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Working with Private Equity Quality of Earnings

This blog series examines best practices for CEOs and CFOs who are considering a private equity transaction, culled from working with hundreds of transactions across all industries. The third topic in our series about working with a PEG is Quality of Earnings; (“QofE”) analysis, also referred to as Sell-Side or “Reverse” Due Diligence.

As the name implies, the seller engages a firm like Frazier & Deeter for a laser focus on those earnings metrics that make a difference to a buyer.  Buyers place a premium on earnings that are both sustainable and predictable.

In today’ s blog we will look at a few insights which are drawn from Frazier & Deeter’s QofE engagements.  We have chosen to present certain qualitative views in addition to the familiar quantitative analyses.

How does the customer view you along a spectrum ranging from supply chain partner to commodity supplier Do you participate in the customer’s design process or just get a PO?  There is nothing inherently wrong with either end of the continuum, as long as the target does not think it is at one end and customer has other ideas.  A few years ago, Dell’s new CFO asked how many suppliers Dell had.  No one knew precisely, the number was so large.  His mandate:  reduce suppliers to less than 50, and make them partners in its business.

Does the customer ask for concessions “outside the envelope,” that may be difficult to quantify?  In a recent due diligence engagement, I asked “Who is your best customer?”   Response:  Customer A.  Indeed, Customer A had the largest sales volume.  Customer A was also one of the lower margin accounts.  Further investigation revealed the target warehoused millions in special inventory for Company A, the target often had to arrange personal and rush delivery and training.  Company A forced later-than-normal merchandise returns, and the target received its payments in 60 days (when 30 was the norm for other customers).   When all the factors were evaluated, Customer A emerged as one of the least profitable.

Quality of Earnings can make or break a deal when working with Private Equity. Asking questions like these will help you understand the Private Equity perspective on your business and its sustainability.

If you would like to discuss Quality of Earnings, business valuations or other aspects of selling to a private equity group, Wes Pennington is available at Wes.Pennington@frazierdeeter.com

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