A search fund is an investment vehicle through which investors financially support an entrepreneur's efforts to locate, acquire, manage, and grow a privately held company.
At Gerald Edelman, we often provide transaction support for these ambitious entrepreneurs from the commencement of the acquisition process and also offer a range of ongoing compliance services for the acquired company post-acquisition.
During the acquisition process, it is essential that the search fund understands all potential financial risks. Due diligence services are provided to help the purchaser identify risks quickly and effectively. Financial due diligence is the process of reviewing a potential acquisition target's financial performance across a historical period (and looking forward) to identify any potential financial hazards. Without high quality financial due diligence, risks may be left undiscovered, resulting in significant issues arising post-completion which could jeopardise the success of a deal.
It's common for search funds to have spent a considerable amount of time understanding their potential target before engaging in financial due diligence and therefore they will often have a strong understanding of their target already. In this article we outline the 10 most common issues identified during financial due diligence that can trip up a searcher's acquisition and highlight areas of focus when building a financial due diligence scope to ensure that key risks are spotted and addressed.
1. Accounting policies
Search funds often target well-established businesses which have been run by owner managers since incorporation. Owner managers usually have a strong understanding of their company's performance but don't always spend much time ensuring that their financials are in line with accounting standards. This often results in incorrect accounting policies applied that call into question the validity of the information being provided.
An accounting policy error we often encounter is improper turnover recognition. This ranges from not recognising turnover at the correct point to not recording accrued or deferred income appropriately (resulting in recording income in the incorrect reporting period). The impact of this is twofold; firstly, this can lead to incorrect computations of profitability and EBITDA.. As a number of search fund deals are partially funded by debt, debt providers often calculate the quantum of debt funding to be made available as a multiple of the EBITDA value. Accordingly, changes in normalised EBITDA can have a significant impact on the debt facility available to the buyer. In addition, an incorrect EBITDA value can cause significant problems for the purchaser when calculating the true return on investment from the acquisition.
Secondly, if a transaction is structured with an earn-out consideration, there is a possibility that revenue may be incorrectly included into an earn-out period, which could result in a purchaser paying a higher level of earn-out consideration than necessary had revenue cut-off been applied correctly. Therefore, it is crucial to get this right.
2. Inaccurate or lack of management accounts
It's common for owner managed businesses to have poorly prepared, inaccurate or sometimes a lack of management accounts. As above, the owners often have an extremely strong understanding of the business and how it is performing, therefore, they see little benefit in producing high quality management accounts. However, for an acquiring party it can create significant difficulties when trying to ascertain performance across each period and the seasonality of earnings and/or working capital requirements.
When inaccuracies are identified, due diligence providers will work with management of the target to resolve these issues. In addition, it is important for the provider to inform the acquirer of the deficiencies to ensure they are aware of the areas which could be inaccurate or may need additional investment post-acquisition.
3. Completion mechanisms
There are two main forms of completion mechanisms: completion accounts and locked box. A completion accounts mechanism determines the final price by reference to the target's financial position at the date of completion, while the locked box mechanism determines the final price by reference to the target's financial position at a fixed date prior to completion.
The completion accounts are usually prepared by the target's management and/or accountants and are subject to review by both the buyer and the seller. Any differences between the estimated financial position at completion and the actual financial position reflected in the completion accounts may result in adjustments to the final purchase price. These adjustments could be made to account for changes in working capital, net debt, or other financial indicators agreed upon in the transaction.
The locked box mechanism aims to provide greater certainty to both the buy and the seller regarding the purchase price. It assumes that any changes in the Target's financial position and value after the locked box date are borne by the seller, while any value created or distributed before that date benefits the seller.
To protect the buyer's interests, measures are typically put in place to prevent leakage of value from the Target between the locked box date and the completion date. For example, restrictions may be imposed on dividend payments, excessive debt incurrence, or non-arm's-length transactions during this period.
