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How COVID-19 changes M&A due diligence
28 Jun 2020Diligence with 20/20 vision
Nothing in recent history has changed the business landscape as drastically or as quickly as the COVID-19 pandemic, and resulting predicted recession, which presents a real challenge for mergers and acquisitions. Market multiples, past cash flow generation, and other measures based on performance formed the foundation of due diligence. But what good are historical measurements when the future may no longer reflect history?
Like the rest of the world, transactions in New Zealand have slowed down dramatically. Borders are closed, international travel is restricted, and though the immediate health risk appears to have been thwarted, our way of life, and our way of doing business, has changed. Management is consumed with weathering the immediate crisis while trillions of committed capital wait for the dust to settle. But deals will resume. In fact, the pandemic may create a wave of new deals as troubled companies look for exit strategies and investors look for a market correction. In some industries, companies may exit the pandemic healthier, attracting a new round of interested sellers. Given these M&A opportunities, how can buyers and sellers accurately gauge value and risk going forward?
Navigating this new terrain, buyers will be more diligent in their approach, while sellers will need to prepare for increased scrutiny. Historical business information may be less useful and will be carefully dissected as an accurate predictor of future performance. There will also be increased focus on forward-looking information, including, forecasts, budgets, backlogs, and pipelines, along with qualitative factors regarding changes in business practices.
Due diligence for the COVID-19 era
In a post-pandemic world, buyers must understand not only the direct impact of COVID-19 on the target but also management’s response to the crisis and the pandemic’s effects on near- and long-term operations. These steps will provide increased visibility to achieve maximum returns on investment. Below are five areas of supplemental due diligence that buyers and sellers should consider.
Expanded EBITDA benchmarks
Consider a pro forma adjustment to reflect 2020 financials under normal operations. The months directly affected by the pandemic are likely not representative of historical financial performance nor indicative of future results. While COVID-19 will adversely impact most companies, some businesses may experience a temporary or permanent benefit, so consider the specific facts. There is no one size fits all approach. The key focus here is to understand the “new normal” of the company. Following are some methods for quantifying the pro forma impact:
- Compare EBITDA trends for the quarter before COVID-19 (on a seasonally adjusted basis) to impacted months and management’s near-term forecasts.
- If momentum for financial performance appears to be stabilising for a series of months, the annualisation of EBITDA for the most recent quarter(s), adjusted for seasonality, may help determine the impact of COVID-19. Shorter reference periods will likely be less reliable than a quarter or half-year approach.
- Benchmark EBITDA trends of the company relative to industry peers.
- Benchmark performance against growth rates from prior years and future year projections.
- With uncertainty clouding the immediate future, understanding operating leverage and breakeven points become more important to model how a change in revenue or costs impacts EBITDA and a time horizon to achieve stability.
Top-line impact
In addition to looking at profitability metrics (e.g., EBITDA margin), it is important to understand the short- and long-term COVID-19 revenue impact.
- Analyse sales trends before, during, and after the pandemic by customer, product, end-market, and channel. This will provide a structure for assessing which key market trends will most impact the top-line performance. Further, it will help identify risks in sectors expected to have extended recovery periods.
- Consider the company’s position in the value chain and potential for lagged pandemic impacts. While businesses with global supply chains were affected early on, certain verticals and sectors may experience lagged effects not yet reflected in historical financials.
- Focus on forecasts in addition to historical results and carefully review budgets, backlogs, and pipelines. Consider historical win rates, budget vs. actual performance, and post COVID cancellation rates.
- Some companies may alter standard practices with increased acceptance of returns and discounting in response to changes in aggregate demand. Other companies may find limited supply provides opportunities to increase pricing.
Vendors and supply chains
Understand the timing and resulting changes in the company’s supply chain recovery. Consider the company’s suppliers and key sourced materials (particularly for sole-sourced materials). Determine if there will be permanent changes resulting from the adaptation process.
Does the company have reliable sources for the timely delivery of the quality materials, and will those relationships survive the pandemic?
- What will be the ongoing impact on vendors and product pricing?
- Does the company have vendor agreements with purchase commitments? With supply chain disruption and changing purchase volumes, consider whether purchase commitments can be met, and penalties for not meeting these obligations.
- Is the company considering diversifying supply risk to multiple vendors or alternative countries? If so, what are the impacts on margin, order fulfilment and quality?
Employees and contractors
Payroll is commonly a company’s most significant expense. Many businesses have been forced to make difficult personnel-related decisions, including reducing working hours and making cuts to the workforce. Understand any financial or operational ramifications of the company’s personnel decisions.
- Pay attention to headcount fluctuations during the crisis. Will the company be able to rehire the workers needed to resume operations as the crisis recedes—especially skilled and experienced team members?
- Did the target receive the Government’s wage subsidy? If so, do current employee expenses need to be normalised?
- Understand whether the target temporarily deferred compensation to employees or reduced employee salaries. Further, has the company delayed pay out of severance, deferred salaries, payroll taxes or bonuses? Consider whether funds should be left behind at close for settling these deferred obligations.
Working capital and additional debt-like items
Given the upheaval of COVID-19, historical accounting methodologies may not reflect all risks on the balance sheet. Additionally, historical working capital may not accurately reflect working capital needs going forward. With the disruption affecting all levels of business, a fresh look at accounting methodology is warranted.
- Consider the trends and potential deterioration of the target’s accounts receivable portfolio. Has the company updated its allowance for bad debts to reflect the risk of these assets and to offset inflated AR levels?
- Has a drop in demand resulted in extended aging of inventories? Consider the need for additional inventory reserves for spoilage, slow-moving, excess and obsolete inventory. This consideration will avoid inflated inventory balances from skewing net working capital.
- How is the company accounting for any wage subsidy or government support? Is the company accruing for deferred payroll taxes?
- Analyse accounts payable trends of your target and whether extended payables should be considered indebtedness in closing agreements.
- Look for rent concessions granted and consider treatment as debt in closing agreements.
COVID-19 is also adding significant complexity to how sale and purchase agreements are negotiated and drafted – look out for our other article on five areas to consider when negotiating a deal right now.
Published in conjunction with Grant Thornton US.
For more information, contact:
Richard Hughes
Partner, Financial Advisory Services
Grant Thornton New Zealand
T +64 9 308 2570
E richard.hughes@nz.gt.com
Max Mitchell
Purchase Agreement Advisory Leader
Grant Thornton US
T +1 312 602 8387
E max.mitchell@us.gt.com