Interest in distressed assets has risen to an all-time high in recent months—and private equity professionals are adapting new tactics to get ahead in this competitive distressed environment. This includes new valuation calculations, strategies for due diligence, mitigating emerging risks, and tax considerations.
There are many signs of distress, including tight liquidity, fully drawn credit lines, significant declines in EBITDA and more. Investors are not currently able to completely assess the impact of the pandemic on potential acquisition targets’ future revenue, profitability and cash flow – which makes valuing those targets accurately a peculiar challenge.
However, the consensus among dealmakers is that the volatility in the markets has given the industry the correction they have been looking for. But now, fund managers are left without the traditional valuation techniques, such as discounted cash flow and benchmarking against publicly traded companies’ valuations, that they’ve relied on historically.
The deep industry expertise that private equity investors possess will serve them well right now, especially since now more than ever, each potential acquisition will be scrutinized on an individual level with less reliance on industry-wide benchmarks. Clearly outlining strategies for mapping returns is critical to successfully investing in distressed assets. It is key to valuation and a vital part of bid development. It should be based on detailed due diligence, as circumstances permit, and include scenario-planning for a range of possible outcomes. Performing holistic due diligence is particularly important right now given that the barriers to success have increased in the current environment. Fund managers should take advantage of new methods of due diligence to give themselves a leg up against competitors in a market where everyone is looking for a good deal.
Operational and financial due diligence
Before Covid-19 hit, private equity fund managers already were trending toward industry specialization. Now, because different industries have faced various levels of turbulence due to the pandemic, operational and financial due diligence will look very different depending on whether the target company is facing headwinds or tailwinds.
For example, for companies in industries that have significant exposure to the turbulence caused by the pandemic—supply chain disruption to the manufacturing and distribution or retail industries, for instance—operational diligence should include:
An investigation into a target’s contracts with third-party suppliers to help determine the target’s force majeure and insurance clauses.
An evaluation of the extent to which the target’s various buyers have been affected and what the recovery timeline may be for those markets
A determination of what employee and contractor safety measures are in place to keep the business running should a subsequent pandemic wave hit.
A review of any employment or labor issues resulting from the pandemic that could prove problematic or lead to litigation.
As investors have realized quickly, due diligence for manufacturers looks drastically different from investing in streaming media or SaaS tech companies.
The assessment of current liquidity and the working capital needed to ramp back up are also likely to be important areas of diligence for investors to focus on. Plus, financial diligence will expand from working capital pegs to assessing cash flow needs, as well as the review of forecasts and business plans.
A good investor will also analyze issues that lead to the business becoming distressed to inform their bid and return potential. Detailed and rigorous due diligence has always been key to a successful acquisition but now is more complex than ever before.
Dealmakers have new tax considerations to factor in when thinking about M&A in this environment. The tax structure of a deal can lower liability and increase cash flow at both the fund and portfolio company level.
Even small changes in how a transaction is structured can have significant tax implications. Therefore, it is important to seek tax advice in the structuring and financing from the start to avoid compounding a challenging situation once the deal is about to be sealed. Otherwise, involved parties may run the risks of encountering unexpected tax issues and liabilities or tax benefits not materializing. Not only does this ensure proper tax structure of the deal but it enables funds to identify a target’s beneficial tax attributes, such as tax basis, net operating losses and tax credit carryforwards. It is important to work with an experienced tax advisor early in the process, even before the letter of intent is signed. This gives the tax advisor more time to better focus tax diligence on the most significant items.
Because of the risks involved in a distressed market—including public image, pricing and quantifying an opportunity, market risk during a pandemic where no one can forecast economic trajectory, lack of new government funding, etc.—the importance of understanding the nuances of new valuation approaches, new due diligence strategies and tax considerations is paramount.
While Covid-19 has led to widespread changes to every corner of the economy, conditions will eventually stabilize, and uncertainty will subside, at which point, dealmakers will ideally look back at this period in time with the assurance that they’ve conducted their most successful restructuring deals to-date.
John Krupar is BDO’s operational value creation practice leader.
James J. Loughlin Jr.is the national leader of BDO’s business restructuring and turnaround services.