The Black Hole in the Due-Diligence Audit

(Taking the Guesswork out of Acquisitions)

So critical to a company’s performance
Is its Operating Dynamic, its Will 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 nurturing 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 recovery.  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 allowed.  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.  Everything 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 managers 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 eroded?  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 running 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 traditional due-diligences.  His would not be one.

The Will to Compete

When one looks at the root causes of corporate performance, the eye is drawn first to strategies, processes, procedures, machinery and such.  However, a moment’s thought shows that the effectiveness of all of these is driven by something else: the management 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, the Will 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 enemy would win.

While business is not exactly war, it does have an equivalent to the Will to Combat: It is the Will to Compete.   Though it almost never clearly articulated, 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 “culture” or “morale” are entirely inadequate to describe this; they are as close to Operating Dynamic as accent 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.

In well functioning businesses it is, of course, positive.  But almost always it is much less, much weaker, than its potential.  However, in some instances it can be great; vastly more powerful than the sum of the leaderships of its managers; a powerful synergy is evoked.

When that happens, you have a world class company, one that succeeds in hard times and flourishes in good.  In such a company managers perform beyond anything they could be expected to do elsewhere.

But when the Will to Compete turns negative and stays that way, it destroys the company.

Almost all companies have now been shaken by the recession.  A great many will have received injuries to their souls, their intrinsic ability to compete.  Some will not know that has happened.  And few will know how badly.

Harry’s concern was to evaluate in depth this Will, this Operating Dynamic.  And to fill the black hole in the Due-Diligence audit.  Not knowing is the major cause in the 70% M&A failure rate.

The Operating Dynamic

The Operating Dynamic can be defined as:

  • The resultant leadership available to guide and drive a company when all internal, organizational forces, both positive and negative, are accounted for.

It is the invisible elephant in the boardroom.  It has its own persona, motivations and energies, distinct and different from those of the individual managers, even the CEO’s.  If  it remains invisible, it is more powerful than even the CEO.

Everyone has seen instances where excellent individual 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, become responsible for its success or failure.

He has the financials and KPI’s at his fingertips.  These, of course (as Harry is tired of saying) are the rear view mirror of the company.  However, the new executive has no information about the cause of performance, that which is generating performance and value; that which is, in the present, laying down the future.

He has to GUESS at this, the driver of all performance.

He has limited – perhaps very limited – time to grasp it, own it, transform it.  If he cannot, he fails and the company loses.  This, rather than incompetence, is the major reason why 50% of all new executives are gone within 18 months, why another 20% are deemed “disappointing”.  In large companies the loss of a senior executive is estimated to cost $1,000,000.  Some would put the imputed cost much higher.

Without explicit and detailed information, taking control of the Operating Dynamic is difficult and time consuming.  And the time available to do so is short; during economic downturns, it is very short indeed.

This Operating Dynamic, this Will to Compete (being an attribute of the organization) functions at the unit and enterprise level – not at the individual level.  Because of this, it needs to be measured and analyzed at the unit and enterprise level, in much the same fashion as the financials depict the results of performance, and with the same level of detail. (It is in the details that the devil – and the power of corporate transformation – resides.)

While the financial statements are
The rear view mirror of the company,

Measures of the Organizational Forces
Show its trajectory, its future.

Unless those measures change.

Organizational Forces

First let us identify the organizational forces comprising the Operating Dynamic.

In all, there are more than a hundred, each of which can have a positive or negative impact, like line items on the financials.  However, in practice, they break into fifteen key forces.  In turn, these are grouped into two major categories: the Critical Functions and the Generators/Blockers.  When measured, these can be expressed in terms of a Balance Sheet and P&L.  But, while the financial statements deal with the past, these statements deal with the causes, and show which way the company is headed.

When known in detail, they can be easily altered, easily improved. As they are entirely within the control of management, it costs virtually nothing to change them.  This can happen quickly.  Changing the Operating Dynamic even a little, profoundly changes the performance of the company.

