Five key due diligence issues that can derail a search fund transaction

1) Revenue recognition

Issues surrounding revenue recognition are perhaps the most common reason we see for transactions falling over. It should be established as quickly as possible whether the revenue recognition policy for each revenue stream is in line with UK GAAP. If not, then the impact of adjusting to UK GAAP compliance should be calculated, with this potentially reducing both revenue and EBITDA. This is particularly important for search funds as when presenting the deal to their investors, it is vital that they can inform them of the correct revenue or EBITDA multiple. 

If (because of a UK GAAP adjustment) this multiple is above the current market rate then investors may be unwilling to continue with the transaction. Similarly if an issue is discovered late it can cause a massive breakdown in investor sentiment. However, if this issue is identified early enough in the process it can be used as a negotiation point to adjust the deal terms/headline offer or win in other key battlegrounds of the deal.

2) Legacy tax issues

Search funds typically acquire well established companies which have been run by owner managers for many years. We see companies where historic action has been undertaken at some point under this long period of ownership which may lead to a tax issue crystallising for the sellers at the point of exit.

For example, there could have been a historic group reorganisation performed without the necessary paperwork which could mean an element of the proceeds from the sale are taxable at income rather than capital gains tax rates. Such a scenario would result in a significantly greater tax liability for the seller and therefore change the commercial reality of the deal, increasing the probability of them no longer considering a sale.

It is vital that any potential tax issues are identified as early as possible to minimise cost if they are ultimately insurmountable. For this reason, we always recommend that at least some tax due diligence is carried out on target company, even if only at a high level.

3) What is the maintainable EBITDA?

The maintainable EBITDA of the company is another vital metric for search fund investors. The multiple paid on this maintainable EBITDA will be benchmarked against comparable companies in the sector with investors far less likely to support a transaction which deviates significantly from the market. 

Therefore, interrogating the maintainable EBITDA presented by the seller and establishing any potential adjustments needed is another crucial step in the diligence process and can ultimately be the difference between whether a transaction completes or abandoned. This is because if the Enterprise value of the transaction is fixed (rather than just set as a multiple of whatever is agreed as the maintainable EBITDA) then the multiple paid will keep increasing (potentially to an unacceptable level) as and when any negative adjustments are discovered.

4) Working capital cycle and cash generation

As search fund transactions often involve an element of debt financing, the ability of the company to generate cash is a key concern, with most lenders setting their loan covenants based on key metrics surrounding this. If the free cash flow is not sufficient then it may be the case that lenders simply cannot get comfortable supporting the transaction. 

Even if debt finance is not being utilised, it will still be vitally important to establish the cash flow cycle of the company to inform your own day to day running of it, allowing you to plan effectively and ensure you don’t encounter any potential going concern issues which cash flow problems could pose. 

Due diligence providers would establish the key payment terms with customers and suppliers and also investigate the typical monthly cash movements. The key objectives are to understand the forecast maintainable cash flows and to make sure the target business is left with enough cash to sustain it in the short term, post-transaction.

5) Undisclosed liabilities and other balance sheet issues 

A key objective of the due diligence phase will be to test the completeness of liabilities and recoverability of assets. The last thing a searcher would want is to complete a transaction only for new, unexpected liabilities to crystallise after the previous owner has departed (making claims under warranties & indemnities can be difficult). Similarly it could prove difficult from a cash flow modelling perspective if a searcher is relying on the receipt of cash from dubious assets which ultimately never arrives.  

Due diligence can identify potential liabilities, with these then classed as debt items to directly compensate the searcher making the acquisition when calculating the Equity Value. Even if not classed as debt they could still be used as valuable bargaining chips to trade off in other areas in a negotiation to ensure improve the deal. Similarly diligence will look to ensure any assets of debatable recoverability are properly provided against.

Conclusion

All things considered; due diligence is a vital part of the search fund acquisition process. The five key points outlined above represent some ideas of areas to initially focus on when assessing a company. 

If you have any questions about the due diligence process or are interested in any of the issues identified above and would like to discuss them in more detail, then please do get in touch. Our transaction services team have great experience in assisting search funds in making successful acquisitions.