m&a part i: deal structure & due diligence financial diligence november 14, 2014

M&A Part I: Deal Structure & Due DiligenceFinancial DiligenceNovember 14, 2014

Financial DiligenceConfidential – All Rights Reserved – Ernst & Young LLP

Brendan MurraySenior Manager - Transaction Support

Tel: +1 617 585 0336Email: [email protected]

Function in EY► Brendan has nine years experience in accounting and finance.

Since joining EY in 2006, Brendan worked for four years in the Assurance practice and, most recently, in Transaction Support since May 2010.

► While in the Assurance practice, Brendan worked in a number of industries including pharmaceutical, healthcare, telecommunications and manufacturing.

Professional experience and select clients► In Transaction Support, Brendan has deep experience performing

buy-side financial and accounting due diligence for a broad range of middle market and large private equity funds and various strategic corporate clients. Industries served include retail/wholesale, telecommunications, software and life sciences.

► Brendan’s buy-side financial diligence work focuses primarily on the quality of recurring earnings (including carve-out and integration considerations), quality of the target company’s balance sheet, establishing target working capital, analyzing forecasts, and commenting on stock purchase agreements. Brendan provides value added findings for clients included the discovery of unsupportable earnings of prior acquisitions, unrealistic forecast projections, deferred capital expenditures,

identification of off-balance sheet liabilities, net working capital adjustments and inappropriately applied accounting standards.

► Select clients include Summit Partners, Goldman Sachs, Berkshire Partners, Advent International, Hologic and AMAG Pharmaceuticals.

Education► M.S. in accountancy from the University of Notre Dame’s

Mendoza College of Business; B.S. in management and business from Skidmore College.

► Certified Public Accountant (CPA) in the state of Massachusetts, member of the American Institute of Certified Public Accountants (AICPA) and Massachusetts Society of Certified Public Accountants (MSCPA).

Financial Diligence

EY’s transaction advisory services

Transaction tax► Federal, state, and international tax

risk analyses► Customs, duties, VAT and other indirect

tax assessments► Evaluation of significant tax exposures► Assessment of optimal transaction structure► Identification of post-transaction tax

minimization options

Human capital► Exposure assessment► Benefit program analyses► Comparability studies► Development of severance plans► Employee retention programs

Operations and technology due diligence► IT platform, cost and scalability analyses► Operations review and strategies► Investments analysis

Valuation ► Business Valuation Services► Tangible/intangible asset

valuation services► Accretion/dilution analyses► Stock compensation analyses► Purchase price allocation► Impairment analyses

Financial due diligence► Assessment of sustainable earnings► Analysis of key revenue and cost drivers► GAAP/Cash accounting differences► Critique of forecast► Identification of balance sheet exposures► Input on closing deal structure► Assess operating working capital needs

Commercial due diligence► Analyze marketplace in terms of competitive

position, pricing trends, growth, etc. ► Validate growth and other key model

assumptions with primary market research

Transaction integration► Synergies analysis and

investment requirements► Assess impact to forecast► Assessment of integration challenges, risks

and resolution strategies► Organization design and governance issues► Communication plan and change management

Distressed/stressed advisory► Corporate structure risk evaluation► 100-day plans► Cash flow change programs► Business closure/downsizing► Business/strategic reviews► Refinancing and debt solutions► Formal insolvency services► Identify where business practices could be

improved and the potential savings► Implement processes which will ensure cash flow

can be converted► Implement framework to guarantee savings

are sustainable

Real estate advisory► Location assessment► ROIC analyses► Lease reviews and financial planning

Financial Diligence

Why perform financial due diligence?

