Management Review: An Important Part of Due Diligence

By English, Gary | Journal of Commercial Lending, February 1994 | Go to article overview

Management Review: An Important Part of Due Diligence


English, Gary, Journal of Commercial Lending


To the loan officer and the borrower, it looked like a good deal. The bank's customer was seeking financing to acquire a phosphate plant that was five years old and in good condition. It had been managed by a large oil company and had met all regulatory requirements. Moreover, the plant was operated with a team-oriented management system which had been featured in management journals. Apparently, the oil company was ready to sell -- for cents on the dollar -- because it had taken advantage of all possible tax breaks and because the phosphate plant was not in the oil company's direct line of business.

A due diligence review showed the phosphate company's legal and financial records were in order. Everything looked good, the bank made the loan, and the borrower acquired the phosphate plant.

The Surprise

Unfortunately, all was not well. Even a cursory management audit of the acquisition during the due diligence review would have found the following:

* Staff members called the team management system a nightmare - -no one seemed to hold authority or accountability but almost anyone could frustrate the efforts of another.

* The teams did not work together.

* There were rumors about unionizing.

* The training system for operators was without any rigor.

* The plant had a poor safety record.

The management system, although publicized in journals as being "high performance," was a disaster. The person who wrote the articles was actually the consultant who instigated the system. But junking the team system for a traditional supervisory structure would require an increase in staff with appropriate technical experience and talent, which was not available. Some workable system might have evolved eventually, if the oil company had not taken most of the experienced managers and left those who were untrained, inexperienced, or poorly suited.

In brief, the company's engineers could not develop a cost-benefit analysis for proposed projects, the human resources manager was a secretary promoted to that position with no additional training, and the young finance officer's education consisted of two courses in accounting.

There were no experienced or well-trained senior staff around which to mold a career development program or to find some way to make things work. No one even knew what a good system was supposed to look like, so the employees continued to do exactly what they had done in the past.

To make matters worse, as part of the purchase agreement, the bank's borrower agreed to keep all inherited staff for two years except in instances of poor performance. In any case, wholesale restaffing was simply not feasible, especially in the remote area where the plant was located.

Poor performance was the norm from both the system and the employees within it. Given the pervasive nature of the problem, it was difficult to find a place to begin to remedy it.

The Role of Due Diligence

Due diligence means looking over a prospective transaction to see if there are any problems that could be costly in the future. However, in today's environment, a lender's due diligence review may need to be upgraded and reexamined. For example, due diligence rarely considers the areas in which some of the greatest potential costs and operating problems are found - -management and staff. Acquiring or financing an operation is much like buying a used car: You need to find out what is under the paint.

The buyer of the phosphate plant had followed customary due diligence practices. However, most purchasers of companies have little regard for the management system or personnel except when some exceptional technical knowledge is involved.

In the case of the phosphate plant, the oil company sold it for cents on the investment dollar. The reason for the discount -- which satisfied the lawyers and accountants -- was that the plant had become fully depreciated. …

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