Don’t Cut Corners On Sell-Side Quality of Earnings Reports

Written by Jerry Dentinger on January 10, 2018

Private-equity backed exits experienced a slight lull in the second quarter of 2017 with a decrease of about 12 percent from last year, according to Preqin. However, the market remains favorable for sellers with a significant amount of dry powder in both private equity and strategic coffers. Commissioning an in-depth sell-side Quality of Earnings (QofE) report provides significant value for private equity fund managers to prove and hold the value of their investments during a sale process.

Sell-side due diligence and QofE reports have gained traction throughout the private equity space in the past 12-18 months, and have quickly evolved to become an essential element of deal-making for the industry. For portfolio companies with an EBITDA greater than $10 million, it’s becoming a common practice for funds to perform sell-side due diligence before engaging in the sale process. For portfolio companies below $10 million in EBITDA, it’s even more highly recommended.

So, what made PE fund managers see the light? QofE analyses add value throughout every step of the sale process, and pay for themselves many times over, whether started at the time of sale or years earlier.

Core value propositions driving increased PE demand include:

  • In the auction process, QofE reports afford sellers significant leverage and maintain the optimum number of buyers to negotiate for the best price and structure.
  • During a deal, QofE reports add tremendous value. A thorough analysis of a company’s financials presented upfront to potential buyers minimizes re-trading during the diligence process.
  • Finally, sell-side QofE reports shorten the selling process, reducing the risk of surprises and managing access to confidential information. A seller-initiated QofE at the time of sale is often instrumental to holding value during the sale process and lowering overall transaction costs.

Four Strategies to Go Beyond the Basics and Maximize QofE Value

Regardless of whether you’re courting buyers for an immediate sale or looking to improve a portfolio company’s value through process improvements, consider incorporating the following four strategies to maximize the value of a QofE process.

1. Dig Beyond the Numbers: Don’t Overlook the Qualitative Side of QofE

At the most fundamental level, QofE reports function as an examination of a company’s fiscal health, including tax and accounting compliance. While that’s certainly the fundamental purpose, the most important value proposition of quality of earnings is rooted in the qualitative aspects of a company’s business model and a holistic understanding of where value is being created. Examining a company’s leadership, reputation, customer and supplier relationships, succession plan and even location are often significant factors to determine its worth and potential for growth.

2. Embrace Big Data Analytics

The proliferation of data has created a major opportunity for both buyers and sellers to analyze and produce meaningful insights. For sellers, QofE analysis proactively identifies new areas to create value. For buyers, it helps confirm or challenge value to justify the investment or re-trade the deal. The process requires sellers to disclose a significant amount of company data to allow buyers to drill into profitability by customer, product, SKU, geography, distribution channel and a variety of other metrics to understand where value is generated. With a variety of Big Data tools available, fund managers can now obtain greater visibility into their investments’ key financial variables and their relationships, identify gaps and evaluate business opportunities in significantly less time. For both buyers and sellers, leveraging data analytics in conjunction with a QofE process provides valuable insights into where value is created. Conversely, analytics can also expose whether value is sustainable or if it truly exists, which could inform funds’ decisions to continue to hold an investment rather than pursue an immediate sale.

3. Stay Ahead of Schedule

Sellers should consider “reverse due diligence” one or two years before starting a sale process so they can identify and capitalize on process improvement opportunities to increase long-term value, identify lower versus higher profit operations, and generate a higher purchase price. Get ahead of the curve and anticipate the demands you will face in the sale process. Too often sellers don’t begin the QofE process until they have a letter of intent or hire a sell-side advisor. At that point in the process, it is often too late to maximize QofE reports due to compressed timelines. Confidentiality clauses start to create challenges the longer funds wait to begin the process as well, making it more difficult to engage financial management in the process. Regardless of whether it is a proprietary sale process or a broad auction, due diligence is extremely detail-oriented, with no topic left off the table. Thus, QofE preparedness should start no later than 90 days before hiring a sell-side advisor to leave time for a robust analysis.

4. Mind the GAAP

How up-to-date are your portfolio companies’ financial records? Keeping your books on generally accepted accounting principles (GAAP) as current as possible is prudent if you are considering a sale. Many companies update their ledgers quarterly or even once a year, whether audited or not and keep certain accounts on a cash basis. In QofE, you need the historical bookend of a trailing 12-month period on accrual basis, and scopes are usually no less than two full years, often three. Monthly GAAP-based financials and corresponding monthly metrics are key.

During sell-side due diligence, simply “checking the boxes” doesn’t cut it anymore. Sellers would be wise to adopt a two-pronged approach, incorporating both quantitative and qualitative strategies, to get a complete picture of their portfolio companies’ value. Sellers can position themselves for a smoother exit process by crafting thorough, comprehensive defenses of their portfolio companies’ worth while simultaneously conveying their value propositions objectively and transparently. Sell-side quality of earnings is likely here to stay.

Jerry Dentinger is a partner and leader of BDO’s Central Region Transaction Advisory Services practice.

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