► Evaluate quality of reported earnings and identify value drivers that are critical to the investment decision; this evaluation may result in:► Busted deal: early identification minimizes third-party service

provider costs and internal opportunity costs► Reduction of purchase price ► Identification of opportunities (or exposures) not included in

management’s model

► Identify issues to be addressed in purchase agreement► Assess strengths of financial personnel and systems► Improve transaction structure ► Identify areas for post-acquisition attention, integration

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Financial Diligence

Why due diligence is unnecessary (myths)

► “The company is audited – the numbers must be right”► “The closing audit will resolve any lurking issues”► “Management confirmed our investment thesis”► “We’ll cover any problems through representations and

warranties in the purchase agreement”► “The lenders are performing due diligence”

Financial Diligence

Why an audit is not enough?

An audit is:► Typically balance sheet focused► Typically focused on one point in time ► Does not address business issues► Does not address quality of earnings► Does not address the forecast period► Does not fully address quality of people, systems

and infrastructure► Level of materiality may be much higher than

buyer's materiality

Financial Diligence

Why an audit is not enough?

Audit Due diligence“What are the numbers? “What is behind the numbers?”

► GAAP based earnings

► Driven by external reporting

► Influenced by materiality

► “Rear view” perspective

► Post-risk event accounting

► Understand quality of earnings and cash flows

► Driven by deal economics

► Materiality magnified by deal

► Pro forma perspective

► Identify risks in advance

► Cash flow and EBITDA focus

Financial Diligence

Select financial diligence considerations

I. Quality of earnings

II. Key business drivers

III. Net working capital considerations

IV. Debt and debt-like items

Financial Diligence

Select financial diligence considerations

► Analyzing quality of earnings / free cash flows (enterprise value)► Historical and projected earnings► Identify run-rate matters

► Understanding of key business drivers► Historical trends, drivers, and relationships

► Net working capital ► Purchase price adjustment mechanism ► Understand operating cash flows (seasonality and growth) for financing

► Debt-like items► Non-operating or one-time cash commitments and contingencies ► Earn-outs, restructuring liabilities, outstanding litigation or claims► Impact to purchase price and financial model

Financial Diligence

Said another way . . . The focus areas of diligence all impact purchase price

Primary focus areas of financial / accounting due diligence include:

► Quality of earnings & key business drivers

► Debt/debt-like items

► Net working capital

Component

The sum of:

Enterprise value $ (Often based on multiple of EBITDA)

+ / - Cash / Debt (net indebtedness)

+ / - Working capital adjustment

+ / - CAPEX adjustments

+/ - Non-operating assets and liabilities

= Purchase price considerationAll impact purchase price

Financial Diligence

Focus of financial diligenceQuality of earnings


II. Understanding of key business drivers

III. Net working capital

IV. Debt-like items

Financial Diligence

EBITDA is typically the basis for determining enterprise value

► Free cash flow is used to compute enterprise value► EBITDA is the starting point for determining FCF

FCF = EBITDA – CapEx +/- working capital change – cash paid for taxes► Represents the net cash flows available to the equity and debt

holders► Is more representative of cash flows than EBITDA because it

considers (i) CapEx, (ii) working capital needs, and (iii) tax cash outflows (not GAAP deferred tax)

► Although FCF is a superior recurring cash flow metric, the investment community speaks in terms of EBITDA because it is (i) a simpler metric to calculate and (ii) easier to compare multiples with other businesses in the industry.

Financial Diligence

Quality of earnings

► Adjusted EBITDA is an amount having:► The benefit of hindsight► The ability to normalize various non-recurring or non-operating

transactions/activities► The ability to present a view on judgmental matters that may differ from

management and company auditors► Basis of purchase price negotiation

► Adjusted EBITDA highlights those areas that may need to be considered/adjusted for financial modeling/forecast purposes

► Basis for negotiating financing terms and amount of leverage► EBITDA is a proxy for cash flow available to service debt principle and

interest payments

Financial Diligence

Implications of quality of earnings on transaction value

► “What is the impact on transaction value?”► Investment decisions

► Setting purchase price► Bank/finance sourcing► Determining transaction leverage► Establishing loan covenants

► Assess transaction risk► Opportunity

► Where is value in the business (product, technology, geography, assets, synergy, customers)?► Are growth assumptions reasonable?► Is the basis for the offer supported by economic reality?

