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:
It’s critical for due diligence providers to analyze a company’s business segments and product lines to identify the range of its exposure to potential issues.
- Cash flows.
- Strength of the customer base and third-party vendors.
- 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.
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.