The unprecedented COVID-19 pandemic is causing significant financial stress for many business owners, while presenting growth opportunities for others. Impacted businesses are suffering from depressed liquidity due to a decrease in sales, the inability to collect cash from customers and an expense structure that does not match the sudden drop in revenue.
A lack of cash on hand or access to credit is making it difficult for business owners to meet their obligations. Programs such as the Paycheck Protection Program (PPP) have offered a temporary reprieve, but without a significant increase in economic activity or an extension of the PPP, business owners will be forced to seek an acquirer or, potentially, file for bankruptcy.
Businesses that maintain stronger balance sheets and are therefore less affected by the epidemic are evaluating the marketplace for distressed companies in search of opportunistic acquisitions. Potential acquirers will need to move quickly to acquire distressed companies in order to maintain the distressed companies’ value. Still, speed, while necessary today, should not prevent a thorough due diligence process.
We have outlined below some of the key issues acquirers should investigate when conducting due diligence on a distressed company.
Identify the Cause of Distress
The first step in analyzing a distressed acquisition target is understanding how the business ended up in its current situation. Every business is different, and each distressed situation is unique. The COVID-19 pandemic is driving an economic downturn that is exacerbating the impact of other common causes of corporate distress, including:
Depressed revenue with high fixed costs
Poor debt management or over-leveraged balance sheets
Loss of a significant customer
Assess the Severity of the Situation
Understanding the severity of the situation when analyzing a prospective acquisition is essential for several reasons. The severity of the issue will provide insight into the timing needed to close a transaction. If a company is on the verge of bankruptcy, the sellers (and their creditors) will require a buyer who can close quickly. They will likely move forward only with a buyer who has the knowledge, capability and financial wherewithal to close efficiently.
Most important, a thoughtful analysis will inform whether an acquisition is economically feasible. The worst-case scenario is where the liquidation value is more than the going-concern value. In this case, the business may not be salvageable, making it an undesirable acquisition target.
Perform Due Diligence Quickly and Thoroughly
The due diligence process is time-sensitive for a distressed acquisition, but the process must still be thorough. Targeting key areas on which to focus attention will make for a more efficient process:
Quality of Financials – Be aware of possible management manipulation of financial information provided. Sometimes distressed companies will inflate revenue or hide expenses to improve profitability on paper. Think about ways the distressing situation may have been covered up historically, and target those areas for further investigation.
Taxes – Outstanding tax liabilities may not be apparent from internal financial statements. Review corporate income, sales and payroll tax returns, and compare them to financial statements. Distressed companies will sometimes defer tax payments when they have liquidity issues. Additionally, companies might not be aware of taxes owed to states where they have nexus. Determining the potential exposure is critical.
Compliance – Review company compliance and regulation procedures, and confirm they are compliant with industry standards. Companies suffering from liquidity issues may save cash by cutting corners.
Accounts Payable – A common cash flow technique is to “stretch” accounts payable by delaying payments to boost cash balances. Review accounts payable aging reports to see how long invoices have been outstanding. Delaying the payments may cause a rift with crucial suppliers, which could impact future operations.
Accounts Receivable – Distressed companies are more likely to offer discounts to expedite cash collections. Markdowns could have implications for their overall revenue model. Review accounts receivable aging reports and allowances for doubtful accounts procedures to determine whether any problems exist.
Accrued Expenses – Accrued expenses are often higher for distressed companies. If accrued expenses are low, review the details and confirm all expected costs are captured. The target may underreport liabilities by excluding costs related to the distress, such as fees for attorneys, accountants or investment bankers.
Environmental – If real estate is involved, an environmental expert should assess the site to identify any environmental problems. Distressed companies may defer addressing detrimental environmental issues, resulting in future liabilities.
Capital Assets – Physically inspect capital assets to make sure they are in satisfactory condition. Distressed companies will sometimes delay capital expenditures to save cash. Ensure clear title to confirm no outstanding liens on equipment exist.
Company Culture – The issues at distressed companies will typically increase the stress level and sometimes create a toxic culture throughout the organization. It is essential to understand the corporate culture and how it is promoted throughout the organization.
Key Employees – Distressed corporate situations may result in key employees pursuing more stable opportunities elsewhere. Identify who the key employees have been historically, and confirm they are still with the company and want to remain in their current positions after the close.
Key Customers and Suppliers – Review top customer and supplier lists for recent years. Determine the current status of these relationships and the impact on future performance.
Change of Control Provisions – Review key agreements for transferability in the event of a change of control. Also, determine whether any payments are due under a change of control provision, since they will be due immediately at closing.
Legal – Review filed or pending litigation claims against the company. Confirm the seller can resolve all ongoing issues, and assess the risk of delaying the transaction closing date.
Uncover the Value Behind the Distress
The distressed situation may cloud the core value of the business. The due diligence process should help illuminate the problem areas and identify the underlying value. A fundamentally good company will be able to return to profitability once provided with investment or resources from the right buyer. Important areas to focus on for identifying value opportunities include:
Adjusted Past Performance – Analyze past performance, adjusted for the impact of distress. For example, if the trouble is related to the loss of a significant customer, adjust historical financial statements to remove the customer’s contribution.
Disposal of Cash-burning Assets – Identify which assets are generating cash and which are not. Determine the salvage value of less productive assets, and incorporate the disposal of these assets into your analysis.
Restructuring Management – Examine the performance of critical managers, and determine whether they are fit to run the business effectively given the capital or resource injection. Analyze the time and expense to replace managers who contributed to the distressing situation.
Monetizing Intangibles – Compare the company’s reputation to that of competitors. There may be hidden value to a strong brand name. An increase in marketing efforts may unlock brand value not monetized by previous owners.
Potential Synergies – A strategic acquisition often creates opportunities for synergies. Revenue synergies can be created by cross-selling products, reducing competition or expanding markets. Cost synergies can be created by eliminating duplicative positions and consolidating resources.
Macro Trends – Analyze the cyclicality of the business and how the company has performed in past business cycles. Review macroeconomic forecasts and estimate how the company will perform in the future. Create a plan to avoid the distressing situation in future economic downturns.
Distressed companies offer a unique time-sensitive opportunity to make acquisitions at a discounted value. It’s important to remember that there are risks involved in any worthwhile investment. PCE understands these risks and is well suited to advise on potential distressed acquisitions. Contact us today for more information.