► What ammunition can we use to negotiate price/structure?► Where are hidden values?

Financial Diligence

Common issues and warning signs

► “What are common issues to watch for?”► Seller EBITDA adjustments that are significant or not easily

supportable► Lack of correlation between EBITDA and cash from operations► Nonrecurring income and expense► Changing revenue and expense run rates

► Erosion in selling prices, gross margins, key customer accounts► Unfavorable cost structure changes

► Seasonality factors► Capital expenditure and “discretionary” spending deferrals► Allocated charges or shared services

Financial Diligence

Common issues and warning signs (cont.)

► “What are common issues to watch for?”► Selling practices

► Large end-of-period sales increases (channel stuffing)► Deterioration of credit terms► Impact of new and discontinued product lines

► Carve-out issues► Discontinued operations► Significant balance sheet and profit and loss fluctuations► Unrecorded/undisclosed liabilities► Other income/expense excluded from EBITDA but includes

recurring operating activity (i.e., Fx settlement gains and losses)

Financial Diligence

Common issues and warning signs (cont.)

► “What are common issues to watch for?”► Changes in estimates — judgmental accounts

► Reserve for bad debts, credits, rebates, customer charge-backs► Inventory obsolescence reserves► Warranty, product liability, self-insurance or other reserves► Restructuring reserves► Purchase accounting reserves

► GAAP vs. Target accounting practices► US GAAP vs. IFRS/local GAAP accounting practices and policies► Changes in accounting policies and practices

► Differences in year-end vs. interim month-end adjustments may impact LTM

► Accounting irregularities

Financial Diligence

Typical EBITDA adjustment categories

EBITDA adjustments generally fall into one of five categories:1. Out-of-period (correction of errors and timing differences)

2. One-time and non-recurring transactions

3. Non-cash transactions

4. Pro-forma items (adjustments to reflect run rates of historical or expected future transactions)

5. Management adjustments

Financial Diligence

Focus of financial diligenceUnderstanding of key business drivers




IV. Debt-like items

Financial Diligence

Understanding key business trends

There are no standard “business diligence” procedures – deal, scope, and access to management specific. This focus area is typically critical for the Buyer’s investment thesis.

Focus area Procedures

Customer attrition/renewal rates

We analyzed how customer maintenance renewal rates were calculated. The analysis identified inaccurate and aggressive methodologies utilized in historical renewal calculations which linked into management’s forecast assumptions.

Revenue recognition/cash collections

We compared historical revenue recognition to supporting bank statements. We analyzed the timing and amount of cash receipts compared to revenue recognition.

Run-rate analysis relative to current year forecast

FY11 results declined ratably throughout the year; therefore, FY12F reflected modest increases from an annual comparison perspective. However, we needed to understand results from a 4Q11 “jumping off point”.

Organic versus acquired growth

Segregated the business in to several buckets, to isolate and analyze the trends in the core organic business versus growth from acquisitions..

Financial Diligence

Focus of financial diligenceNet working capital




IV. Debt-like items

Financial Diligence

Overview of net working capital

► What is net working capital?► Generally, current assets, less current

liabilities, excluding cash, indebtedness and income taxes.

► Why is NWC important?► Valuation importance — Calculated

enterprise value (“EV”) for a business typically contemplates a “normal level” of delivered NWC. Absent this concept, Sellers could plunder corporate coffers between signing and closing through asset monetization and current liability deferrals.

► NWC shortfalls post-transaction could require Buyer to provide additional cash to fund operations.

► Modeling importance – Change in NWC is a key component to derive free cash flow, and in turn, debt paydown.

► Financing importance – Understanding “peak-to-trough” monthly NWC trends to determine size of revolver facility.

► NWC and the SPA► Many SPAs include an adjustment for

the difference between a predetermined target NWC and a closing NWC.

► Makes Buyer whole, dollar-for-dollar, for any shortfall in delivered NWC vs. “normal” level of NWC (contemplated in EV of Target).