Overall, completion accounts and locked box mechanisms differ in terms of when the purchase price is determined. Completion accounts determine the price post-transaction, considering the actual financial position at the completion date, while the locked box mechanism fixes the price based on a predetermined financial position before the completion date. Certain mechanisms may be more suited to different companies depending on the nature of the business. An advisor providing financial due diligence and deal advisory services will often discuss what the most appropriate approach will be when designing the completion mechanism.
4. Working capital targets
The working capital target is also a key area of negotiation surrounding the completion mechanism of a deal. The working capital target serves as a benchmark against which the actual working capital at the completion date is compared. This is designed to address potential changes in the target's working capital during the transaction process. If the actual working capital at the completion date exceeds the target, the buyer may receive an adjustment payment from the seller to compensate for the excess. Conversely, if the actual working capital falls short of the target, the seller may need to reimburse the buyer for the shortfall.
Working capital analysis will help to assess the target's cashflow cycle and ensure that no additional injections of cash are required after completion of the deal. Financial due diligence providers will therefore calculate a working capital target and ensure the company has enough cash to operate post completion before generating unwinding the cash locked up in its working capital cycle.
Calculating a working capital target can be challenging when the company has seasonal demand. Below we have presented a working capital cycle where the company has a large fluctuation of working capital during the year.
In highly seasonal businesses, it is essential to base the working capital target on the most active periods, which are the periods when most cash will be tied up in working capital. Highly seasonable businesses will require sufficient cash reserves to fund their seasonal sale cycles. A straight forward 12-month average will likely significantly underestimate the actual working capital requirements of the business and mean that insufficient working capital is left in the business to fund the peak months of activity.
To illustrate this, in the above example a 12-month average would produce a working capital target of c.£3,000. However, this amount would figure will not be sufficient during the Target's peak months (August-November) where the average working capital would be c.£95,000 and the peak is c.£150,000. Therefore it is key that the acquirers understand the importance of determining an appropriate level of working capital while factoring in the nature of the business.
Additionally, as searchers' transactions usually utilise debt financing to fund a proportion of the acquisition, the ability of the target company to generate cash is crucial as most lenders set their loan covenants based on different metrics of cash generation. If the cash flow is insufficient, the lender may not be comfortable funding the deal.
5. Lease commitments
It is typical for SMEs, the most common type of target for search funds, to utilise various forms leasing such as hire purchase, finance leases and property leases.
Hire purchase agreements and finance leases are often used to spread capital expenditure over a prolonged period. These agreements should usually be defined as debt within the SPA however it is common place for early iterations of this document to place this liability outside of the definition of debt. If this is not corrected, the purchaser will inherit the outstanding balances in relation to finance leases and hire purchase obligations without a corresponding deduction to consideration, thereby overpaying for the Target.
The financial due diligence provider should therefore review the hire purchase contracts to calculate the outstanding amount due at completion ensuring the debt adjustment is correct. In addition, there should be a review of all leased equipment ensuring that management is aware of leases due to end in the near future and have set out plans to replace the appliances.
Similar to hire purchase agreements, SMEs often lease production and other facilities which are critical to the performance of the entity. The company has often adapted the site and as such an unplanned location change could significantly affect the performance of the Target. Therefore, during the financial due diligence process it is essential that these contracts are reviewed in detail.
The key areas of focus while reviewing property lease agreements are the lease end dates and the counterparty to the lease. If the lease is due to end in the near future and the landlord does not intend to renew the lease agreement, the new owner could be left scrambling to find a new property to lease. This process is often lengthy and has the potential to severely undermine the company's performance and as such early identification of this risk is essential.
In addition, understanding who the property is leased from is important. If the property is subleased, the target has little control or interaction with the property's owner. This exposes the target to additional risks. For instance, if the secondary landlord (which the target leases off) breaches their lease agreement with the owner of the property, this lease can be terminated, which in turn would terminate the target's lease agreement. Therefore the review of leases should be covered by legal due diligence as well as financial due diligence.
