By focusing on pre–quality of earnings gap analysis and enhanced addback scrutiny, private equity firms and their portfolio companies can better position themselves for successful exits.
An effective sell-side quality of earnings analysis identifies risks and provides insights into cash flow stability, operational efficiency, and a portfolio company’s true earning potential. Today’s private equity environment calls for a strategic sell-side approach that anticipates scrutiny while ensuring operational consistency and better integrated financial consolidation. By focusing on two key areas—pre-quality of earnings gap analysis and enhanced addback scrutiny—investors and operators can better position themselves for successful exits.
Demonstrate Financial Reporting Maturity Through Quality of Earnings Analysis in the Financial-Due-Diligence Process
A comprehensive sell-side quality of earnings analysis has become a cornerstone of risk mitigation in private equity transactions. It often identifies red flags and poor financial reporting practices that would otherwise remain hidden. So before entering the quality of earnings phase, portfolio companies should conduct a deep-dive into potential gaps (e.g., missing revenue adjustments) to speed up sell-side due diligence.
Heading into an exit, it’s especially important for company management to understand and correct gaps in financial reporting. If these gaps are identified as part of the quality of earnings process, operators will find themselves redoing their numbers at a critical moment. A thorough analysis of quarterly and monthly reporting processes ensures gaps are identified prior to the sale process.
Key takeaway: A thorough analysis of financial reporting prior to the sale process prevents constant redos when the clock is ticking toward an exit, preserving deal momentum.
Prepare for Heightened Scrutiny on Addbacks in the Financial Due Diligence Process
As buyers become more sophisticated—and rely on external advisors to pressure-test assumptions—every addback and adjustment faces enhanced scrutiny during due diligence. Quality of earnings adjustments to earnings before interest, taxes, depreciation, and amortization (EBIDTA) are common in mergers and acquisitions. But in recent years analysts have continued to find correlation between the number of addbacks at deal inception and the severity of projection misses and misalignment.
An S&P Global analysis showed elevated addbacks, averaging 29% of management projected EBITDA and 55% of EBITDA reported over the last 12 months. Escalated addbacks create higher risk of missing projections and potential credit degradation after the deal, which raises the scrutiny of these addbacks in the quality of earnings process.
Key takeaway: In general, excessive addbacks can muddy the financial picture of a company and cause investors to doubt the true profitability and risk being presented. Management should be prepared to support any EBITDA addbacks with qualitative, objective evidence as the correlations between addbacks and projection misses will make buyers more focused on addback legitimacy.
To learn more or to schedule a call with one of MorganFranklin Consulting’s private equity experts, contact us today.
