The Means to an End
Private equity firms are increasingly conducting sell-side due diligence to uncover details in two major areas that impact selling price: quality of earnings and taxes.
This content is brought to you by Plante Moran. It originally appeared in the September/October 2018 issue of Middle Market Growth.
In today’s M&A market, careful attention to a company’s exit strategy is more important than ever. That’s why private equity firms are increasingly conducting sell-side due diligence, a process that can increase the odds of a smooth, successful sale. Consultants with the right experience and expertise to guide sellers through the transaction process can help firms meet their investment goals.
Traditionally used in European and other international markets, sell-side diligence is growing in popularity in the United States. The team at audit, tax, consulting and wealth management firm Plante Moran has seen the growth firsthand as they’ve worked to help clients achieve maximum valuations and expedited closings. “Sell-side due diligence was substantially less prevalent in the U.S. middle market five to seven years ago,” says Eric Wozniak, partner of transaction advisory services at Plante Moran, which serves clients through its multiple U.S. and international office locations. However, as the surge in mergers and acquisitions continues, it’s increasingly important to ferret out issues that could delay or derail a transaction. “As deals become increasingly competitive, buyers, including private equity firms, are taking steps to try to close transactions as efficiently as possible,” Wozniak notes.
Investment banks encourage the approach. “We are actively recommending sell-side due diligence to clients more frequently today than five years ago,” says Joe Wagner, director at PMCF, a middle-market investment bank that provides merger and acquisition services to family-owned and PE-backed companies. “We find it especially valuable in select situations, including clients with complex financial reporting, significant pro-forma adjustments to EBITDA, revised/updated accounting pronouncements impacting the presentation of the historical figures, or carve-out situations, among others.”
Sellers find that this type of pre-qualification has many benefits. By uncovering potential risk areas before going to market, the process prepares the management team for the buyer’s due diligence process. If done far enough in advance of a transaction, sellers can potentially fix any problems or position an issue appropriately for a potential buyer, Wozniak says.
What’s more, an independent, third-party presentation of the seller’s financial and tax results “accelerates the buyer’s due diligence because the seller already has a report with the data the buyer is going to ask for,” explains Robert Shefferly III, tax partner at Plante Moran.
There are two major areas where sell-side due diligence can uncover details that directly impact selling price: quality of earnings and taxes.
Elements of Earnings Quality
The sell-side due diligence process illuminates the factors that impact earnings, and thus it reveals how to enhance a company’s valuation. “One of the biggest advantages is that it shows how different things positively or negatively affect EBITDA,” Wozniak says. “By the end of the process, you certainly have a better sense of the true value drivers of the business.”
PLANTE MORAN AND SELL-SIDE DILIGENCE
It matters which firm is selected to perform a seller’s due diligence. Plante Moran believes it has the experience, expertise and culture to help sellers achieve their goals.
- Experienced team: Plante Moran’s multidisciplinary team includes several former auditors, attorneys and investment bankers. “We have direct experience in transactions from the corporate finance side, so we understand the nuances involved,” Wozniak says.
- “One-firm” approach: Unlike other national firms that have geographic or service-based profit centers, Plante Moran has a “one-firm” approach. It handpicks an engagement team from across the firm, specifically tailored to the seller’s industry and required expertise.
- Personal touch: Plante Moran prides itself on its personal touch. “We really view ourselves as an extension of the client’s team, helping them to identify the issues and coaching them through the process,” McHale says.
- Proven track record: Serving over 400 private equity firms and more than 500 portfolio clients nationwide, Plante Moran has a record of superior service.
Non-GAAP adjustments are common to reflect the go-forward run rate of the business. For example, an increase or decrease in product or service pricing may impact the quality of earnings, notes Michele McHale, national leader of Plante Moran’s private equity practice. “In addition, a certain issue may be immaterial in an audit, but when you’re looking at a sale, the business is typically valued based on a multiple of EBITDA, therefore the materiality threshold is significantly lower,” she says, adding that understanding the full picture “puts the seller in a better position to maximize the value they are going to get for their company.” This is especially useful when selling carve-outs or divisions of larger companies that may not have separately reported financial statements.