6. Intra month cash analysis
Intra month cash analysis is a process to predict potential cash out goings on a day-to-day basis. This is an additional level of detail on top of the working capital analysis, which usually reviews the Ttarget's position at the end of each month. If there are significant cash swings during the month, the purchaser may be able to push for an additional adjustment to support the entity post- completion, but before the working capital adjustment is made.
For this analysis, an advisor will review the daily bank balances for a full year and exclude any non-trading cash movements, such as transfers, to see daily variances in operating cash. This data is then used to calculate the minimum level of operating cash required for the target by calculating the difference between the opening cash balance and the minimum cash balance across a 30-day rolling period.
The example below shows the cash outflow variance for a full year on a 30 day rolling period, which shows the largest outflow being c.£125,000. This would therefore be the minimum level of cash we expect the target to have post-completion to ensure that day to day cash obligations are still met. This analysis can also be a tool to negotiate an additional adjustment in the working capital target to account for intra-month cash movements.
7. Invoice discount facilities
Invoice discount facilities are frequently used by companies a beneficial tool for companies to improve their cashflow in between invoices being issued and receipt of payment.
From a due diligence perspective, it is common that these facility agreements will have a change of control clause which allows the lender to withdraw the facility if the entity changes owner. When these clauses are included within the contract, we recommend the purchaser approaches the lender prior to completion to ensure they do not invoke their right to withdraw the facility after the change of ownership.
Additionally, it is beneficial for the financial due diligence provider to review whether this facility is required in the first place. The analysis will cover the additional fees incurred in having the facility in place, to reviewing the impact on working capital and cashflows, should the facility be removed. Analysis may indicate that the invoice discounting facility may not be required to keep the entity operational and may be terminated so post completion.
8. Forecast review
Typically search funds acquisitions will be partly funded through debt financing. Part of the process will involve lenders assessing a cashflow forecast model to review the expected future performance of the target and ensure that covenant thresholds are not breached based on their lending criteria.
The forecast model is usually prepared by the searcher and then reviewed in detail by the financial due diligence provider. During the review, the model is checked ensure that all formulas are correct and that assumptions are reasonable. Sensitivity analysis is then carried out to ensure that in the event results deviate from the forecast, there is sufficient headroom available to ensure covenants are not breached.
9. Undisclosed liabilities
During the due diligence process, a critical objective is to identify all potential liabilities or off- balance- sheet financing and ascertain the recoverability of assets. Failing to do so could lead to unexpected liabilities emerging after the transaction is complete, which could be difficult to address through warranties and indemnities. Additionally, relying on the receipt of cash from uncertain assets that never materialise could pose problems for cash flow modelling.
This can be especially problematic if management information is lacking. Financial due diligence can help identify potential undisclosed liabilities and assess the recoverability of assets which will reduce the risk of surprises after the transaction is complete.
10. Complex transactions
Occasionally we may also come across a Target where complex accounting transactions have taken place during our period of review. For example, group companies with discontinued operations or disposals of subsidiaries. In order for our analysis to be directly comparable, any companies that have been discontinued or disposed of should be excluded from comparison analysis to ensure that we are comparing like for like results.
This can present various challenges such as identifying details of any intercompany transactions that need to be eliminated, the impact of any contingent and deferred consideration and working with limited financial information that is available from management.
For example, when management accounts do not have separate lines for revenue or expenses incurred by discontinued operations or disposed of subsidiaries, assumptions must be made to calculate reasonable levels of revenue and costs to be removed. Adjustments of this nature can have relatively significant impacts on the stated profitability of the company and are prone to accounting errors, so it is an area of significant focus when encountered. Due diligence providers should check over this information to ensure these adjustments are accurate ensuring that the financial data fairly represents the entity being acquired.
The above points outline some of the key areas focused on during the financial due diligence process for searchers, which if left unidentified can cause the acquiring party significant headaches further down the line.
Originally published 14 Aug 2023
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
