had been run-ning between 60% and 80% for decades. It would be higher because of the recession. Harry had seen other equity firms seduced by the findings of a tradi-tional due-diligences. His would not be one.

The Will to Compete

When one looks at the root causes of corporate per-formance, the eye is drawn first to strategies, pro-cesses, procedures, machinery and such. However, a moment’s thought shows that the effectiveness of all of these is driven by something else: the manage-ment systems the company uses. If we look even deeper, we see that the effectiveness of these is caused, in turn, by something else again, something that might be termed the Operating Dynamic of the organization. Or, its Will To Compete. In this paper we shall use these terms interchangeably. This is the “people” end of the business; the soft stuff; the stuff that is not supposed to be measurable; the stuff that only inspired leaders could deal with. But here we are not talking about individuals.

Napoleons first strategy of war was to have an army, mobilized and motivated to confront the enemy. He called this esprit, theWill to Combat. Creating it, shaping it, renewing it, was the fundamental work of all his commanders. If a general could not lead it, if it were weak or wayward – and indeed it can be – the

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enemy would win.

While business is not exactly war, it does have an equivalent to the Will to Combat: It is theWill to Compete. Though it almost never clearly articulat-ed, in the final analysis, managing it, strengthening it, restoring it, is the work the CEO was really hired to do; everything else is secondary. (The terms “cul-ture” or “morale” are entirely inadequate to describe this; they are as close to Operating Dynamic as ac-cent is to the human soul.)

This Will to Compete is the ground and root cause of all corporate performance. Its effect can be great or small, positive or negative. It drives success, or stagnation, or failure.

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its own persona, motivations and energies, distinct and different from those of the individual manag-ers, even the CEO’s. If it remains invisible, it is more powerful than even the CEO.

Everyone has seen instances where excellent indi-vidual managers collectively flounder, and instances where average managers who, as a team, perform excellently. Unless the elephant is brought into the open and understood, it dominates the ambitions, the thinking, the actions and, finally, the results of the company.

Let’s take an example: Imagine for a moment that an executive has just taken over an organization, be-come responsible for its success or failure.

In well functioning businesses it is, of course, posi-He has the financials and KPI’s at his fingertips. tive. But almost always it is much less, much weaker,These, of course (as Harry is tired of saying) are than its potential. However, in some instances it canthe rear view mirror of the company. However, the be great; vastly more powerful than the sum of thenew executive has no information about thecause leaderships of its managers; a powerful synergy isof performance, that which is generating perfor-evoked. manceand value; that which is, in the present, lay-ing down the future. When that happens, you have a world class compa-ny, one that succeeds in hard times and flourishes inHe has toGUESS atthis, the driver of all perfor-good. In such a company managers perform beyondmance. anything they could be expected to do elsewhere. He has limited – perhaps very limited – time to grasp But when the Will to Compete turns negative andit, own it, transform it. If he cannot, he fails and the stays that way, it destroys the company.company loses. This, rather than incompetence, is the major reason why50% of all new executives Almost all companies have now been shaken by theare gone within 18 months, why another 20% are recession. A great many will have received injuriesdeemed “disappointing”. In large companies the loss to their souls, their intrinsic ability to compete. Someof a senior executive is estimated to cost $1,000,000. will not know that has happened. And few willSome would put the imputed cost much higher. know how badly. Without explicit and detailed information, taking Harry’s concern was to evaluate in depth this Will,control of the Operating Dynamic is difficult and this Operating Dynamic. And to fill the black hole intime consuming. And the time available to do so is the Due-Diligence audit. Not knowing is the majorshort; during economic downturns, it is very short cause in the 70% M&A failure rate.indeed. The Operating DynamicThis Operating Dynamic, this Will to Compete (be-ing an attribute of the organization) functions at the The Operating Dynamic can be defined as:unit and enterprise level – not at the individual level. Because of this, it needs to be measured and ana- •The resultant leadership available to guidelyzed at the unit and enterprise level, in much the and drive a company when all internal, orga-same fashion as the financials depict the results of nizational forces, both positive and negative,performance, and with the same level of detail. (It is are accounted for.in the details that the devil – and the power of cor-porate transformation – resides.) It is the invisible elephant in the boardroom. It has

