Innovative and intensive due diligence have become more critical than ever for private equity (PE) buyers hunting for attractive new deals and those seeking to stabilize portfolio companies that were impacted by COVID-19 disruptions.
Dealmakers are under significant pressure to source deals and identify the strengths and weaknesses of targeted assets with increased speed and efficiency and without compromising quality. While the pipeline for PE players has never been more attractive, one of the biggest challenges of the hunt is sorting through pandemic-related impacts and developments (some of which are not so obvious) that could obscure potential weaknesses and ultimately lead to a nonperforming asset.
Traditional metrics, like market multiples, cash flow, EBITDA, accounts receivable, salaries, changes in vendor pricing and commitments, and working conditions all have to be assessed from different perspectives in the post-COVID-19 landscape. There are also increased risks in the areas of technology and digital transformation that have heightened the need for buyers to prioritize information technology due diligence and audits.
Practical challenges — and opportunities
The ability to properly vet a target lies in analyzing an abundant amount of financial and operational information within a relatively short window of time. However, even with the pandemic waning, many workplaces still remain closed or are operating with reduced hours, which means site visits and in-person access to target management may still not be possible.
Additionally, reduced headcount at many organizations and the current distributed workforce environment mean less personal interaction and more remote dealings with relevant parties, a change in approach that could be extremely taxing for buyers and sellers who are not digitally matured. The good news for dealmakers, however, is that many new automation tools are available today to help manage and improve the efficiency of the due diligence process.
The due diligence process may be taking longer as a result of the challenges, but for the most part, these challenges have not stopped determined, motivated buyers and sellers from pursuing or closing new deals.
IT due diligence and audits
Over the past year and a half, the pandemic has accelerated digital transformation across many industries as companies seek to increase their competitiveness and build operational resilience. Insights into a target company’s IT landscape have become more important in this environment.
Additionally, the recent string of headlines about major cyberattacks, ransomware and technology outages has also highlighted the need for due diligence teams to focus on comprehensive tech audits. From a business continuity standpoint, it’s crucial for buyers to know which systems and applications the target company uses and whether or not it has strong defenses against cybersecurity threats and built-in resilience capabilities. On a more practical level, how suitable are these systems for the company, considering factors such as company size, industry and customer base?
And from a scalability perspective, PE buyers will want to know if the current capabilities can keep up with the growth of the company.
Additional key considerations for due diligence teams
The operational disruptions and the economic slump precipitated by the pandemic require a thorough analysis of a target’s financial performance — one centered on the following distinct areas:
Quality of earnings — Given the drastic revenue impacts from the pandemic, both positive and negative, PE buyers must determine if current financials are an accurate representation of the target’s true earnings power by assessing estimates and highlighting nonrecurring or unusual income and expense items. In analyzing EBITDA, for example, a key question is whether or not the losses or interruption in business caused by the pandemic qualify as an event that is “extraordinary, unusual or nonrecurring.”
Other important actions that should be considered as part of the earnings/EBITDA evaluation include:
- Pro forma adjustments to reflect FY20 results under normal conditions.
- Review of management’s assumptions. How realistic are its projections in light of historical results and the current operating environment?
- Understanding of the pipelines and other factors considered in creating a budget and/or forecast.
- Comparison of historical EBITDA during the pandemic period to prior periods. What is the fundamental driver of earnings, and which historical items should be excluded from assessing earnings quality? How closely do the target’s earnings approximate cash flows, and how are variances explained?
- Review of competitor trends.
Financial and operational trends – PE buyers should identify and analyze key financial and operational trends that are important to gauge the likely future earnings power of the target. This means having a complete understanding of:
- Any potential impacts due to COVID-19 that may have any lagged effects (i.e., not presented in the current set of financials).
- The impact of the current business landscape or regulatory change on the target’s earnings potential.
- Accounts receivable trends and how they were affected by the pandemic. In other words, a thorough review of the reserve and current and prior risk areas is critical.
- Accounts payable trends and whether or not certain aged payables could be considered debt-like items.
- The necessity for additional inventory reserves, if applicable.
- The impact of any stimulus funds or government relief programs received and future payroll expense accruals.
The following questions are crucial when considering operational trends:
- What are the key factors that are driving margin compression or expansion, rate of cash conversion and return on invested capital?
- What is the impact of the current business landscape or regulatory change on the target’s earnings potential?
- What is the target’s performance with respect to key performance indicators, and what are the quality and reasonableness of the benchmarks established?
- What is the required capitalization of the entity, and what are the future capitalization requirements?
- What accounting treatments does the target utilize in relation to its peers, and what is the reasonableness of estimates?
- Is the target subject to any off-balance sheet or contingent liabilities that management did not disclose?
A well-rounded approach to due diligence requires proper planning and the right expertise. This is true in normal times but even more so in the current dynamic and heightened risk environment. In this post-pandemic landscape, impacts to revenue, working capital, quality of earnings, accounts receivable and information technology are just a few of the many key areas that have to be analyzed more diligently to obtain a comprehensive picture of a target’s financial risks and opportunities.