Prove it: Show me the money Using advanced analytics to assess deal value

The art and science of M&A continues to evolve. Using advanced analytics, sellers are attempting to present their business on a full “investment” pro forma basis. With the same tools, buyers are testing these adjustments, as well as using analytics to find additional sources of value. The net result: greater rigor in the M&A process.

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© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Introduction Do rising seller adjustments signal a new rigor in M&A? Rather than simply presenting audited financial results, gain from a planned price hike, or the savings from cost-sellers are investing time and money to provide additional cutting measures initiated in the past 12 months, or the information that may show more accurately how their contribution of an acquisition that has not been executed. business is performing. This includes greater use of With run-rate adjustments, the seller paints a picture of the adjustments to reported EBITDA that reflect the “run rate” value a buyer may realize post-sale—and seeks to be paid of the business, accounting for investments the company for all or part of this upside. has made as well as one-time adjustments that affect From the buyer’s perspective, the proliferation of seller reported EBITDA. Buyers are understandably more adjustments is cause for heightened skepticism—and the skeptical of certain adjustments and are scrutinizing impetus to do more homework of their own. Smart buyers them to make sure they are purchasing off of the true are using advanced analytics to make up for information recurring cash flow of the business. asymmetry in general and to separate best-case scenarios On the surface, this looks like business as usual. Sellers from credible sources of value. We find that almost no are doing what they can to make a good deal. And buyers adjustments go unchallenged these days. are trying to build confidence for a deal that they can fairly The net effect of this activity around adjustments is a underwrite. subtle but significant advance in the art and science of due However, increasing use of pro forma adjustments diligence. Sellers are doing more to validate the selling by sellers to reported EBITDA is part of a larger trend thesis, and buyers are developing a more detailed and of sellers doing more to prepare assets for sale and objective view of post-deal value potential. Sometimes, in demonstrate value that they see in the business. the course of due diligence, buyers even discover sources Seller adjustments have become the new normal of of value that sellers have not highlighted. M&A, routinely appearing in a confidential information In this paper, we present an overview of our research on memorandum (CIM) drafted by investment bankers and in adjustments that were proposed in transactions from 2013 sell-side quality of earnings reports. to 2018 (see Methodology) and offer high-level insights for Increasingly, these reports include not only “housekeeping buyers and sellers. By understanding where adjustments adjustments” to clean up accounts for sale but also run- are typically being proposed, buyers are better able to rate adjustments. These reflect current or expected impact challenge seller assumptions. By understanding how of changes or recent investments in the business that adjustments can be structured to withstand buyer scrutiny, do not appear in financial reports, such as the revenue sellers can prepare for more successful auctions.

Methodology

We reviewed more than 1,800 M&A transactions across all industries between 2013 and 2018, using proprietary transaction data. The data was compiled by KPMG’s Benchmarking Plus team, which harvests transaction data from M&A engagements.

To begin our research, the team used machine learning to automate analysis of large volumes of unstructured text data and accurately codify adjustments into standardized categories. The machine learning model was trained to predict the codification of reported earnings adjustments from due diligence reports. We measured the impact of adjustments by dividing the total value of pro forma adjusted EBITDA by reported EBITDA. This methodology will be applied to ongoing research into the use and impact of adjustments.

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Exhibit 1: Seller-adjusted pro forma EBITDA as a percentage of reported EBITDA

135%

130%

125%

132.8% 120% 127.8% 126.7% 126.7%

115% 119.6% 120.6%

110% 2013 2014 2015 2016 2017 2018

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Key findings: Where adjustments are growing To understand how adjustments are being used and how they affect valuations, KPMG developed a proprietary database of more than 1,800 transactions. We found that from 2013 to 2018, seller adjustments grew in both number and size. On average, there were 5.8 adjustments per transaction in 2013 and 7.9 in 2018. The combined average value of these adjustments rose from 119.6 percent of reported EBITDA to approximately 132.8 percent

(Exhibit 1). While the number and size of adjustments grew over the six years of deals included in the analysis, only 62.7 percent of deals had pro forma adjustments in the most recent year. This suggests that the use of pro forma adjustments may continue to grow. In our analysis, we grouped the EBITDA adjustments into three categories (accounting related, pro forma and non-cash/transaction-related). Several important trends emerge from the data:

