Macroeconomic trends impacting the due diligence landscape: 2023 outlook

Both the buy-side and the sell-side due diligence process feel different from what we experienced during the height of the pandemic and into 2022, where the processes generally happened in a compressed time, ramping up before clients secured exclusivity. This pushed buyers to rely more heavily on sell-side due diligence findings.

Processes have now slowed. Buyers have returned to a pre-pandemic structure where, unless a process is very competitive, they will not spend significant dollars until they are awarded exclusivity. Also, the diligence process is becoming phased, with business/commercial diligence leading the way, followed by financial, tax, legal, and other work streams.

It used to be that pro forma adjustments, mostly positive for the seller, positioned the business using a 12-month run-rate. Some sell-side processes went so far as to incorporate pro forma adjustments based on future events/transactions that may or may not be contractual. Let’s face it, the latter adjustments belong as “EBITDA other considerations” and should be reflected in the financial projections. Today, these adjustments are being discounted heavily in valuations, with sellers being asked to have more skin in the game through earn-out structures or seller notes.

We are seeing far more scrutiny with synergies adjustments, even in refinancing transactions. Lenders want to see support and, where possible, a trend showing that synergies are being realized. Previously, much of the discussion around synergies was taken at face value.

Very little time is being spent on post-COVID adjustments, with the impacts of closures, government stimulus, etc., now in the rearview mirror. Buyers are focusing on current and future trends.

At the peak of the M&A frenzy, investment bankers – in their rush to bring companies to market – didn’t want sellers to spend the time to have critical baseline financial information available. Now, we’re seeing more sellers hiring accounting advisory professionals, interim CFOs/controllers, and others to clean up the financials and get them close to GAAP. This process allows the sell-side due diligence team to hit the ground running, leading to more efficient processes and creating less stress as buyers, too, ramp up their diligence process. However, it does delay the market launch.

Every dollar counts. Materiality thresholds are lower as power shifts to buyers. Bankers no longer have the leverage to pit multiple parties against one another. Recurring and non-recurring adjustments are being heavily analyzed, with close attention to the nature of the adjustments and year-over-year trends. There is greater understanding that there will always be a level of recurring non-recurring adjustments that should be factored into the analysis.

For many investors, management teams as well as key employees are being integrated into their investment thesis. Background checks that raise questions are another reason to take pause. Buyers, instead of pushing this to post-closing, are now using this to force change as a condition of closing. Until recently, sensitivities and fear of losing a transaction by making management team changes were prevalent. But that was when you had multiple parties vying for the same asset, so open conversations were few and far between.

So, what does this all mean for deal-making in 2023 and the due diligence that goes along with it? It means there is more opportunity for investors to be disciplined and patient. It means investors need to be cognizant of, and find opportunities to take advantage of, the changing market dynamics we are seeing. It’s time for both buyers and sellers to get back to fundamentals. Looking forward to seeing how this will all play out.

Claudine Cohen, Managing Principal, Value360

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