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•Performance Management While the ﬁnancial statements are the rear view mirror of the company, •Proﬁtable Growth Orientation •Talent Management Measures of the Organization Forces show its trajectory, its future. Some of these, of course, are more important than others, depending on industry and company size, and each is comprised of sub-elements. When mea-Unless those measures change. sured and weighted, they provide theBalance Sheetthe effectiveness and impact of the for Operating Dynamic. Each sub-element can have a Organizational Forcespositive or negative value. If positive, that organiza-tional force is driving the company towards success; First let us identify the organizational forces compris-if negative, it is weakening it. The bottom line shows ing the Operating Dynamic.whether the entire Operating Dynamic is driving the company up or down. In all, there are more than a hundred, each of which can have a positive or negative impact, like lineThis Balance Sheet shows the innate trajectory of the items on the financials. However, in practice, theycompany. It is forward looking.Its predictive hori-break into fifteen key forces. In turn, these arezon is far greater than any anything that can be grouped into two major categories: the Critical Func-provided by financial models. tions and the Generators/Blockers. When measured, these can be expressed in terms of aBalance Sheet Whilethe six Critical Functions are the proximate andP&Ldrivers of corporate performance, how well they. But, while the financial statements deal with the past, these statements deal with the causes,work is driven in turn by nine Generators / Blockers. and show which way the company is headed.It is worth mentioning again that these are entirely within the control of management; changing them is When known in detail, they can be easily altered,easy and costs virtually nothing. easily improved. As they are entirely within the control of management, it costs virtually nothingThese are the major avenues to changing the Critical to change them. This can happen quickly. Chang-Functions, and through them the bottom line perfor-ing the Operating Dynamic even a little, profoundlymance of the company. changes the performance of the company. The Generators / Blockers are, in alpha order: Longitudinal studies by McKinsey and the London School of Economics, now of more than 4,000 com- •Accountability panies, have shown thatchanging just three of the Critical Functions by 20% improves the •Acknowledgement of Work bottom line by 40%. And this happens for high performing companies as well as troubled. This lev- •Adaptability el of profit improvement is something no strategic change, or the most draconian of retrenchments, can •Commitment of Management provide. •Corporate Assertiveness In alpha order, the Critical Functions are: •Corporate Decisiveness •Customer Orientation •Effectiveness •Innovation •Internal Competition / Cooperation •Lean Operations •Openness of Management

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Each of these is comprised of numerous elements. When measured and weighted, they provide a Growth and Loss (G&L) statement for the Operating Dynamic. This is the full analogue of the financial P&L.

To summarize:the Critical Functions are the prox-imate drivers of performance; these are shown on the Balance Sheet. The Generators / Blockers are the drivers of the Critical Functions; they are shown on the G&L. The Balance Sheet provides the trajectory of the company. The G&L shows the trajectory of the Balance Sheet. Improving the Critical Functions (Balance Sheet) by 20%, improves the bottom line by 40%. The way to improve the Critical Functions is through the Generators / Blockers, the G&L.

Hard Numbers for Soft Issues

The Operating Dynamic, being a function of the or-ganization, must be measured from that perspective, just as the financial statements must measure perfor-mance for the company as a whole and, if the com-pany is large enough, for each of its units. Equity in-vestors by motivation, training and practice, instinc-tively looks at organizational performance and the results of performance, in this way. By extension, they intuitively look at the causes of performance in the same way.

But how does one put hard numbers on the causes of performance or, as they are often mislabeled, “soft issues?” One way, of course, is to interview exten-sively in terms of the fifteen drivers. This was our initial process begun in 1980. But it is cumbersome and fraught with error and spin.

When Perception is Reality

Since 1985 we have used a survey called The Corpo-rate 360°; this is now on the web. It asks managers and supervisors (it is not designed for workers) in sixty different ways, for their perceptions of the or-ganizational forces that are at work within the com-pany. It takes only about five or ten minutes.

Because perception is reality when it comes to or-ganizational forces and human behaviors, managers will act and react as they perceive these forces to be. They respond to the survey in the same way. Their opinions arede factoaccurate. And it is our experi-ence that they seldom lie. Certainly, front line su-pervisors – caught between the rock of senior man-

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agement and the hard place of reality – want their perceptions known and their opinions heard. They answer truthfully.

The individual responses are passed through a mod-el that generates a report of about thirty pages that surrounds a Balance Sheet and a G&L statement. Each line item is scored in numeric and, for simplic-ity, in alpha terms. Each line item is then expanded with definitions and expressed in ways that essen-tially elicit statements of corrective action when that is needed.

Changing the Operating Dynamic

Once detailed measures are available, the elephant becomes visible in all its parts.

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