Accretive Solutions Q3 2015 Quarterly Learning Series Due Diligence Best Practices
Agenda Buy-side and Sell-side Due Diligence Due diligence what is it and why is it important Summary 2
3 Section 1 Buy-side and Sell-side Due Diligence
Why M&A? Financial Back existing management team Pursue attractive growth opportunities Reposition underperforming business Support existing platform Employ capital to achieve return Buyers Strategic Drive revenue growth Diversify business Geographic, product or customer expansion Defensive Technology Sellers Obtain liquidity for non-diversified asset Divest non-core assets/operations Provide return to investors Regulatory required divestiture Access additional capital and capabilities to continue growth trajectory 4
Benefits of financial vs. strategic buyers Financial Strategic Company can remain independent Reward existing management team Confidentiality Competitive valuation Gain strong financial partner Flexible transaction structures May offer highest price due to synergies, strategic fit or financial wherewithal Access to certain customers, distribution channels, technologies, etc. that can enhance the growth of the business 5
sell-side diligence Overview Prepared sellers drive value What you need to know when preparing to sell: Investors are increasingly selective about the transactions they pursue. Transaction success is extremely fragile investors are less willing to tolerate issues whether perceived or factual. Buyer-identified issues can put a seller in a defensive negotiating position on price and transaction terms. Why perform sell-side due diligence: Level the playing field when soliciting offers all investors bid off validated EBITDA, reducing the likelihood they can re-trade on price before close. Minimize surprises being forthright with issues will enhance your credibility; those issues can be appropriately framed and corrective measures discussed. Expedited closing a thorough sellside report will address most buyer questions, hopefully reducing the depth of their own investigation. Buyers can be asked to disclose the extent of independent due diligence in their offer. How sell-side diligence differs from your audit: Sell-side diligence focuses value drivers and business considerations of critical importance to potential buyers, not just on the Company's balance sheet. A focus on presenting sustainable EBITDA; assessing the quality of your earnings. Focus on recent periods. It is important to present financial information on the most recent interim periods. 6
sell-side value drivers Our procedures are designed to mitigate the fact sellers and buyers often have conflicting agendas but seek similar outcomes outcomes sell-side due diligence can help you control Your Goals Maximize valuation Optimize structure and minimize taxes Avoid surprises from bidders due diligence Meet timetables and manage expectations Control information release Limit reps, warranties, indemnifications Shared outcomes Preserve value Reduce uncertainty Minimize post-close disputes Minimize distractions Maintain credibility Buyer Goals Highlight liabilities and risks Challenge run rates and forecasts Understand sustainability Maximize reps, warranties, indemnifications Develop advantage vs. other bidders Reduce price and uncertainty Control sales process Conducting Sell-side due diligence contributes to your successful transaction outcome by: Preserving enterprise value Sell-side diligence allows the buyer to be proactive and present normalized earnings before buyer scrutiny. Adjustments are substantiated and given credibility by Grant Thornton. Reducing uncertainty Transparency reduces surprises. Both parties are presented with a reliable quality of earnings, diminishing ability to renegotiate price. Minimizing post-close disputes The clarity and level of detail provided throughout the diligence process contributes to enhanced buyer / seller understanding. 7 Minimizing distractions The process will prepare Management for the rigors of buy-side diligence and lead to a more efficient and confident interaction. Maintaining credibility As an objective and independent advisor, Grant Thornton will provide bidders information that is complete, accurate and credible. Identifying an efficient tax structure Tax structuring professionals can work with you to ensure an outcome that minimizes your tax liability.
