3 Ways PE Firms Can Ensure Relevant Due Diligence for M&A Targets Ahead of a Recession

Economic uncertainty, market volatility, rising interest rates, inflation and the ongoing Ukraine-Russia conflict affected the M&A market in the third quarter of 2022 to the point that deal volumes declined across the globe. Most experts agree that a recession is here or likely imminent, and even if one is not, it still is a scenario that companies must prepare for.

That said, while private equity deal activity declined only by a bit in Q3, when compared to the years prior to COVID, it actually increased slightly. As for Q4, there was already chatter, particularly in the lower U.S. midmarket, that deal volumes might increase due to the rush to close deals before the year ended.

As private equity firms continue to pursue deals, they should look to their due diligence firms and operators to ensure extra steps are taken to accurately assess and vet potential acquisition targets given the economic climate and the possibility of a recession.

Due diligence providers will need to go beyond their standard reporting checklists and expand their assessments of three key areas:

1. Cash flows
2. Strength of the customer base and third-party vendors
3. Accounting and financial reporting software

If the COVID-19 pandemic spurred a focus on reallocations and prompted a closer look at EBITDA and gross profits, a recession will call for a deeper focus on cash flows and the potential for surviving ongoing market swings.

Cash-flow analysis

It has become important for any due diligence provider to stress test a company’s ability to sustain losses and maintain sustainable liquidity and cash.

While conducting a cash-flow analysis is not standard practice for due diligence providers, it should be now. Analyzing a company’s cash flows will help providers determine whether it is ready for a deal ahead of a recession. During a recession, a capital-intensive company would inevitably see its cash flows being strained to pay its debt load, and it’s likely to need more cash to carry out operations. The company would likely be in a negative cash position. Whether it be due to inherited debt or lease commitments, a cash-flow analysis can help PE firms anticipate and prepare for such possibilities.

A cash-flow analysis should begin by evaluating sales by discounts, returns and allowances, all related to cash, and evaluate for seasonality. It should then do the reverse for vendors and suppliers when evaluating purchases and operational expense transactions.

The final step would be to run multiple models based on certain assumed stress situations gleaned from historical data, as well as those expected to occur in the future. This will help you project future cash flows, which will help determine the core stress and breaking points.

Examining customers and vendors

It’s critical for due diligence providers to also analyze a company’s business segments and product lines to identify the range of exposure to potential issues and determine where risks lie.

As such, due diligence providers should look closely at the strength of a company’s customer base and the ability of its vendors to withstand financial or market turmoil. For example, if a company sells primarily to wholesale rather than retail customers, it will have different exposures to both customer bases. Is the company at risk of losing its bigger customers during a recession? How geographically diverse is its customer base? A customer in Asia will likely see different economic conditions compared to one in North America. It is also worth noting whether segments are spread across a wide range of customers or if the company targets a narrow range of customers.

These factors will help you better understand a company’s concentration of customers and resulting areas of exposure that, if a recession were to arrive, would impact its cash flows.

Similarly, PE firms should be able to assess how a company’s vendors operate to gain a firm understanding of how much capital it will need. They also should examine potential supply chain and logistics issues, exposure to government regulations and buildup of inventory. This may also require an analysis of vendor geographic concentrations or an analysis of their current projections and backlogs.

Such an analysis will provide a more accurate picture of how ready a company might be to weather a recession.

Upgrading financial reporting and accounting software

Digital accounting and financial reporting systems are fairly widespread these days, but any company still using older planning and reporting systems, such as Quickbooks, will face multiple limitations. For example, it may find it difficult to realistically analyze cash flow, customers, vendors and operations. As such, the company will need to upgrade to more sophisticated enterprise resources planning (ERP) systems, which let you extract and analyze  greater amounts of data at a quicker pace.

From a business perspective, the cost of implementing an ERP system, even in the face of an impending recession, is worthwhile. Despite incurring additional costs upfront, prioritizing a system upgrade now can help prevent greater losses in the long term or in the event that an older reporting system mischaracterizes or misreports specific items.

A company may use Quickbooks for financial reporting and accounting while using a proprietary system to measure and track other operational parts of the business. For example, a company could unknowingly have one inventory calculation in a proprietary system and a different one in their Quickbooks system. Having such disparate reporting systems could lead to devastating miscalculations that could seriously confound a company’s ability to navigate market swings.

To avoid situations like this, it is worth committing the time and resources to evaluate reporting systems and ensure they are as up to date, aligned and streamlined as possible.

Final considerations

Foreign currency fluctuations have continued to be a factor affecting the success of deals in recent months. Over the past few months, currency fluctuations have increasingly affected firms’ P&L and have resulted in deals being abandoned. Consequently, currency fluctuations should be taken into account during due diligence.

Stress testing potential acquisition targets and ensuring their reporting systems are modernized are additional, yet crucial, due diligence considerations that private equity firms should implement irrespective of a recession scenario. They will only strengthen deals and better protect all parties involved while ensuring financial readiness for M&A — come rain or shine.

Written by Corey Massella. Originally published by TechCrunch.