Economic instability, market Volatility, rising interest rates, inflation and the Ukraine-Russia conflict have impacted the M&A market in the third quarter of 2022, with deal volumes declining worldwide. Many experts agree that a recession is here or likely soon, and even if it’s not one, it’s one that companies should prepare for.
That said, while private equity deals slowed slightly in Q3, compared to pre-Covid years, they actually increased slightly. As for Q4, deal volumes are likely to increase due to the rush to close deals before the end of the year, particularly in the lower US midmarket.
As private equity firms continue to execute deals, they should look to their due diligence firms and operators to ensure that additional steps are taken to properly evaluate and screen potential targets in light of the economic climate and recession.
Diligence providers should go beyond standard reporting checklists and expand their assessment in three key areas:
It is essential for due diligence providers to analyze the company’s business segments and product lines to identify the extent of exposure to emerging issues.
- cash flow.
- Customer base and strength of third party suppliers.
- Accounting and financial reporting software.
While the Covid-19 pandemic has focused attention on real estate and prompted a closer look at EBITDA and gross profit, the downturn will require a deeper focus on cash flows and the ability to survive continued market turbulence.
Cash flow analysis
It has become important for any due diligence provider to test the 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. Analyzing a company’s cash flow can help suppliers determine whether they are ready for a deal before bankruptcy. A company that raises capital during a recession will inevitably see its cash flow tighten to pay off its debt load, and may need more cash to operate. The company may be in a negative financial situation. Cash flow analysis due to legacy debt or lease commitments can help PE firms anticipate and prepare for such opportunities.
A cash flow analysis should begin by evaluating sales with discounts, returns, and allowances, all related to cash, and assessing timeliness. Then, when evaluating purchases and operating transactions, he should make a reversal for suppliers and suppliers.
