In recent months, financial due diligence has become a larger priority for many businesses. Chris Sharpe shares insights from deals across a range of sectors, as well as broader themes prevalent in today’s market.
It has been an incredibly volatile year for M&A activity. Many deals were either paused or aborted because of COVID-19. Instead, corporates concentrated on internal challenges, and financial sponsors focused on the financial and operational health of their portfolio businesses.
After a few quiet months, deal activity returned. This was driven by multiple factors: coronavirus support from the government, strategy realignment, pressure to invest and, later on, the spectre of anticipated Capital Gains Tax (CGT) changes.
By Q4 2020, M&A activity was hot, particularly mid-market M&A, albeit with an increased number of deals including an element of earn-out or deferred consideration.
As M&A has returned, many businesses are focusing increasingly on financial due diligence to make sense of recent trading performance, support their valuation and determine equity price adjustments.
Over a year on, it's clear that our diligence on deals has certainly been shaped by coronavirus, although with marked variation between sectors. The traditional focus areas (reliability of financial data, quality of earnings, net debt, normalised working capital, and forecast assessment) remain key and on most deals their importance has been further elevated.
However, clients are now homing in on concerns such as short-term trading trends, performance of individual products, markets, customers, and more broadly, the ability of the target company to recover from recent problems.
The best way to reflect on what has happened to financial diligence over the last 14 months is to summarise the key focus areas and challenges on some of our deals.
What are the key focus areas of completed deals?
Managed print services
Revenue from the managed print services market was significantly impacted by office closures, with concern around print volumes (and the mix of fixed billing arrangements), client bases and viability of upselling equipment contracts.
Other key considerations included the extent to which profit was propped-up by furlough and other discretionary cost savings, as well as the long-term diversification towards complimentary offerings (ie IT services).
Operations in the construction industry ceased during the initial lockdown, meaning the focus for this business was on the loss of revenue and the ability to protect profit through flexing costs.
Other key considerations included working capital trends, such as delayed customer and supplier payments, the shape of the recovery curve post-lockdown and the ability to quantify proforma / run-rate EBITDA to support lending.
Accident repair vehicle rental
The reduction in traffic volume during the first lockdown caused customer demand for this business to plummet. Until the summer, recovery was only incremental.
From a diligence perspective, it was clear that recent months had to be discarded when considering run-rate profitability, however the long-term outlook was less certain. Consideration was given to extrapolating current revenue with an appropriate cost base as well as the more aggressive assumption of a rapid return to historical traffic volumes.
The short-term impact on software as a service (SaaS) reseller services was noticeable as key customers reduced discretionary spend and fewer customers commenced implementation projects.
The key diligence challenge for this business was marrying the initial negative impact (offset by various cost saving initiatives) with the expectation that demand would thereafter increase as clients invested in robust and flexible IT infrastructure to cope with problems caused by these circumstances.
The business benefited from an increase in demand in internet shopping, a transition from lower margin air freight to higher margin sea freight as airline routes closed, and tactical use of furlough. Key diligence challenges included normalising the short-term margin and cost benefits and forming a view on the likely long-term outlook.
There was significant volatility in demand as the business’ client base variously terminated agreements, reshaped their demand or required additional support.
Our key focus was a granular impact analysis of the performance and evolution of all material contracts, as well as analysing all adjustments in the cost base (staff, contractors, property, insurance, health and safety).
The primary consideration for this business was customer stockpiling and irregular ordering patterns and the extent to which this impacted EBITDA calculations. In April 2020 bulk orders resulted in an unusual spike in revenue. The key challenge was to quantify the revenue resulting from stockpiling and the period in which it would unwind.
How are buyers approaching financial due diligence now?
As well as focusing on historical performance and adjustments to equity value, buyers have increasingly studied indicators to assess future profitability. As a result, our diligence has focused heavily on trading performance after lockdowns, the ability to generate ‘catch-up’ revenue and the strength of pipelines and order books. This financial analysis has often been supported by commercial diligence to help our clients to assess the new market opportunity and the transition in customer demand.
A year ago it was uncertain if buyers would consider coronavirus adjustments to be a flimsy excuse, or whether add-backs would be given credit when considering a dip in profit. The reality has been somewhere in the middle, depending on the sector, the pricing structure of the deal, and the competitive dynamics between the parties.
More specifically, buyers have typically accepted reasonable and quantifiable earning adjustments, such as one-off costs incurred by lockdowns, but have been less willing to give credit for unquantified lost sales unless the seller can thereafter demonstrate a real revenue recovery.
Debt and debt-like items have also been a key focus area as companies have relied upon new sources of funding and/or have extended worked capital creditors to support the drop off in trading.
Uncontentious new debt items have included government loans such as the Coronavirus Business Interruption Loan Scheme (CBILS) and deferred VAT, with most debate saved for coronavirus related debt-like items such as stretched creditors (negotiated or otherwise), delayed capex, early payments from customers and ‘frozen’ deferred income due to postponement of services.
Determining an appropriate working capital target has also become more contentious. Trading volatility and active working capital management has made agreeing a ‘normal’ level of working capital a real challenge.
Where coronavirus has reduced average working capital, we have seen buyers seeking to peg working capital to either previous levels or an average derived from the forecast model. Another interesting trend has been a shift towards the perceived low risk option of completion accounts where the buyer has the security of scrutinising the balance sheet post deal.
In summary, we can expect this heightened focus to continue at least until the corporate environment has stabilised and businesses have demonstrated a ‘new-normal’ track record.
If you would like to start a conversation around transactions, get in touch with Chris Sharpe.