Gareth Murphy, co-founder and head of the private equity consulting practice at Fluid, examines how sponsors can harness technology due diligence as an operational improvement tool, beyond simple risk mitigation.

Operational diligence is often the domain of the big deals, where a target has significant operational complexity - multiple sites, products and jurisdictions with distribution centres, service centres, logistics operations and thousands of staff. It can also be needed because of a situational component to a deal, such as a carve-out or a merger with significant anticipated synergies.

By operational, we are talking about the processes and pathways within the business, whether it is a manufacturing production line, an HR process for onboarding new recruits, or workforce management systems controlling the daily activities of a service delivery team.

Anywhere within an organisation, there are processes and practices involving physical machines, paper or digital pathways, and movements of people or goods.  These can be efficient or inefficient, value-enhancing or time-absorbing.  Understanding where value creation can be unlocked, or profit-draining inefficiency can be eradicated, could be key to unlocking an investment's potential.

If management time and tolerable transaction costs were limitless, then there is no doubt more diligence would be undertaken.  In lower-mid-market transactions, there is often a higher emphasis on the capability of the management team, the net result being that operational diligence is rarely, if ever, undertaken.

Matt Cobbold of Palatine Private Equity says: “We’d value an operational perspective on many of our transactions, but there is a lack of providers and it’s difficult to fit it in as a distinct workstream alongside the growing number of other diligences we now do.”

The evolution of technology diligence

On the other hand, technology or IT diligence (ITDD) has been rooted historically in risk mitigation - is there a disaster recovery plan, are IT infrastructure and systems secure and scalable, are backups taken and properly stored? This tickbox approach to identifying red flag risks is necessary, but no longer sufficient in today's world.

The ‘old-school’ ITDD approach mirrors the outdated approach to IT in general - one where the only concern of IT is to ‘keep the lights on’, and insufficient consideration is given to technology-driven value creation, either through lean transformation of the operating model, unparalleled business intelligence and data insights, or creation of an unrivalled customer experience.

Whether pre- or post-deal, or pre-exit, Fluid’s technology diligence approach mirrors its approach to digital transformation: focusing on business outcomes above technology deliverables, and considering people, process, then technology (in that order).

This is because technology alone can never provide the whole answer, even though – in today’s world - it is increasingly a necessary component of any solution. For any technology initiative to succeed it must be grounded in clear business objectives, which – if they are to be achieved – necessitate redesigned processes and require the buy-in of the people involved, so that they champion the new world that is envisioned. This is why Fluid place as much emphasis in their team on business change as on technical skills.

A new diligence paradigm for the lower-mid market

With all of this in mind, it is clear there is an opportunity in merging these disciplines and creating a new combined technology and operational diligence offering that will disrupt traditional diligence across the deal landscape.

As Tom Bottomley, a non-executive director at Fluid, says: “If a technology diligence assessment of risks and opportunities can simultaneously validate and challenge the company’s operating processes and recommend value-enhancing business change, without a substantial increase in the budget or the burden placed on the management team, then that has significant value within the lower mid-market’s pricing structure.”

We should take a moment to examine what the market currently understands by technology, IT or digital due diligence. In broad terms, IT diligence is old school: the box-ticking evaluation of IT risks.  Digital diligence often focuses on the ‘front end’ - the digital footprint and customer pathways - as well as digital marketing, and user and customer experience.  Technology diligence - the core business processes and their delivery capability - is where the wiring of the black box comes under real scrutiny.  This is where Fluid is, and where operational diligence and the new technology diligence overlap.

LAVA Advisory Partners, an independent corporate advisory firm, also recognises the value of an operational perspective. They brought on board Tom Rowe-Jones with a background in M&A operations at blue-chip firms, to spot when help from a specialist provider might be required. However there simply aren’t many, if any, providers offering operational diligence to the lower mid-market. Tom said “I am excited by this new offering from Fluid because it fills a gap in this market, for businesses with operational complexities.” And Matt Cobbold agrees: “I think a combined offering would be very compelling for the lower mid-market”.