Financial due diligence needs to adapt post-COVID-19 as recent trading performance is now unlikely to be a reliable measure of future profitability.
Since the onset of COVID-19, M&A plans have slowed. While the timing is uncertain, we expect a ramp-up of activity when the crisis eases, with buyers recommencing their plans and/or identifying new targets impacted by COVID-19.
Although the dynamics of the deal environment will have changed, clients will pose the same fundamental question to financial due diligence professionals: what is the historical underlying and future profitability of the business?
Financial diligence needs to be flexible across sectors
In the pre-COVID-19 era, it was customary to form a view of underlying and future profitability by analysing recent trading performance, and adjusting for non-recurring items and the impact of known changes. Given the unprecedented financial impact of COVID-19, recent trading performance is now unlikely to be a good indicator of future profitability, with external factors impacting each business and sector differently.
Some businesses will have ceased trading during COVID-19, hospitality being a prominent example. Diligence will need to consider the extent to which such businesses will recover against a backdrop of a changing cost base and evolution of social interaction, work habits and travel patterns.
Trading will have continued for most businesses but at a lower level. Much of the economy (business support services is a good example) will fall within this bucket, impacted by the sharp decline in general economic activity, as well as sector-specific challenges. Diligence will need to focus on the timing and phasing of a recovery, changes in the nature of demand, the financial resilience of the business and the ability of the business model to flex in order to capture new opportunities.
Finally, a minority of businesses will have benefited from COVID-19, at least in the short term, including supermarkets, DIY retailers and pharmaceutical suppliers. Diligence will need to consider whether the upside will continue or if the market will return to pre-COVID-19 levels.
Approach to assessing profitability needs to evolve
How can we determine historical underlying and future profitability if recent trading no longer provides a reasonable proxy?
1 Should we place reliance on and extrapolate the trading results achieved to February 2020 (considering seasonality)?
This may be a useful starting point but many businesses and sectors will have experienced significant unanticipated variability in demand, plus structural, operational or strategic changes resulting from the COVID-19 lockdown. This may mean the business and its target addressable market are, and could remain, substantially different in the future.
2 Should we continue to rely on trading results to the date of the transaction, adjusted for the estimated impact of COVID-19?
Perhaps, but normalising profit is likely to be highly subjective, relying on significant revenue and cost adjustments. Further, this approach will still not address the future profitability of the business.
3 Should we largely ignore historical trading performance and place more emphasis on management forecasts?
Perhaps, but does management have a track record of accurate forecasting and are we confident that it is possible to forecast accurately in these unprecedented times?
4 Should we focus on recent underlying operating cash conversion, particularly to assess the downside risk to trading?
Most businesses will be experiencing a cash squeeze as debtor days extend – is this the new norm?
Financial due diligence process – going beyond the numbers
Analysing historical performance will remain important for businesses less impacted by COVID-19. For others, a more fundamental analysis of the business and its ability to flex to a new normal will be more salient. Understanding the dynamics of demand, the sector, and wider social and economic changes will be key. Addressing the key profitability question will need diligence to go beyond the numbers.
Addressing the historical underlying and future profitability question won't be easy and this challenge will go to the heart of diligence over the coming months, particularly until the business has established a post-COVID-19 track record.
As well as taking a multi-lens view of historical profitability, we will be placing additional emphasis on the dynamics of the customers and sector, as well as assessing any protect-and-restore strategies pursued by management during COVID-19.
In the short term, completing transactions will carry additional risk. But more attractive pricing, supported by robust diligence, is likely to be attractive to many buyers.
Get help and support for your business through the transaction cycle – contact Chris Sharpe.