In a “Quality of Earnings” (Q of E) report the accounting firm audits the financial statements to vet EBITDA, to determine what it is. Their report will also likely assess the risk of maintaining recent performance at a relatively high level (customer concentration, product mix/margins, etc.). The Q of E has always been a standard component of the diligence process. But in today’s deal environment, for a PE firm to understand the full potential of a target – and therefore be competitive in the bid process – they need to go deeper.
A buy side Q of Ops diligence (similar to a Q of E but with a focus on Operations instead) looks at how management runs the company today and determines what EBITDA “should be”. It answers three basic questions.
- What is the likelihood that the company can replicate current performance in the future? What risks exist that endanger the stability of company EBITDA and free cash flow.
- What fundamental changes are needed to scale the company?
- What is the financial impact of realizing the latent or hidden value within the company? The impact on EBITDA, working capital, capacity, lead times, retention, employee engagement, sustainability and/or safety.
Why do a Q of Ops?
Our clients that perform a Q of Ops report the following reasons:
- They are tired of losing on a deal and then seeing the winning PE firm succeed in growing the value of the company.
- They are frustrated when they end up having to “write a check after writing the check”. They want to know what they will have to do to maintain EBITDA and grow the company before they close.
- They are concerned about hitting the ground running post close. They want management focused on getting ahead of plan early in the hold and on building momentum for sustainable value growth while they are onboarding the portfolio company.
Sell Side Q of Ops
One major accounting firm we work with reported that they did 0 sell side Q of E’s in 2013, 2 in 2014, 54 in 2015 and over 130 in 2017. It is a real trend and is proving to be a good investment. This preparation leads to a smoother close and gives the seller a chance to prepare answers to likely questions and objections.
A sell side Q of Ops is most relevant when the PE firm is:
- Worried that selling a portfolio company with mediocre performance will drag down fund performance.
- Concerned that the portfolio company is, as one client put it, “a $5 million EBITDA company doing $3 million”.
- Exhausted from investing so much personal time into a portfolio company.
The sellside Q of Ops quantifies the latent value hidden beneath current management practices. It provides the PE firm and the management team a clear data-driven path to realize that value BEFORE entering the exit phase.
First Steps?
If you relate to the any of the symptoms described above, reach out to Tim Van Mieghem to explore whether the Q of Ops would be a good investment.
Timothy Van Mieghem
tvm@proactiongroup.com
The ProAction Group, LLC
150 North Wacker Drive
Suite 2500
Chicago, IL 60606
Tel: (312) 371-8323
www.proactiongroup.com
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