Longitudinal studies by McKinsey and the London School of Economics, now of more than 4,000 companies, have shown that changing just three of the Critical Functions by 20% improves the bottom line by 40%.  And this happens for high performing companies as well as troubled.  This level of profit improvement is something no strategic change, or the most draconian of retrenchments, can provide.

In alpha order, the Critical Functions are:

  • Customer Orientation
  • Innovation
  • Lean Operations
  • Performance Management
  • Profitable Growth Orientation
  • Talent Management

Some of these, of course, are more important than others, depending on industry and company size, and each is comprised of sub-elements.  When measured and weighted, they provide the Balance Sheet for the effectiveness and impact of the Operating Dynamic.  Each sub-element can have a positive or negative value.  If positive, that organizational force is driving the company towards success; if negative, it is weakening it.  The bottom line shows whether the entire Operating Dynamic is driving the company up or down.

This Balance Sheet shows the innate trajectory of the company.  It is forward looking.  Its predictive horizon is far greater than any anything that can be provided by financial models. 

While the six Critical Functions are the proximate drivers of corporate performance, how well they work is driven in turn by nine Generators / Blockers.  It is worth mentioning again that these are entirely within the control of management; changing them is easy and costs virtually nothing.

These are the major avenues to changing the Critical Functions, and through them the bottom line performance of the company.

The Generators / Blockers are, in alpha order:

  • Accountability
  • Acknowledgement of Work
  • Adaptability
  • Commitment of Management
  • Corporate Assertiveness
  • Corporate Decisiveness
  • Effectiveness
  • Internal Competition / Cooperation
  • Openness of Management

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 proximate 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 organization, must be measured from that perspective, just as the financial statements must measure performance for the company as a whole and, if the company is large enough, for each of its units.  Equity investors by motivation, training and practice, instinctively look 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 extensively 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 Corporate 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 organizational forces that are at work within the company.  It takes only about five or ten minutes.

Because perception is reality when it comes to organizational 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 are de facto accurate.  And it is our experience that they seldom lie.  Certainly, front line supervisors – caught between the rock of senior management and the hard place of reality – want their perceptions known and their opinions heard.  They answer truthfully.

The individual responses are passed through a model 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 simplicity, in alpha terms.  Each line item is then expanded with definitions and expressed in ways that essentially 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.  An investor, like Harry, looking at this can really see what he is buying, and what he should pay.

But it is also simple to change those parts, to transform the company’s Will to Compete.  As the component forces are entirely within the control of management, changing those costs virtually nothing.  When you think of the bottom line improvements that are possible, the ROI’s can be extraordinary.

All that is needed is for the investor to call on the management team to confront the data.  And for each line item deemed negative or inadequate, get commitments to specific action steps to correct or improve them.  In our work, we enter these commitments on line, real time, directly into the report, with names and due dates.  In the course of a few hours, the report becomes the plan of transformation.

While we are speaking here about a single intervention, the process described above can and should be done periodically.   The McKinsey/LSE study indicates that a 20% improvement generates a 40% improvement in financial returns.  And that this is available to high performing companies as well as troubled.  H R could manage the survey, the CFO or the model could generate the report, and the CEO could lead the planning session.

An interesting exercise for senior managers is to ask what (even) a 10% improvement in profits would do for their company.  And what they would have to do to get it.

Harry was looking again at the numbers.

He placed the financial statements on the table.  The company was profitable, at least it was last month.  Next to them he placed the Balance Sheet and G&L for the Operating Dynamic.  He could immediately see it was deficient in three specific areas: Performance Management, Accountability, and Corporate Decisiveness.  These could have been caused merely by the act of being up for sale – but they did exist.  However, they were enough to guarantee the acquisition would fail – unless they were changed.

That was the bad news.

The good news was Harry could confront the seller with that information and reduce his expectations.  However, Harry could also see precisely what to do to improve things and who would do it; that it could be done quickly; and that it would cost virtually nothing except Harry’s determination to do it.

It was time to make an offer.  And it was time to create a new beginning.