Counting the cost of COVID-19 through focussed Due Diligence
In the wake of the COVID-19 pandemic and the subsequent recovery currently taking hold, it is evident that specific industries and businesses look dramatically different to what they did pre-pandemic (e.g., healthcare). Some of the changes they have experienced will be temporary, and some will become ingrained as these industries adjust to the “new normal”. As in the aftermath of any crisis, investment opportunities abound. However, as deal activity begins to increase, effective and focused Due Diligence will be vital in forming comprehensive and realistic opinions about the future outlook of different companies.
The pandemic has directed our Due Diligence focus.
The pandemic brought a combination of disruption, hardship, and opportunity to each industry and business. In considering the future economic outlook of different businesses and their associated attractiveness for investment, we have highlighted three core focus areas that form part of the due diligence process:
01. Resilience of the revenue model
The pandemic has brought about a change in consumption habits and behaviours that are becoming permanent business drivers for companies. Perhaps the most critical element of any Due Diligence performed post the pandemic involves assessing the potential for top-line revenue growth, the translation of this growth into profit and the dependence on other players along the value chain to enable this growth.
When your focus is on top-line revenue growth, company sales should be broken down and analysed by customer, product, project, revenue stream and channel (where each of these are relevant) before, during and after the pandemic. This breakdown enables one to assess the shift in a company’s revenue make-up and the associated impact (either positive or negative) on their revenue number. One can then evaluate the likelihood of future growth or recovery in top-line revenues as economic activity normalises.
As revenues declined, companies embarked on wholesale cost-cutting initiatives to ensure business continuity. As economic activity rebounds, it is now necessary to examine the state of a company’s human capital and the operations platform in place. One should ask the question as to whether significant capacity exists to support future recovery/expansion or if significant capital outlay is required to drive growth. Understanding a company’s operating leverage and how movements in revenue affect its EBITDA margin are essential when forecasting its short and medium-term economic outlook.
Thirdly, where reliance exists on other players along the value chain for key business inputs (e.g., mining equipment manufacturers dependence on steel), the position and relative health of key suppliers should be considered as part of any Due Diligence. The holistic effects of the pandemic have highlighted the interdependence and relative strength of players across all value chains which remains a key enabler for growth within any business.
02. Strength and adaptability of the management team & employees
The saying “Never let a good crisis go to waste.” is particularly apt here. The responsiveness and resilience displayed by the management team during the pandemic is a valuable litmus test to determine their future capabilities. A key question is whether or not management was able to retain a long-term strategic mindset in the midst of dealing with the disorder and uncertainty the pandemic delivered. Furthermore, were they able to galvanise and secure buy-in from their employees. Did their employees feel cared for and safe during these challenging times, and did their employees demonstrate adaptability? The advisory role played by the board and other key shareholders should also be critiqued to assess the holistic health of relationships amongst all stakeholders in the business.
03. Ability to prudently manage cash flows
The pandemic resulted in unprecedented shutdowns of industry and a halt on all economic activity. Any Due Diligence should analyse the company’s forward-looking cash position in detail and model the effect of any significant forthcoming repayments on cash flow. The working capital cycle and management is a key area of focus to ensure that the business is able to operate effectively. Also, one would need to analyse the obligations incurred before and during the pandemic to assess repayments due and the efficiency in the capital structure of the business to support its future growth ambitions.
Questions to ask throughout the course of your Due Diligence
The pandemic has necessitated a greater forward-looking emphasis on any Due Diligence. To summarise, any Due Diligence performed should seek to answer the following key questions:
- Is there a sustainable market for this business moving forward?
- Does the business have the ability to grow top-line revenue in this market?
- Were cost-cutting efforts sustainable, or is an increase in the cost base likely?
- Can the supply chain continue to serve the business efficiently, or have the dynamics changed?
- Does management and the wider stakeholder group have the required skills to support growth?
- Has the business managed to avoid significant cash flow pressures?
The current economic and business environment has necessitated a greater need for targeted Due Diligences. Due Diligence processes have been elevated from pure tick-box exercises to test how the strategic vision of the business measures up to the current position and capabilities of the organisation. These processes should deliver valuable insights that facilitate greater understanding and transparency of the business, thereby supporting a higher probability of post-transaction success.