Financial Diligence

What is the purpose of the net working capital adjustment?

Purpose of NWC purchase price mechanism ► Protects the Buyer from the Seller plundering coffers between signing

and closing through the current asset monetization and current liability deferrals (i.e., accelerated receivable collections and delaying payment of payables and accruals).

► Protects buyer from asset deterioration, unusual liabilities and other adverse changes not covered in material adverse changes clauses.

“Fairness” concept► “Fairness” is in the eye of the beholder ► “Fairness” of targeted NWC varies by Company and deal – In

general, Buyer wants targeted NWC to be set as high as possible whereas Seller wants targeted NWC to be set as low as possible.

Financial Diligence

What do we mean by net working capital?

Represents level of investment necessary to allow for normal settlement cycle on trade items and accommodate customer expectations about timing and availability of “inventory” (e.g., fund normal commercial activities).

Include as a component

of working capital► Trade receivable► Inventory► Prepaid insurance► Trade accounts payable► Accrued wages► Accrued vacation► Accrued medical insurance

May be excluded as a component of working capital

► Cash► Interest receivable► Shareholder receivable► Fixed assets► Deposits (asset)► Goodwill► Deferred income taxes

(asset or liability)► Short-term investments► Past-due accounts payable

► Accrued interest► Line of credit► Current portion of LTD► Long-term debt► Interco Accts (in carve out

transactions)► Restructuring reserves

Financial Diligence

Key considerations when analyzing net working capital

► Seasonality► Acquired businesses (“Add-ons”) ► Extended A/R terms► Growth versus mature businesses► Past practices of managing working

capital vs. current or go-forward practices (e.g., stretching payables and accelerating collection of receivables, adjusting reserves, etc.)

► Interim versus year-end accounting (true-up of bonuses, reserves, etc.)

► Existence of non-operating (e.g., restructuring reserves) or intercompany/affiliate assets and liabilities

► Intra-period (month) NWC swings► Cash receipts cycles► Cash disbursement cycles

► Definition of net working capital

Financial Diligence

Focus of financial diligenceDebt-like items




IV. Debt-like items

Financial Diligence

Net debt concepts

► Purchase agreements typically include a definition of indebtedness► Typical debt instruments (long-term debt, short-term revolver, notes, etc.)► Debt-related liabilities, such as accrued interest► If transaction is not cash-free, cash delivered may offset debt

► Certain liabilities may be preferred to be treated as debt ► Seller essentially funds these liabilities as a reduction of purchase price by

including in debt definition► Examples: deferred revenue, extended payables, on-balance sheet

pension obligations► Indebtedness definition could include off-balance sheet liabilities (e.g.,

change in control payments, unfunded pension liabilities)► If debt definition is aggressive and inclusive of many items, Seller

may view the mechanism as a valuation consideration

Financial Diligence

Net debt concepts

► Working capital considerations► If working capital purchase price adjustment mechanism is used,

indebtedness definition should reflect treatment of working capital► Typically, items excluded from definition of net working capital are included

in definition of indebtedness► Work with attorneys to read contract language and ensure treatment is

consistent between mechanisms

► Deferred revenue/customer deposits► Complex – several treatment options ► Most aggressive treatment is to treat as debt► Nature of deferred revenue should be considered in treatment (i.e., cash

received in advance for inventory versus deferral of recognition of service revenue)

Financial Diligence

Some debt-like item examples

► Capital leases► Off balance sheet liabilities► Unpaid (CIC) bonuses► Aged payables ► Earn-out liabilities► Liabilities related to discontinued

operations (e.g., severance)► Litigation reserves► Deferred revenue, to the extent

not captured within the working capital or separate mechanism

► Deferred capex► Large and unusual self

insurance liabilities► Pension liabilities

(other than 401k)► Employee, shareholders’

loans payable► Deferred tax liabilities

m&a part i: deal structure & due diligence financial diligence november 14, 2014

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