Conducting financial due diligence in Covid times

The Covid-19 pandemic has resulted in an economic and medical crisis besides presenting the greatest global challenge since World War II.

For businesses, the effects of the pandemic are far and wide – from disruptions to supply chain and business operations, to trade restrictions and the inability to fulfil contractual obligations. However, with Pfizer and BioNTech, and Moderna announcing successful trials of their vaccines, many companies are now thinking through their recovery and a new reality phase.

So, what does this mean for investors looking to invest in these Covid-19 dominated times and how do they conduct a financial due diligence to aid in negotiating and drafting sales agreements?

In the Covid-19 era, new trends such as deferred spend on capital expenditure, slower inventory turns, extended term payables, long outstanding debtor balances, employee claims, litigations, one-off costs such as restart-up costs, tax deferrals, deferred bonuses, and labour cost impact and productivity, have emerged.

While such trends may be a concern to merger and acquisition activities, it is expected that buyers should apply a greater, but tailored due diligence process, which has a knock-on effect on the sale and purchase agreement.

Except for distressed assets, it is expected that buyers will be walking into a company with adequate assets.

In relation to financial due diligence over this period, companies have tried to isolate the one-time impact of Covid-19 on earnings beforeinterest, tax, depreciation and amortisation (EBITDA). However, such analysis has limited value and relevance in presenting adjusted EBITDA for the year 2020 as this is subjective.

As such, buyers are likely to increase their focus on forward looking financial performance and cash flows, and present cash burn and pre-tax cash flows of companies they seek to invest. They will also focus on ‘Value Creation’ within a deal when looking at price and exit strategies.

Compared to the traditional financial due diligence, there is an emphasis for buyers to focus on the following areas as part of their investment decision processes in the current challenging business environment:

FULL YEAR 2020 BUDGET AND HOW THIS BRIDGES TO THE 2021 BUDGET

Buyers should analyse the movement in trailing EBITDA for the last 12 months as well as 2021 projected EBITDA of companies. This, in addition to analysing the company performance in Q2  2020, Q3 2020 and partly, Q4 2020, will help to understand whether the effects of Covid-19 are temporary or more permanent in nature. Further, in analysing the 2021 project EBITDA, investors should think through sensitivities and scenario planning, digital readiness, value creation and sustainable cost base.

SUPPLY CHAIN ANALYSIS

It is expected that as part of their investment decision, buyers will carry out a detailed supply chain analysis, with the aim of making delivery of supplies smoother and reliable. Additionally, buyers are likely to evaluate historical demand (and sources) and pricing, and its reliability as barometer to predict future demand and affordability.

BUDGETING ACCURACY

This is often key when performing a financial due diligence. It helps buyers to ascertain whether a company can control spending and allocate resources effectively through long-term historical budgeting accuracy. Specifically, during the Covid-19 period, buyers are likely to have a greater degree of confidence on a company’s projected financial performance and position if sellers can budget accurately during this period.

CURRENT YEAR TRADING

Analysing the current year trading and full year run-rate will help to appreciate the impact of Covid-19 on the cost base of a company, but also, on projected EBITDA for purposes of evaluating the impact and sustainability on EBITDA during the reaction, resilience and the new reality phase.

SHORT TERM CASH FLOW FORECASTING

Buyers are also critically looking at the steps that companies have taken to conserve cash, optimise working capital to preserve and improve liquidity through 13-week cash flow forecasting.

KEY PERFORMANCE INDICATORS AND MARKET ANALYSIS

There is a need to compare pre- and post- Covid-19 key performance indicators, as this will help assess the reasonableness of 2021 budget and forecast as well as understand the changing business patterns. Additionally, there is need to supplement this comparison through analysis of the following: market; long-term customer demand; performance of peers; and business model changes. Given the current supply chain challenges, it is expected that companies will retain higher inventory in the future to avoid stock outs as well as re-strategise to source or manufacture raw materials locally. The latter has already been seen in the automotive industry with an increase in local assembly instead of finished product imports.

CORPORATE GOVERNANCE

There may be a need for buyers to evaluate the gaps in the corporate governance/management structure within the Value Creation. This, of course, does not suggest that the management of companies are unsuitable in their roles but instead, additional roles may be required to supplement a company’s Board in its strategic thinking.
It is expected that the analysis from the financial due diligence will feed into the sale and purchase agreement.

However, with Covid-19, negotiating and drafting of sale and purchase price agreements has become even more challenging because of the following:

ACCOUNTING PRINCIPLES AND ACCOUNTING ESTIMATES

It is often difficult to prepare accounts because of the treatment of subjective areas driven by the dramatic changes in the market. For example, in line with IFRS 9: Financial Instruments, it is important to understand how provisions of debtor balances are affected because of Covid-19. Furthermore, buyers are likely to adjust for accounting estimates and judgement in the sale and purchase agreements because of a higher level of uncertainty.

EARN-OUT PROVISIONS

Unsurprisingly, sellers are looking for additional security to cover future earn outs given the increase in credit risk in an uncertain environment. Thus, both the buyer and the seller may find it difficult to agree on the financial metrics as well as the adjustments to the purchase price. However, in part, we have assisted buyers overcome this through a structured and phased exit of shareholders and/or management.

TARGET NET WORKING CAPITAL

While subjective, it is often easier to average working capital over a number of periods to understand what the normal working capital is. However, over the pandemic period, the exam question is to identify what the normal working capital looks like over the next few months given the changes in business operating models as well as strategies. 

REPRESENTATIONS AND WARRANTIES

Historically, sale and purchase agreements did not consider specific events such as Covid-19 and as such, there is a need for buyers to carefully consider any undisclosed and/or new liabilities, supply chain disruptions and valuation of assets prior to transaction close.

In summary, a thorough financial due diligence process should consider the impact of Covid-19 on the company’s business and operations, and future prospects as well as the impact on the sale and purchase agreements. 

While some of the consequences of the pandemic are obvious such as increase in health and safety costs for manufacturing companies and decline in dine-in demand for quick servicing restaurants due to social-distancing requirements, some of the implications are less obvious. For instance, it is difficult to quantify the impact of the pandemic on a company’s customers or suppliers.

As such, buyers should ensure that a thorough financial due diligence, Value Creation plan and a well-negotiated and documented sale and purchase agreement is in place to reflect the economic impact of Covid-19. If any of these are missing, the value of a deal could be at risk.

Ravi Shah, Manager in Deal Advisory at KPMG Advisory Services Limited. [email protected].