Uptick in Deals Brings Adjusted EBITDA Considerations for Private Equity

In Q3 2020, as many businesses looked for more signs of optimism, we saw a significant increase in deal activity with our clients, as did Pitchbook and Refinitiv. There are numerous reasons for the increase in mergers and acquisitions, but one thing is certain: the economic effects of the pandemic have made the process of assessing acquisition targets uncertain and challenging.

Many irregular and non-recurring costs occurred as a result of the pandemic and could distort an acquisition target's reported earnings. The challenge will be to distinguish between lasting changes and those that will recede once the pandemic is behind us.

Although EBITDA—earnings before interest, taxes, depreciation, and amortization—is a standard measure of a target’s economic performance, the usual approaches to assessing the quality of earnings might not be sufficient. To account for the pandemic’s effects, private equity firms may have to reconsider traditional methods and considerations used in calculating adjusted EBITDA.

Adjusted EBITDA

For many businesses, recent performance is unlikely to be a good indicator of future results. The pandemic may have led to temporary difficulties, benefits that may dissipate in the coming months, or, in certain instances, permanent changes.

These uncertain times make it necessary to examine how changes in a business’s performance affect EBITDA and to consider how long it will take to return to normalized levels. The pandemic is changing the way private equity firms must approach "adjusted EBITDA," which removes irregular and non-recurring items in order to focus on core business operations.

Target companies may have incurred additional expenses as a result of COVID-19.  Arriving at adjusted EBITDA requires taking a closer look at expenses and areas specifically related to the pandemic, such as:

  • Increased IT and other infrastructure costs necessary to mobilize a remote workforce
  • Severance and restructuring costs associated with workforce reductions
  • Purchase of supplies and materials in response to recommendations from the Center for Disease Control and other governing bodies and regulatory agencies
  • Excess cleaning costs associated with sanitizing and cleaning facilities
  • Excess costs or losses associated with the cancellation of events
  • Increased administrative costs in connection with monitoring and administering internal COVID-19 policies
  • Reduction or loss of revenue resulting from diminished demand during affected periods
  • Decreasing margins as a result of increases in material costs due to supply chain interruptions
  • Costs related to restructured leases that many companies adversely affected by the pandemic have taken steps in an effort to temporarily defer payments, or in certain cases, converted leases into debt

Assessing Impact on Revenue: For many companies, the primary impact of COVID-19 is the decline in revenue. Private equity firms must determine whether the revenue changes are short-term or they will have long-term effects on the business. To analyze and normalize revenue and address the reduction in revenue, the "before-and-after" method compares seasonally adjusted EBITDA trends in pre-pandemic periods with affected months. This includes analyzing and comparing actual results with the target’s forecasts or budgets.

To further explore revenue loss, an investor or private equity firm should consider examining the target's EBITDA trends in comparison to industry trends and historical growth rates and projections. Understanding the drivers of any differences will help determine whether declines are related directly to the pandemic or are the result of other outside economic factors.    

Working Capital Considerations

Arriving at a baseline level of working capital, or a “Working Capital Peg,” has become difficult due to inconsistent results and unpredictability. Declining demand, supply chain constraints and cash flow preservation could have significant impacts on working capital. Here are specific areas to consider when establishing a Working Capital Peg.

  • Accounts receivable: The continued focus on preserving cash flow and the difficult times many companies still face may result in the prolonged aging of accounts receivable. The current economic situation may require a harder look at significantly aged accounts. A reserve may be necessary for those determined to be uncollectible.
  • Inventory: Slowing sales also may result in aged inventory. In determining the Working Capital Peg, a private equity firm or investor should thoroughly analyze the inventory items to determine whether a reserve needs to be established to account for slowing moving or obsolete inventory. Disruptions in the supply chain could result in increased input costs, temporarily inflating the typical carrying value of inventory and potentially leading companies to be overstocked because they anticipated being unable to meet future demand.
  • Accounts payable: An analysis of accounts payable may reveal strained relationships with key vendors or suppliers. Just as customers and clients will be prone to stretching payments during this period, many companies will seek to delay payments to vendors, which can lead to a skewed view of normalized accounts payable.

Also, depending on the expected close date of a transaction, the last twelve months may not be indicative of a normalized level of working capital. Given the current economic uncertainty, an in-depth analysis of the working capital accounts will require identifying and understanding adjustments necessary to establish a Working Capital Peg. 

Other considerations

Private equity firms should also determine whether the target has accepted funds from the Paycheck Protection Program (PPP). If so, it should be determined whether the loan forgiveness amounts were estimated or calculated correctly. If the potential acquiring entity holds a current PPP loan, that should also be considered.  The private equity firm or investor should specifically address PPP funds in the purchase and sale agreement and consider establishing an escrow to resolve any potential unforgiven amounts at closing.

Changing approaches for a changing environment

By adjusting traditional approaches used to analyze adjusted EBITDA, private equity firms can better assess the long-term and short-term effects of the pandemic on target companies. In this ever- changing environment, the pandemic’s actual impact may not be fully understood for some time and will be part of due diligence for several years to come. As you explore the intricacies of mergers and acquisitions activity, we welcome you to contact us for guidance on financial and tax due diligence, valuation or CFO advisory services.