Economic uncertainty, market volatility, rising interest rates, inflation and the ongoing conflict between Ukraine and Russia impacted the M&A market in Q3 2022 to the point that transaction volumes turned down over the world. Most experts agree that a recession is or is likely imminent, and even if it doesn’t, it’s still a scenario companies should prepare for.
That said, while activity in private equity deals only declined a little in the third quarter, compared to the years prior to COVID, it actually increased slightly. Turning to the fourth quarter, there were already rumors, particularly in the lower US mid-market, that deal volumes could increase due to the rush to close deals before the end of the year.
As private equity firms continue to pursue deals, they should look to their due diligence firms and operators to ensure additional steps are taken to carefully review and scrutinize 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 in three key areas:
It is critical for due diligence providers to analyze a company’s business segments and product lines to identify the level of exposure to potential issues.
- money rolls;
- Strength of the customer base and external suppliers;
- Accounting and financial reporting software.
If the COVID-19 pandemic has led to a greater focus on redistributions and a closer look at EBITDA and gross profit, a recession will require a deeper focus on cash flows and the ability to survive sustained market swings.
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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 performing a cash flow analysis is not standard practice for due diligence providers, it should be by now. By analyzing a company’s cash flows, providers can determine whether it is ready for a deal ahead of a recession. During a recession, a capital-intensive company inevitably sees its cash flows squeezed to pay down its debt load, and is likely to need more cash to run operations. The company would likely be in a negative cash position. Whether it’s inherited debt or lease obligations, a cash flow analysis can help PE companies anticipate and prepare for such opportunities.
A cash flow analysis should start by evaluating sales based on 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 operating expense transactions.