(1) Pro forma adjustments can be challenging to confidently support because they often involve predictions of future performance, such as new revenue sources or expected cost savings, and they can have the greatest impact on EBITDA. Average pro forma adjustments per deal rose from 10.1 percent of reported EBITDA to 14.5 percent from 2013 to 2018. The share of transactions that include pro forma adjustments to revenue and/or cost rose from 56.9 percent of transactions in 2013

to 62.7 percent of transactions in 2018. This may reflect the evolution of pre-sale due diligence in the market. We see greater use of advanced analytics by sellers to quantify the impact of recent or expected changes in the business in preparation for the sale process. Indeed, we also find that using advanced analytics helps either party in the transaction be more successful: sellers can make a stronger case for adjustments and buyers can build confidence in adjustments or find a basis for challenges.

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(2) “Housekeeping” accounting adjustments are the fastest-growing category. Adjustments for items such as accounting policy changes, inventory adjustments, or out-of-period entries increased from an average value of

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

5.6 percent of reported EBITDA per deal in 2013 to 10.5 percent in 2018. We view the growth of these adjustments as another sign that sellers are putting in more up front effort to better prepare assets for sale with their sell-side advisors and ensure an efficient transaction process.

(3) Non-cash and transaction-related adjustments are growing rapidly. These adjustments nearly doubled from 4.0 percent of reported EBITDA in 2013 to 7.8 percent in 2018 (Exhibit 2). They include non-cash stock compensation, asset impairments, and costs associated with acquisitions—items that do not affect a company’s ability to generate cash. Therefore, they are generally considered non-confrontational by both buyers and sellers. Similarly, transaction-related expenses such as professional fees or restructuring charges are not viewed as recurring operational costs and therefore not viewed as part of operational cash flow. The increase in transaction-related expenses showing up in adjustments is likely the result of high M&A activity as well as a trend toward greater use of pre-sale diligence by sellers.

(4) Buyers are not shy about challenging adjustments. Buyers routinely vet seller-proposed adjustments, and successful challenges supported by data-based insights can give buyers the basis to negotiate reductions in the final transaction price. In the transactions we studied, there is a difference in the impact of offsetting adjustments by sellers made in response to accounting adjustments and pro forma adjustments. Offsetting adjustments amounted to more than 95 percent of the value of proposed for accounting adjustments (excluding non-cash and transaction-related costs) and more than 43 percent for pro forma adjustments. Offsetting adjustments can include both direct responses to seller adjustments and new adjustments identified by buyers.

(5) Buyers are finding value, too. Not only are buyers able to challenge seller adjustments, but they are also discovering additional sources of value during due diligence as they assess the validity of seller adjustments. In the deals we studied, buyers found incremental value amounting to 34.2 percent of reported EBITDA---on top of seller adjustments.

Exhibit 2: How categories of adjustments grew from 2013 to 2018

2013: Total adjustment value = 119.6% of 2018: Total adjustment value = 132.8% of reported EBITDA reported EBITDA

Note: Total may not sum due to rounding Source: KPMG proprietary data

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Exhibit 3: Transactions with pro forma adjustments rose from 56.9 percent of deals in 2013 to 62.7 percent in 2018

70%

65%

60%

55% 65.8% 61.7% 62.7% 61.2%

56.9% 57.2% 50%

45% FY 2013 FY 2014 FY 2015 FY 2016 FY 2017 FY 2018

Source: KPMG proprietary data

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Run-rate adjustments have significant impact Five years ago, it was less common for buyers to see pro forma adjustments in a CIM. The share of transactions with the effects of acquisitions that have not been executed and adjustments to pro forma EBITDA rose from 56.9 percent may only be at the letter of intent (LOI) stage. Overall, pro to 62.7 percent from 2013 to 2018 (Exhibit 3). However, forma run-rate adjustments for acquisitions rose from 1.2 the more significant change has been in the nature of percent of EBITDA in 2013 to 1.9 percent in 2018, while the adjustments that are being proposed. six-year average was 2.1 percent of EBITDA.

