This article has been written together with Alberto Chocano Almagro
Covid-19 is having a material impact on most economic sectors, including M&A. Due to the short- and medium-term economic uncertainty and volatility that has resulted, aligning buyer and seller expectations may prove challenging, even if such a crisis brings significant market opportunities.
Market participants choosing to proceed with M&A transactions during this unprecedented time or those with deals already signed will undoubtedly need to reevaluate deal terms and contemplate a wide variety of unique risks and challenges.
Here are the key aspects of financial due diligence that require particularly close attention under the present circumstances.
1. Impact on revenue and profitability of the target company
Investors need to fully understand the impact of Covid-19 on revenue and profit. They’ll have to closely analyze assessments of revenue and margin loss caused by the closure of business activities, decrease in customer demand and customer attrition.
EBITDAC (i.e. EBITDA excluding the estimated impact of Covid-19) will likely be a key measure of underlying profit, though it will be challenging to accurately quantify adjustments. Vendors are required to provide the necessary evidence to support any adjustments.
Performing detailed analyses and substantive procedures around revenues/expenses and trade receivables/payables (e.g. cut-off testing) can comfort buyers.
2. Assessment of business plan assumptions and achievability
Forecasting will be considerably tougher than usual and likely involve a range of potential scenarios.
Scenario analysis will be a critical topic of discussion among sellers and buyers, financiers and the target’s management. Scenarios must reflect any potential changes to business models, and, due to the economic uncertainty caused by the pandemic, assumptions will be revisited frequently. As part of the forecasting exercise, investors and financiers may request a stress test.
3. Working capital analysis
Covid-19 has led to disruptions in working capital cycles, which are unlikely to normalize in the short term.
Working capital and cash requirements may be impacted by revenue and payments cycle disruptions, as well as businesses’ requirement to preserve cash. Remember to identify one-time items when assessing a business’s normalized working capital levels, and determine appropriate target working capital for the purpose of closing adjustments.
4. Actual and potential liability exposure
Besides the traditional adjustments to the target’s reported net debt, the due diligence process may reveal new potential cash and debt-like items associated with Covid-19: liabilities with former (e.g. dismissed) and current employees (variable remuneration), deferred interest expense (and potential associated penalties), unpaid creditors, deferred taxes government grants, etc.
Covid-19 could lead to the breach of several covenants usually provided for in financial agreements – business and financial covenants with earnings components, such as EBITDA.
The due diligence scope of work will consider (1) the analysis of Covid-19 net debt adjustments and (2) the financial implications of the target’s compliance with the current covenants, and (3) conditions for potential waivers set by financial institutions.
5. Analysis of the response plan regarding employees
The pandemic may result in employee reduction, salary suspension, severance payments, remuneration scheme reviews and changes in top management. Various pro forma and normalization adjustments in relation to the above will be considered.
The due diligence process will also assess assumptions underlying the actuarial valuation of employee defined benefit pension plans.
6. Target company’s ability to deliver financial statements and audits in a timely manner
Impacts on financial reporting will depend on the degree to which a company’s operations are exposed to Covid-19. Key areas impacted include the going concern assessment and reassessment of accounting estimates and policies, e.g. revenue recognition. Companies may find it challenging to support the audit process and provide audit evidence.
7. On-site versus virtual diligence
It may not be possible to conduct certain in-person critical diligence activities, e.g. on-site inspections of sensitive information or physical assets. Buyers may utilize alternative sources of information, e.g. historical third-party reports, and other remote technologies.
This overview is not meant to be an exhaustive list and is subject to change depending on each individual case.
KPMG Luxembourg’s dedicated due diligence team specializes in local and cross-border transactions. We have a significant track record of assisting and advising boards, corporate development teams and private equity houses on transactions. As part of the Global KPMG Deal Advisory network, we can leverage its experts, market insights and tools to benefit clients. Visit our website for more information