What Working On A Deal In The Snack Foods Industry Taught Me About Private Equity

Due diligence, the process of vetting assumptions, validating numbers, and otherwise kicking the tires of a potential investment, is a crucial yet oft-unappreciated process. Too many times in the heat of a deal things get missed, and all stakeholders (investors across the capital structure, employees, key vendors, etc) suffer.

My partner and I are a bit obsessive about due diligence, but we have our reasons. As restructuring professionals (first at two nationally-recognised middle-market shops and currently at our own firm ) we have seen the wreckage of too many deals that should never have been done, with enterprise value evaporating along with jobs due to some previously undetected time bomb.

One particularly apt example from my partner’s experience will serve to illustrate my point. Fresh out of business school my partner was put on a team working on busted roll-ups in the Snack Foods Industry.

This $200MM company had flipped the switch on an improperly tested and under-funded ERP implementation, and immediately all hell had broken lose. Suddenly, the company lost all visibility into operations, and as a result missed its biggest seasonal order windows. Customers bailed, the PE owners
did not see a path to a return, and the lender demanded an exit. In the end this promising company was acquired by a competitor out of chapter 11. In many ways, this catastrophe was due to a failure to appreciate the severity of the company’s lack of IT infrastructure and know-how, a key factor that should have been identified during due diligence.

Two other highlights should further illuminate my point:

  • Crushingly seasonal sales patterns: generally speaking, a DSO over 150 implies some horrendous things about a company’s liquidity. Nothing like putting in a 90+ hour week frantically trying to save a company at its seasonal liquidity trough and having to take the time to explain that yes, those EBITDA margins are impressive, but sadly, too much of your sales are tied up in working capital.
  • Chronic inability to match orders to production: at a major Snack Foods company (yes, another one) my partner had the sad task of watching a company die in part because no one had realised (until it was far too late) that, despite impressive sales growth, orders were not being matched to production, and as a result some production outputs were piling up (making the borrowing base look better than it was, and generally creating havoc), while others were selling out (necessitating reorders, and slowly bleeding cash from the organisation).

Yes, when investors (equity or debt) miss something, or see an issue and fail to think through the implications bad things happen.

In addition to the issue of due diligence on companies there is also the issue of due diligence on investment vehicles. In this case, sadly the overwhelming bias is for large, established entities. And yet larger firms
have their own problems (not least the problem of how to generate worthwhile returns on the massive assets they have under management). In the case of due diligence on investment vehicles the downside of failure is not necessarily job loss but the impact of sub-par investment returns should not be under-estimated.

It is sad but true: due diligence is hard. It should never be limited to a “check the boxes” exercise or a simple identification of risk factors but should instead be a holistic process that ends with the potential investor understanding the risks and rewards inherent in an investment decision.

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