Cost-related run-rate adjustments, which include Run-rate adjustments are just one of many types of adjustments to reflect future value of cost reductions and pro forma adjustments, including backwards-looking ones operational improvements, doubled to 7.0 percent in 2018. that restate results to reflect the full-year impact of Revenue run-rate adjustments include adjustments to measures that have taken place. For example, an capture anticipated changes in future earnings from things adjustment might be made to account for the effect of such as an investment in a new plant, or the expected a reduction in force that happened mid-year to show effect on revenue from a new product line, or a planned the impact on full-year results. pricing increase. As noted, nearly 40 percent of transactions in 2018 did not The value of revenue run-rate adjustments rose from include pro forma adjustments, which suggests that we 1.8 percent of reported EBITDA in 2013 to 5.1 percent can expect use of pro forma adjustments to keep growing.

in 2018. Sellers also use run-rate adjustments to factor in

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Increasingly, diligence is conducted with advanced analytics There is no question the market has become more a projection. The buyer used demographic data for each competitive over the past few years. Due diligence by trade area to come up with a more precise estimate to sellers and buyers has evolved, with both sides relying refine the seller’s assertions. increasingly on advanced analytics to develop and support Increasingly, the heavy analytics lifting begins before the their positions. Advanced analytics can enable sellers to seller starts an auction, before a buyer prepares a bid, and come to market better prepared with well supported long before any deal is executed. Armed with the insights adjustments to show the current and future earnings they’ve discovered in the course of their analysis, both potential of the business. sides can be better prepared to proceed. Buyers, meanwhile, are using the same techniques to Yet, there is much to learn. Our research finds that more challenge seller assertions as well as probe other sources than half of the adjustments presented in the typical sales of value beyond routine post-merger synergies before they process are not supported with advanced analytics. It make their bids. When presented with seller adjustments, is clear sellers will continue to hone the skills they use they’re learning to marshal their own data to push back. to prepare deals, and buyers will be obliged to keep up. For example, when a seller presented a revenue As buyers close the gap, expect to see more successful adjustment to account for the contribution of new stores, challenges to adjustments. Meanwhile, we will continue it used historical new-store ramp-up averages to generate to track and analyze the growing use and impact of seller adjustments in due diligence.

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© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Mastering the new due diligence The increased activity around adjustments that we describe in this research is evidence of how the due diligence process is evolving. In a highly competitive market, sellers have learned to prepare more thoroughly for the sale process and find ways to demonstrate the true value of their assets. Buyers have become increasingly adept at probing seller adjustments and using analytics to make their own assessments. This process has become part of the deal routine, and it behooves both buyers and sellers to sharpen their skills in this area.

What sellers can do Prepare, prepare, prepare. When preparing an asset for sale, it pays to invest the time and resources that can help streamline the process and enhance value. Evaluate what work can be done to present the asset in the best possible light. This can include cleaning up accounts, developing substantial carve-out financials (if appropriate), prepping management for buyer due-diligence calls, completing performance improvement initiatives, or executing pending personnel plans.

Stress test the selling thesis. Perform due diligence on your asset to fully understand its value. Using advanced analytics, identify the sources of value that are not obvious and can be highlighted when the asset is presented for sale.

Anticipate challenges. Look at your offering from the buyer’s perspective. Think about what adjustments and/or key questions you would focus on if you were on the other side of the table. Then prepare your position.

Be thorough. It will be an investment to prepare adjustments that withstand strong challenges and ensure an efficient and competitive process, but the ROI is worth it. If you can keep one extra potential buyer engaged, the return on the investment will multiply.

What buyers can do Assemble a team. Assemble an integrated multi-disciplinary team to evaluate adjustments using advanced analytics. Identify experts (internal and external) who have industry knowledge as well as the financial acumen to evaluate a complex business.

Use due diligence strategically. Proper due diligence goes beyond verifying what sellers present. A thorough commercial, financial, and operational due diligence process establishes an objective view of the target, its true value, opportunities, and risks.

Challenge adjustments vigorously. Challenge adjustments vigorously, using data, benchmarks, and analytics to affirm, refute or enhance the seller’s claims.

Apply adjustment lessons. Investing in adjustment evaluation can pay dividends for buyers long after the deal is struck. The insights gleaned can provide a roadmap for capturing post-merger value and a list of priorities to be addressed, such as making sure that revenue and cost savings materialize.