sell-side diligence approach PHASE 1 PHASE 2 PHASE 3 Preliminary Diligence Full Scope Diligence Closing and Post-Closing Support Phase 1 Objective Phase 2 Objective Phase 3 Objective Identification of key accounting issues and their impact on EBITDA Phase 1 Typical Scope Obtain an understanding of the business and its operations Perform a high-level analysis of financial information, designed to identify nonrecurring and non-operating items impacting EBITDA Document descriptions and maintain support for identified EBITDA adjustments Other considerations: Phase 1 Phase 3 Quantification and accounting analysis, including in-depth EBITDA, working capital, financial performance and position analysis on financial information Phase 2 Typical Scope Accumulate findings from Phase 1, update adjusted EBITDA Expand analysis of historical operating trends and other areas typically addressed in diligence including the following: Analyzing division level profitability Understanding cost structure Understanding working capital requirements Prepare unbranded databook to be shared with third party buyers Support Management s proactive and reactive negotiations by preparing fact-based positions of strength Phase 3 Typical Scope Assist development of a data room, and preparation of financial data and schedules on a basis of accounting consistent with the financial statements and Information Memorandum Liaise with prospective purchasers, including addressing their questions which arise as part of their diligence Assist with purchase price adjustments, closing schedules and other post-closing issues Sector groups / subject matter experts utilized as required Scope / phases tailored to the specific requirements Flexible fee arrangements aligned to sellers objectives Other service areas utilized as required, including IT, human capital, tax structuring 8
9 Section 2 Due diligence what is it and why is it important
What is Due Diligence? Basic Definition A systematic process of challenging a seller's principal representations about a potential target and challenging other critical issues Simply, getting the correct facts on the business There are many categories of due diligence Legal Environmental Insurance Customer PP&E Benefits Today we are discussing: Financial Market Management Assessment Other 10
Why is financial due diligence performed? The intended purpose of financial due diligence is to: Link seller's "story" with actual results Quality of earnings, working capital requirements and debt like items Assess key financial assumptions used in valuation Support negotiation of deal terms and conditions Support post-acquisition integration planning The scope and focus of financial due diligence is much different than an audit 11
Financial diligence can affect valuation Pre Diligence Valuation EBITDA per CIM x = Buyer's Multiple Enterprise Value Assumed in LOI $50.0M 8 $400.0M Post Diligence Valuation EBITDA per Due Diligence x = Buyer's Multiple Post - Diligence Enterprise Value $45.0M 8 $360.0M 12
Tax diligence can affect valuation Value may be negatively be impacted by exposure items Structuring alternatives may provide "win/win" solutions Tax assets (existing tax basis, step-up, NOLs, etc.) may hold value to the buyer Effective tax rate and future cash tax planning 13
Key Elements of Tax Diligence Understand deal terms, proposed structure, business issues Plan appropriately limited resources Understand successor liability profile Understand target's significant economic events Understand target's tax "footprint" What to do with findings? 14
Section 3 Financial diligence 15
What is financial due diligence? Does not constitute an audit in accordance with GAAP We do not express an opinion or provide assurance Process of: Challenging a seller s assumptions (or anticipating a buyer s assumptions) about the historical and projected performance of an industry, business or group of assets; Obtaining information to confirm an investment thesis and to finance a transaction; Assessing financial personnel and systems; Discovering issues to be addressed in the purchase agreement; and Identifying pressure points and opportunities in a Target s current and future operations (e.g., synergies, restructuring, integration, etc.) 16
Why financial due diligence is important When buying a company: Identifying deal breakers early minimizes third party and internal opportunity costs Assessing a sustainable level of earnings reduces the risk of overpayment Analyzing the quality of a Target s assets and liabilities helps understand free cash flows When selling a company: Raises issues early while there is time to address Protects the integrity of the sale process Critical to making judgments on valuation 17
Why isn t an audit enough? Different in scope and focus than due diligence, an audit: Typically is balance sheet focused Does not address quality of earnings, nor EBITDA Does not address business issues Performed at point in time and does not address interim periods or periods after the audit Does not cover forecast period Does not address quality of people, systems and infrastructure Level of materiality may be much higher than buyer's materiality 18
Financial Due Diligence: Core focus Business & Deal Drivers Attributes of the Target that contribute to sustainable earnings and cash flow. Examples: Products and technology Geography Production capability Trade name Synergies with acquirer Customers/ Vendors Working Capital Understand the normal level of investment in working capital. Typically: A/R and inventories Accruals Reserves Deferred costs Industry-specific accounting issues Often linked to EBITDA adjustments Quality of Earnings Attempt to get to a normalized or run-rate EBITDA or earnings stream. Generally four categories: Corrections of errors and timing issues 19 Debt-like Items Identify items with debt-like characteristics. May be included in definition of debt in purchase agreement. Examples: Noncash transactions Lease obligations Nonrecurring transactions Deferred revenue Pro forma adjustments for historical or Pension / employee expected future transactions benefit obligations Customer deposits Contingent liabilities / offbalance sheet commitments
Focus on value drivers Purchase price components Due diligence focus areas Enterprise Value EV commonly based on EBITDA multiple or discounted cash flow Quality of Earnings P&L Analysis Terminal Value Debt and debtlike items Most deals "cash and debt free" Debt and debtlike items Multiple Multiple Cash and investments Working capital adjustment Net asset or other adjustment Quality of information, controls, and processes Normal level of closing date working capital should be provided by seller Accounting and Reporting Considerations Working Capital Equity Value As determined by the mechanics of the sale and purchase agreement SPA Considerations 20
