Trends in Lower Middle Market M&A- The Use of Sell-Side Quality of Earnings Reports

Through our involvement as a buyer in private markets, we have noticed a trend of sell-side Quality of Earnings (QofE) Reports becoming more common in lower middle market (“LMM”) M&A deals.  While LMM buyers routinely use QofE reviews during diligence, LMM sellers have been increasingly using a detailed quality of earnings analysis to help maximize the value of their business and mitigate unwanted surprises during a transaction.  While sell-side QofE has seemingly become the standard in the Middle market, its use has been increasingly common down market in LMM deals.  If you have considered engaging an investment banker recently, you likely have been asked to have a sell side quality of earnings report done.  Sellers may be surprised by a request to bear these additional deal related costs at the beginning of an engagement.  Why do investment bankers push for these reports and do the benefits justify the costs?

The Typical Reaction to More Fees

As you enter into a sell-side investment banking engagement and think through a sources and uses report at deal close on a hypothetical sale, you may be struck by the success fees your banker will earn as well as your estimated legal and accounting costs.   In addition to your tax burden, it may seem like every expert involved in the sale process has a hand in your pocket.  You may then be wondering why your investment banker requests that you commit to additional costs for a service that you normally associate with the buyer’s diligence process in an M&A transaction.  The short answer is investment bankers are motivated by success fees, and their job is to sell your company.  It is natural to receive a request that will help make the sale process smoother.  Sell-side QofE engagements can offer value to sellers in the lower middle market but may not be necessary.

What Does a Sell-Side QofE Report Entail?

The specific scope of a QofE review can vary, but generally a sell-side quality of earnings report will focus on the “quality” or sustainability of the company’s earnings.  Buyers are naturally focused on valuation and most businesses are often valued based on a multiple of EBITDA.  A sell-side quality of earnings report will focus on unusual or nonrecurring income and expense items, over or under-stated assets and liabilities, trend analysis, fluctuations in monthly and annual performance, and the application of accounting principles.  These factors, among others, are all analyzed to reflect normalized EBITDA as well as to evaluate the add-backs to bridge reported EBITDA with adjusted EBITDA.   The review will also evaluate working capital trends to assess the normalized levels of working capital needed to operate the business, helping sellers prepare for negotiations around the often-contested working capital target or “working capital peg”.

Primary Benefits of a Sell-Side QofE Engagement

A sell-side QofE report helps private and closely-held businesses identify potential issues early in the transaction process, minimizing surprises that may emerge late in a transaction.  Sell-side QofE may also help reduce the amount of time a company is on the market and certainly helps sellers understand how a buyer may view the durability of the company’s earnings power.  Investment bankers naturally gain from reconciling your initial view of the attractiveness of your company’s financial profile against an independent third party, level setting your valuation expectations and increasing the likelihood a deal will get done and success fees earned.  QofE service providers typically explain that the review may pay for itself by preserving value through an acquisition and arming sellers with the information needed to support your TTM and run-rate EBITDA figures when negotiating with buyers.  Performing a sell-side QofE in the lower middle market can also project confidence, demonstrating to buyers that the seller has taken the process seriously and is committed to a transaction valued on a supportable adjusted EBITDA figure.

Areas to Consider if You Move Forward with a Sell-Side QofE

The quality of sell-side QofE reports varies.  With any professional service provider, you often pay for what you get.  Not all QofE providers offer the same level of service or sector expertise.  National and regional accounting firms typically have dedicated Transaction Advisory Groups with a variety of sector specific teams, while local accounting firms may or may not be able to provide the same level of capabilities.  Cost-conscious sellers that limit the scope of the engagement may inhibit the ability of the QofE team to perform the depth of review they prefer, yielding a report with less quality. 

Ideally, the QofE team should be in active communication with your investment bankers to ensure the narrative behind the deal materials such as the Confidential Information Memorandum and financial models are consistent with the results of the QofE report.  Staying in communication with the QofE review team after buy-side diligence commences will ensure the QofE team offers support to the seller throughout the process.  

Our View

Is a sell-side QofE review worth the cost for a LMM seller?  We think it depends.  While sell-side QofE reviews have become more common in the LMM, they are not yet ubiquitous.  Middle market sellers may be harmed by not going through the QofE process as they bring their company to market given how standard sell-side QofE reviews have become in that larger market segment.  For sellers in the LMM, you should carefully weigh the benefits and costs of getting a sell-side QofE report done.  A sell-side QofE review is a large financial commitment made by the seller that may yield direct benefits in the form of a higher valuation due to the discovery of favorable EBITDA adjustments.  More likely than direct upside benefits, the QofE review will arm the seller and their investment bankers with support during the buy-side diligence process to help preserve value in a transaction.  Additionally, the seller will benefit by reducing uncertainty and identifying concerns a typical buyer will flag during diligence.  If you have confidence in your accounting and finance functions and feel strongly about the accuracy of your TTM EBITDA figures and the reasonableness of your adjustments and add-backs, a sell-side QofE report can signal confidence to the market but may not materially change the outcome of a transaction.  If you expect challenges in diligence and are sincere about closing a transaction in a reasonable time frame, it may be better to surface material issues at the outset to avoid a busted deal late in the transaction process.  Just do not expect a sell-side QofE review to always yield upside adjustments on your valuation- sometimes accountants can be good salespeople. 

Vail Valley Asset Management – Full Service Investment Management for Business Owners

We offer a highly differentiated investment solution for lower middle market business owners centered around our unwavering commitment as fully aligned fiduciaries.  We view our clients’ business ownership as their most important asset that is at the core of our portfolio management process.  At Vail Valley Asset Management, we are 100% fiduciary 100% of the time, and offer a source of objective advice to business owners.  Building and operating a business is complex, requiring dedication, vision, and perseverance.  Selling your company attracts sell-side service providers motivated by success fees and other deal-related fees.  You deserve a trusted and unbiased advocate with a deep understanding of private markets to guide you through the complexities of the M&A process.   If you are a business owner looking for a financial advisor with expertise in private markets and the M&A process, contact us at Vail Valley Asset Management to schedule a consultation.