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Financial Due Diligence on distressed businesses (Part 1)

Given the current state of our national finances, there will be a number of businesses in distress which will either raise funds via the sale of a proportion of equity or even be forced to sell entirely. Avoiding business failure and successfully completing a ‘distressed transaction’ is important for the economy - by maintaining employment directly for the business and its supply chain.

2009 will see standard SME valuation methods abandoned. Not only will earnings multiples reduce – as buyers become wary of uncertainty – but the profits used to value businesses will be slashed. In the midst of falling asset prices, astute investors will identify ‘needy’ SME businesses that are significantly undervalued. We will see companies buying competitors, customers and suppliers as the liquidity problems bite.

If businesses can be acquired using comparatively low valuations, is it still worthwhile undertaking a formal Financial Due Diligence process? 

There are three principal reasons why I believe it is still a fundamental part of the investment process:

  • Whilst an acquisition may be at a comparatively low valuation - if the underlying business is defective, then the investor will still lose money (even if it is less than would have been lost in 2007!)
  • The acquisition process uses the most valuable resource of all – time. If potential problems are identified early on it prevents the acquirer wasting time chasing a deal which will never complete.
  • Deal structure is still crucial – particularly from a tax perspective – and professional advice on this is necessary to maximise long term shareholder value. For corporate acquisitions it is important that the structure is organised so that the financial health of the acquired business does not threaten existing operations.

I will write another blog in the near future on the areas of financial due diligence to focus on for distressed acquisitions.

 

 

Date: 2nd January, 2009
Author: Julian Dobbin

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