Business and deal drivers Linking the story to the financial information Understanding the business in light of the acquirer's investment thesis and transaction structure Things to look for: Reliance on a few major customers, contracts or vendors Major contributors to profitability Need for significant future expenditures Litigation/regulatory problems Quality of the financial processes and controls Credibility and integrity of management 21
Typical Quality of Earnings analysis Quality of earnings $ in thousands Ref. No. Fiscal 13 Fiscal 14 TTM 15 Revenue or sales 143,570 192,541 292,678 Net income (loss) 11,171 25,219 36,510 Add-backs Interest expense / (income) 2,560 3,701 4,378 Depreciation and amortization 14,356 17,981 19,783 Income tax expense 3,351 7,568 10,952 Unadjusted EBITDA 31,438 54,469 71,623 Management adjustments [Description] MA-01-1,080 2,000 [Description] MA-02 4,000 4,000 4,000 [Description] MA-03 1,600 3,000 1,200 Total Management adjustments 5,600 8,080 7,200 Management adjusted EBITDA 37,038 62,549 78,823 Due diligence adjustments [placeholder] DD-01 608 1,090 1,045 [placeholder] DD-02 (1,671) (2,781) (2,906) [placeholder] DD-03 (304) (469) 165 Total due diligence adjustments (1,367) (2,160) (1,696) Adjusted EBITDA 35,671 60,389 77,127 Unadjusted EBITDA % 21.9% 28.3% 24.5% Management adjusted EBITDA % 25.8% 32.5% 26.9% Adjusted EBITDA % 24.8% 31.4% 26.4% Adjusts a target's historical EBITDA to reflect a normalized run rate Logical steps are to: Reconcile net income to reported EBITDA Understand management's adjustments to EBITDA Complete diligence to identify undisclosed adjustments Adjusted EBITDA should be bridged from period to period 22
Quality of earnings Major areas Pro-forma adjustments for historical or expected future events Corrections of errors and timing issues Non-recurring transactions Non-cash transactions 23
Quality of earnings Corrections of errors and timing issues GAAP departures Pro-forma adjustments for historical or expected future events Non-recurring transactions Corrections of errors and timing issues Non-cash transactions Passed audit adjustments GAAP compliance Changes in accounting judgments and estimates Changes in accounting practices Interim financials soft close 24
Quality of earnings Non-cash transactions Pro-forma adjustments for historical or expected future events Non-recurring transactions Corrections of errors and timing issues Non-cash transactions Equity compensation Restructuring charges Impairment charges Pension charges Gains and losses on disposals 25
Quality of earnings Nonrecurring transactions Pro-forma adjustments for historical or expected future events Non-recurring transactions Corrections of errors and timing issues Non-cash transactions One-time sales or channel stuffing Commodity movements Capitalized internal costs Product-line start up Transaction costs 26
Quality of earnings Pro-forma adjustments Pro-forma adjustments for historical or expected future events Non-recurring transactions Corrections of errors and timing issues Non-cash transactions Management/owner compensation Consolidation New/lost business run rate Related party transactions/pricing Carve-out allocations fixed vs. variable cost 27
Working Capital The Overriding Concept Working capital typically excludes cash, debt and taxes Enterprise value conceptually includes a "normal" level of working capital to support operation of the business If insufficient working capital is delivered at closing, the Buyer will have to invest in additional working capital If excess working capital is delivered, the seller has left excess value in the business 28
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 (i.e., 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 Exclude as a component of working capital Cash (depends on treatment of cash) Interest receivable Shareholder receivable LIFO reserve Fixed assets Deposits (asset) Goodwill Investment in subsidiary Deferred income taxes (asset or liability) Short-term investments Past-due accounts payable Accrued interest FAS 87 liability Line of credit Current portion of long-term debt Long-term debt Interco accounts (in carve out transactions) Restructuring reserves 29
Working capital adjustments Most deals have a dollar for dollar post-closing adjustment to recognize over/under delivered working capital relative to a negotiated target level The mechanism protections both buyer and seller impact of movements in working capital Without an adjustment mechanism, the Seller could monetize working capital prior to closing to disadvantage the Buyer There is no correct working capital target just a negotiated amount 30
Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Working capital Working capital Working Capital Establishing the target Working capital metrics Seasonal business $30,000 Working capital metrics Growing business $30,000 $25,000 $25,000 $20,000 $20,000 $15,000 $15,000 $10,000 $10,000 $5,000 $5,000 Working capital metrics Seasonal business December 31, 2013 High working capital $ 28,500 Low working capital $ 9,500 Trailing 12-month working capital $ 19,000 Average working capital may be a reasonable target Working capital metrics Growing business December 31, 2013 High working capital $ 28,500 Low working capital $ 9,500 Trailing 12-month working capital $ 19,000 More recent working capital may be a reasonable target 31
Typical working capital adjustments Cash, debt and income tax related accounts Corresponding adjustments to Q of E adjustments Non-operational items in working capital Operating items classified as long-term for GAAP 32
Debt-like items Acquired debt and debt-like items conceptually reduce equity value: Operating and/or capital lease liabilities Pension liabilities Deferred revenue Customer deposits Deferred compensation Earn-out agreements from past deals 33
Section 4 Summary 34
Key Takeaways Analyze Analysis provides understanding of the business as well as structuring and valuation implications EBITDA The normalized EBITDA run rate is a critical input in most valuation models, financing agreements and post acquisition performance measurement 35 Working Capital Working capital and debt-like analyses can have a dollar for dollar impact on the purchase price Tax Diligence Tax diligence should be tailored to the specific transaction Avoid Disputes Sound diligence and well defined PA terms may help avoid costly disputes
Questions? 36
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