In this episode of Private Equity 360, Bob Woosley speaks with Tim Koch, National Practice Leader of Transaction Advisory Services, about what a Quality of Earnings (QofE) is and how it can affect a transaction, good and bad.
Private Equity 360: QofE: Top Mistakes to Avoid
This transcript was assembled by hand and may contain some errors.
It has been edited for readability.
Bob Woosley Welcome to our podcast today. This is Bob Woosley, National Practice Leader of Frazier & Deeter. Our podcast today is called QofE: Top Mistakes to Avoid, this is a subject that we’ve been asked about a lot.
Quality of Earnings engagements are prevalent in both the buy side and sell side, and I’m very pleased to welcome a real expert, Tim Koch, who’s Frazier & Deeter’s National Practice Leader for Transaction Advisory Services. Good morning, Tim. How are you?
Tim Koch Good morning, Bob. Thanks for having me.
Bob Tim, it was interesting to me when I started getting more into private equity to learn a little bit more about the difference between a good QofE and a bad QofE, and also was very surprised to see that how prevalent quality of earnings engagements were in most transactions these days. If you could just give us a little bit of a view of the landscape, why are these QofE’s and what is a QofE? Why are they so prevalent now?
Tim Yes, so quality of earnings analysis reports are used to educate buyers when they’re evaluating making an investment in a company. They’re very important because they’re typically more of an extensive analysis of financial results and financial positions of a target company, much more extensive than what you would find in an audit report. So, the quality of earnings will dive a little bit deeper into the revenue streams of the business, the expenses of the business in working capital, and some of the things that really drive the value of the businesses that the private equity group ensure the investors are looking to acquire.
For most of these transactions, I think it’s almost becoming the standard or the norm for investment bankers to ask their clients to have sell side quality of earnings reports done. As a matter of fact, we’ve got several examples where we work with various private equity groups and we did the quality of earnings analysis when they acquired the company. Fast forward two, three, four, five, six, seven years, whatever the whole period is, the financial statements get audited each year after the private equity group owns them.
Then, we have the private equity group reach back out to us and have a sell side quality of earnings analysis done, and that’s becoming the norm. So, in addition to companies that are looking to be sold for the first time and having a sell side quality of earnings analysis completed, we’re also seeing it for buyers that have owned the company and have had the financials audited every year since they’ve owned the company, so it’s becoming the standard.
Bob Well, I was surprised and we’ve had a lot of companies that we’ve seen sell. They have financial audits from typically a good CPA firm or maybe a lower tier CPA firm, but we always get the question like, why do we have to do a QofE when we’ve been audited for the last three years? I know investment bankers struggle with that, but could you talk about that a little bit?
Tim That’s a common question that comes up, especially when you’re on the sell side of a transaction. And the people that own the business have just engaged an investment banker and they have their financial statements audited, the last thing they want to hear is, “Oh gosh, you should consider having a quality of earnings analysis on your company.”. An audit is great and is going to allow you to do a trailing 12-month analysis, which will get you the most up to date analysis. It will also typically highlight when you go into the monthly analysis, it will typically highlight outliers in unusual things that have been accounted for just fine in the audit.
But something that a buyer or a seller might want to be aware of, whether it’s a one-time revenue or a one-time expense. Typically, that will get identified in the quality of earnings analysis. But, I think what people have learned in the current environment is it’s so competitive and there’s so many people chasing good transactions in good companies. The last thing they want to see happen is invest a lot of time, money, and effort in a transaction that falls apart because of some accounting matters or working capital that really could have been anticipated and addressed if the seller had done a quality of earnings report.
Bob I understand. Tim, I know that you and your team does nothing but this, but I know you’ve worked with a lot of private equity firms on the buy side. You’ve told me some stories about how when you’re evaluating a prospective company that your private equity firm’s going to purchase, you’re reviewing somebody else’s QofE that’s been done and an investment banker has asked them to do it. You’ve told me a couple of stories about how you can’t believe some of the quality, good and bad of QofE’s you see. So, tell us a little bit about not necessarily a bad QofE, but what are some of the things you see for sale side QofE’s that maybe could have been avoided?
Tim Yes, you really see a full range of quality of earnings reports and, there’s a lot of times where the firm might be under tremendous fee pressure. They may not do as much work that is really warranted or needed to fully identify the issues impacting revenue expenses and ultimately EBITA and cash flow of the business. We’re very careful on the buy side to certainly read sell side QofE reports, read audit reports, look at audit work papers, interview audit partners, and people that have been serving the company. But, we also go through a fairly rigorous process to validate what what all these parties are telling us, even if they have a sell side QofE report.
