Originally published in American City Business Journals

By Joanne Baginski

As merger-and-acquisition activity becomes increasingly competitive, buyers are demanding that a comprehensive capabilities assessment around people, processes and systems be part of their due-diligence process.

With private equity and strategic buyers often competing to buy the same middle-market companies, a capabilities assessment goes beyond quality of earnings or ensuring the numbers are right to understanding the capabilities of the management team and the systems the business has in place to support future growth.

That is becoming a significant part of calculating exactly how much to bid for a target company and to judge how much that investment can grow in the years after the merger or whether it might need significant additional investments in order to hit desired targets.

As the Harvard Business Review noted, “Too often, deal makers simply ignore, defer, or underestimate the significance of people issues in mergers and acquisitions. They gather reams of financial, commercial, and operational data, but their attention to what we call human due diligence — understanding the culture of an organization and the roles, capabilities, and attitudes of its people — is at best cursory and at worst nonexistent.”

Buyers should make sure their due diligence includes a capabilities assessment that looks closely at these four vital areas:

1. People: Managing a company and supporting rapid growth — which is what investors will want in the years after the transaction — require specific capabilities and experience. A capability assessment of the senior managers that will remain after the merger is essential to identify any potential problems. As many as 90 percent of mergers fail to hit financial targets, a failure attributed to “incompatible cultures, management styles, poor motivation, loss of key talent, lack of communication, diminished trust and uncertainty of long-term goals,” according to the Society for Human Resource Management. Private-equity buyers want to grow the business to drive value for a potential exit in three to five years. That makes it essential to assess whether key managers have the right skills to grow the business and to highlight any positions where new talent may be needed directly after the merger closes.

2. Relationships: A due-diligence examination of customer relationships will look at such things as volume of sales by customer and the profit margin of each customer. A deeper look could also identify any issues related to quality control, the timing of delivering orders, whether customers are loyal, and if they would recommend the firm to others. Good customer relationships are essential to hitting growth targets, so buyers should assess whether the company needs to launch a campaign to improve relationships after the merger or if it needs to overhaul such things as quality control or customer-service procedures. Relationships with key customers at middle-market companies often rely on key staff in sales and marketing functions. It’s important that these relationship contacts remain happy, so the assessment should suggest the best compensation incentive plans for after the merger. If the assessment finds that key staff might undermine relationships, imperiling growth, it should recommend a consultant to develop an appropriate personnel plan.
3. Technology and facilities: Many companies operate for years with out-of-date systems and aging facilities that can impede growth after a transaction. Does the company need upgrades to its computers/network/security systems, and to its enterprise software? Replacing something like a firm’s enterprise resource planning software — managing accounting, procurement, project management and manufacturing processes — is costly. Likewise, at manufacturing companies, an assessment should look at facilities to see if the factories are operating at full capacity or will need upgrades and expansion requiring significant capital.
4. Accounting: Every due-diligence process starts with a forensic look at the accounts of the target company. Does the balance sheet contain any surprises? Has there been a change in “ordinary course of business”? Has the company been using appropriate estimates for reserves and accruals?  The assessment should also evaluate whether the company has the accounting software and processes in place to scale. Companies without such capabilities may need significant software investments, of $1 million or more, and that should be considered in the valuation any bid.

With deals so competitive, the use of capabilities assessments has proliferated in recent years as private equity and strategic buyers work to ensure that high valuations are worth it. Getting this part right may have as much to do with the long-term success of the deal as anything else.

Joanne Baginski leads the transaction advisory services practice at EKS&H.