Wozniak cites examples of what sell-side diligence can find. In manufacturing and distribution companies, a close look at inventory and cost of goods sold can lead to a change in earnings. “Poor inventory tracking and inconsistent costing methodologies can lead to adjustments to the income statement,” he explains. “And adjustments to the income statement, while potentially immaterial to an audit, may matter in a transaction, where every dollar of earnings may have multi-dollar impact to valuation.”
Plante Moran has demonstrated to clients how accurate accounting of inventory can lead directly to a change in earnings, for better or worse.
“In one instance, profitability went up and the seller received a higher price for the business,” Wozniak recalls. “And we have had it go the other way, where the profitability was negatively impacted to the point that the seller decided to delay the sale process until the company was better positioned to meet the seller’s valuation expectations.”
Recognition of revenue is another area where due diligence can enlighten a seller. Companies selling software by subscription, for example, sometimes recognize revenue up front rather than over the life of the subscription. When revenue recognition is properly accounted for, earnings for the various historical periods being analyzed can change.
The Intricacy of Taxes
Examining taxes can uncover minor issues—or even major ones—that the seller can either remediate or quantify accurately to inform the buyer, Shefferly says. Approaching a transaction with such information is always beneficial, even if the diligence uncovers problems. “The seller always has better information than the buyer, so passing accurate information to the buyer forestalls them from guesstimating the impact,” he says. “The buyer will always estimate on the high side because they are protecting themselves.”
Payment of state and local taxes, as well as proper elections, are often trouble spots, Shefferly adds. It’s not uncommon for a company to make mistakes in state and local taxes—including income, franchise, sales and other taxes—because the rules and overlapping jurisdictions can be confusing. The company may not have paid tax in a particular jurisdiction, or taxes were apportioned incorrectly among multiple jurisdictions. With that knowledge, the seller can either pay the taxes or, if they are relatively minor, quantify them to show the buyer that they are not material, he says. A company might remediate by filing a voluntary disclosure, which notifies the state where the company failed to pay taxes. With voluntary disclosure, most states will agree to drop penalties if the company pays back taxes for a certain number of years. If the amount is so small that it would cost more in fees than in taxes owed, the seller might opt to simply disclose the liability to the buyer.
Another area of potential exposure is making proper elections for the structure of the company. Were elections filed on time and correctly? Does the seller have a record of the IRS acknowledgement of proper elections? A potential buyer will want proof of filing and acceptance letters.
Sell-side due diligence also prompts discussion about the structure of the entity that is for sale, which can affect how it goes to market. “The company may only sell stock and not allow the buyer to make any elections to treat the sale as an asset sale for tax purposes,” Shefferly notes.
Sell-side diligence can also surface advantages that the seller can promote to the buyer. The seller might outline possible tax planning ideas identified but not implemented and quantify their potential benefits, for example. “They might list in the report tax attributes the buyer will benefit from post-close such as net operating losses, along with any limitations a buyer may have on using these tax attributes,” he says.
It’s Never Too Early
Firms should perform this type of diligence well ahead of taking a company to market so they have time to correct any issues that might lower their price. If a seller waits until the transaction, it can be too late. “It’s hard to change a flat tire when you’re already going 70 mph down the highway,” Wozniak says. “With early sell-side diligence, you can see the flat and fix it before you get on the highway.”
READYING FOR THE SALE
To optimize a transaction outcome for clients, PMCF, the investment banking affiliate of Plante Moran, recommends what it calls a “sale readiness review.”
“While closely aligned with seller due diligence, sale-readiness planning is a more holistic assessment to ensure that overall shareholder objectives are met,” says Joe Wagner, director at PMCF. PMCF suggests paying close attention to these key attributes of sale readiness.
Current market dynamics
- Capital markets
- M&A markets
- Macro economy
Shareholder readiness
- Transaction objectives, such as legacy, value and management team opportunity
- Timing to exit
- What is the shareholders’ “number” required to ultimately transact?
Company readiness
- Financial performance: growth, margin and capital investment trends
- Positioning and differentiators of the company
- Supportability of projections
- Identification and mitigation of potential issues, which PMCF calls “value eroders.” Examples include customer concentration, product or technology obsolescence risk, lack of forecast visibility, management gaps or departure risk of key people, and environmental issues at facilities.
This story originally appeared in the September/October 2018 print edition of Middle Market Growth magazine. Read the full issue in the archive.