A well-done sell side QofE report will lay out the financial data, the historical financial data, and educate the readers as to the top three or so issues that are going to be of interest to a buyer. Whether it be revenue recognition, significant adjustments to the historical earnings of the business for excessive compensation to the owners, and I shouldn’t call it excessive compensation because they’ve earned it, it’s just compensation above what the market might might say is the norm for certain positions. I can go on and on about stories on the buy side where there’s not a QofE, and the banker takes the company to market and goes through a competitive process to get private equity groups and other buyers interested in buying the company and ultimately whittling down to a to a single buyer.
When we represent those companies and we go in due diligence, I can’t tell you how many times we go through this process and there’s issues put on the table that easily could have been addressed by the seller in anticipation of going to sell the company, whether it’s through a quality of earnings process or a little more rigorous process.
Bob You really need to do a sell side QofE, don’t market your company without one, because surprise will come up and then all of a sudden the deal gets re-traded and there’s less likelihood that the deal closes. Is that what you’re saying?
Tim We see a lot of that. Listen, I’m not the private equity group, and so I’m not in their investment committee meetings, obviously. But I’m pretty certain that when they negotiate the terms of the transaction and get a company under a letter of intent, they don’t have any interest in re-pricing the transaction. What leads to the re-pricing of the transaction, is that the information that they were provided to make their bed is it is not accurate, and it’s not fully disclosing the true financial condition of the business or the performance of the business. These parties enter into these agreements in good faith.
I like to believe and have every intention of completing their due diligence process and closing the transaction as it’s been laid out in their negotiations and the letter of intent, the analysis of the historical EBITA of the business, and the analysis of working capital that ultimately will get presented to our client, who many times will then share the information with the seller. They’ll use that information ultimately to agree to revisions, whether it be the purchase price, a working capital target or certain reps and warranties that the buyer may be asking of the seller to complete the transactions.
Bob Tim, if you don’t mind, say you’re on the sell side of a QofE and you’ve been retained by the company on the recommendation of an investment banker. What happens when you find things that you talked about educating the seller that really need to be brought up that could hurt the seller in the process? What’s the best way to communicate those issues?
Tim Certainly. When you’re working on the sell side, working with these companies that are going to be sold or looking to recapitalize for the first time, and working with these investment bankers, the key is to get all the significant issues identified and communicated with both the seller and the investment banker. If there’s issues that we identify in the due diligence process, again, the last thing that somebody wants is to go spend 3, 6, 9 months of time and money to try to sell the business knowing that there’s an issue or two, that could potentially derail the transaction or kill the transaction and then you have to start all over. We see that happen from time to time.
A real simple example would be the seller has not been charging, collecting, and remitting sales tax in all the states that they should be and it should not be a deal killer, it should simply be less devout. Let’s gather the data, let’s evaluate the issue, let’s quantify how much money we’re talking about, and let’s come up with a mitigation strategy as part of the sales process. So, the key is to identify the issues, go through the due diligence process, identify the issues, have conversations with the company and the investment bankers, and come up with a strategy to mitigate the risks that are identified to increase the likelihood that the transaction goes to the finish line and gets closed.
There’s also issues identified where we work closely with the investment banker to make sure that they’re properly highlighted in the sales process. We gather extensive data and we do quite extensive analytics to identify the most powerful drivers and trends in the business, whether it’s line of business trends or product trends, and make sure that all the parties are aware of those and they’re properly highlighted in the sales process. So, it’s a two-way street. You’re looking for issues that might not be properly accounted for. Considered in the EBITA, you could have some one-time sales that you might have to think about removing, you can have some non-recurring one-time expenses that should be considered, you could have some rent that you’re paying to a related party that is really not market based rent.
These are all the kinds of things that you want to identify in advance, as well as the positive trends and the opportunities for the business going forward, and work closely with the investment banker to make sure everything is properly considered.
Bob Well, Tim, thank you so much. We really appreciate your time today. For more information, go to www.frazierdeeter.com. Tim, I know your email is firstname.lastname@example.org. Thank you for your time, and thank our listeners for listening to this podcast on Quality of Earnings engagements. Thank you, everyone.
Tim Thanks, Bob.