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Recession Due Diligence
Economic uncertainty, market volatility, rising interest rates, and inflation caused the 2022 M&A deal volumes to decline globally. Most experts agree that a recession is here or likely imminent; it is a scenario for which sellers must prepare.
As buyers continue to pursue deals, they increase their due diligence to ensure extra steps are taken to assess and vet potential acquisition targets accurately.
Buyers are going beyond their standard reporting checklists and expanding their assessments of three key areas:
- Cash flows
- Strength of the customer base and third-party vendors
- Accounting and financial reporting software
The COVID-19 pandemic 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
Buyers must stress test a company’s ability to sustain losses and maintain sustainable liquidity and cash during due diligence.
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. A cash-flow analysis can help PE firms anticipate and prepare for such possibilities. Multiple models based on certain assumed stress situations will help determine the core stress and breaking points.
A cash-flow analysis should begin by evaluating sales by discounts, returns, and allowances, all related to cash, and assess for seasonality. It should then do the reverse for vendors and suppliers when evaluating purchases and operational expense transactions.
Examining customers and vendors
Buyers must also analyze a company’s business segments and product lines to identify the exposure range to potential issues and determine where risks lie.
Buyers will look closely at the strength of a company’s customer base and the ability of its vendors to withstand financial or market turmoil. Is the company at risk of losing its larger customers during a recession? How geographically diverse is its customer base? A customer in Asia will likely see different economic conditions than 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.
Upgrading financial reporting and accounting software
Any company still using older planning and reporting systems, such as QuickBooks, will face multiple limitations. 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 faster.
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
Stress testing potential acquisition targets and ensuring their reporting systems are modernized are additional, yet crucial, due diligence considerations that buyers will implement regardless of a recession scenario. They will only strengthen deals and better protect all parties involved while ensuring financial readiness for M&A.
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