It is critical for both buyers and sellers to understand how adjustments fit into valuation, due diligence, and negotiation. Today, the proliferation of adjustments makes M&A more challenging. Eventually, it may lead to a more efficient deal process. Our goal is to provide ongoing research and analysis of adjustments and other developments in M&A techniques to help buyers and sellers compete effectively.

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Benchmarking Plus

Benchmarking Plus goes beyond the usual publicly sourced information and taps into KPMG’s proprietary database giving you access to thousands of private companies (and growing) across a variety of industries gleaned from past engagement experience. Our proprietary data is supplemented with public data and industry-specific data through third-party databases to provide a holistic perspective on any issue.

In today’s M&A environment where deals don’t wait, having access to benchmarks to provide clear answers to critical questions is essential to any transaction. For acquirers, Benchmarking Plus provides comparisons between the target and best-in-class peers and identifies performance gaps. For sellers, Benchmarking Plus helps build clarity about the selling thesis and identify areas of strength to present to the market.

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

How we can help KPMG helps clients on both the buy side and sell side across the entire deal cycle, including in the formulation and evaluation of adjustments to reported EBITDA. Our wide-ranging M&A services start with deal strategy (market intelligence, target identification, and portfolio analysis) and continue through evaluation, negotiation, and due diligence (including tax diligence). We also provide integration and post-deal value creation services, including sustained performance improvement initiatives.

At every stage, our dedicated industry teams provide leading industry knowledge, supported by a unique database of industry benchmarks and metrics. This depth of knowledge enables faster target identification and intense focus on industry-specific issues that can determine value.

Our market-leading investments in advanced analytics help us deliver insights at deal speed. This is critical for quickly evaluating or substantiating accounting and pro forma adjustments. These investments in technology and data include deal advisory analytics platforms, proprietary tools, and unique data sets, including the proprietary transaction Benchmarking Plus database used in this paper to analyze six years of seller adjustments. Our data and tools help clients model financial performance, negotiate terms, and plan post-deal performance improvements.

We serve clients with fully integrated, multi-disciplinary teams that operate as a single, cohesive deal advisor. This enables smooth orchestration of deal activities across multiple functions. KPMG teams use our Integrated Value Delivery (IVD) model throughout the engagement and are supported by a proprietary, cloud-based workflow system that increases speed and reduces cost.

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© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Gina O’Donnell Director

Gina is a director in the Deal Advisory practice focused on financial due diligence for private equity and strategic clients. She has performed numerous buy-side and sell-side diligence engagements primarily concentrated in the healthcare and life sciences industry.

Jason Balon Principal

Jason is a principal in the Deal Advisory practice, focused on financial due diligence for private equity buyers and their portfolio companies. He has provided buy-side and sell-side transaction services assistance across numerous industries for private equity investors and their related platform companies.

Marc Craig Director

Marc leads the U.S. Benchmarking Plus program, which draws on KPMG’s proprietary databases and third-party data to provide KPMG teams with valuable information derived from engagements with thousands of private companies across a variety of industries.

Joe Hartman Partner

Joe is the national co-head for KPMG’s Private Equity Deal Advisory practice and, over the past 20 plus years, has performed due diligence on more than 1,000 transactions across numerous industries with total transaction value in excess of $300 billion.

Authors Dan Tiemann

Global Lead Partner, Transaction Services

Dan is KPMG’s global lead partner for Transaction Services and the U.S. service group leader for Deal Advisory and Strategy. He has more than 25 years of transaction experience and has been a financial consultant to numerous investors and lenders on more than 500 leveraged transactions. In addition, he has assisted numerous private equity investors in conducting due diligence and integrating target companies.

We would like to thank our contributors: Grace Baek, Deepak Sheshegowda and the entire KPMG Global Services Analytics team, as well as Jeff Potter, Geoffrey Lewis, Tara Thompson, and John Hart

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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

The KPMG name and logo are registered trademarks or trademarks of KPMG International.

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. DASD-2019-2385

Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates or related entities.

For more information, contact us:

Joe Hartman Jason Balon Partner, Deal Advisory Principal, Deal Advisory 312-665-2489 312-665-1476jhartman@kpmg.com jbalon@kpmg.com

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