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Ensuring Relevant Due Diligence for M&A Targets Ahead of a Recession: A Guide for Private Equity Firms on Three Key Strategies

CryptoCove December 22, 2024

The third quarter of 2022 saw a significant decline in M&A activity globally due to economic uncertainty, market volatility, rising interest rates, inflation, and the ongoing Ukraine-Russia conflict. While private equity deal activity decreased only slightly compared to pre-COVID levels, it is essential for PE firms to prepare for a potential recession by conducting thorough due diligence.

Table of Contents

Preparing for a Potential Recession

Most experts agree that a recession is likely imminent or already here. Even if one is not imminent, companies must still prepare for such a scenario. Private equity firms should focus on their due diligence providers and operators to ensure additional steps are taken to accurately assess and vet potential acquisition targets.

Enhanced Due Diligence in the Current Economic Climate

Due diligence providers will need to go beyond standard reporting checklists and expand their assessments of three key areas:

1. Cash Flows

In a recession, companies will face significant cash flow challenges. A thorough analysis of a target company’s cash flow statements is essential to understand its financial health.

Key Considerations:

Cash Conversion Cycle: Assess the time it takes for the company to convert its inventory into cash.
Days Sales Outstanding (DSO): Analyze the average number of days it takes for customers to pay their outstanding balances.
Working Capital Management: Evaluate the company’s ability to manage its working capital effectively.

2. Reporting Systems

Outdated or disparate reporting systems can lead to inaccurate financial representations, causing significant issues in a recession. Private equity firms should ensure that their target companies have modernized and streamlined reporting systems.

Key Considerations:

Financial Reporting: Evaluate the accuracy and reliability of the company’s financial reports.
Accounting Systems: Assess the company’s accounting system to identify any potential discrepancies or errors.
Inventory Management: Analyze the company’s inventory management processes to ensure accurate calculations.

3. Foreign Currency Fluctuations

Currency fluctuations can significantly impact a company’s profitability and deal success. Private equity firms should consider these factors when conducting due diligence.

Key Considerations:

Currency Exposure: Assess the target company’s exposure to foreign currency fluctuations.
Hedging Strategies: Evaluate the effectiveness of the company’s hedging strategies to mitigate potential losses.

Final Considerations

Stress testing potential acquisition targets and ensuring their reporting systems are modernized are essential due diligence considerations for private equity firms. These steps will strengthen deals, better protect all parties involved, and ensure financial readiness for M&A – regardless of market conditions.