Quality of Earnings: Is it a Deal Killer in M&A?

Volume 10 Issue 5, February 28, 2023

Today I want to talk to you about quality of earnings (QofE or QoE). I want to focus on this single concept because it's become one of the reasons — if not the leading reason — why healthcare transactions go sideways.

Before I get further into this discussion, I thought it would be helpful to define QofE. Investopedia does a good job explaining the concept, with the publication stating, "A company's QofE is revealed by dismissing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers on performance. Once these are removed, the earnings that are derived from higher sales or lower costs can be seen clearly." The publication goes on to note that the more closely companies follow generally accepted accounting principles (GAAP), the higher its QofE will likely be. 

QofE reports are a useful tool banks are increasingly requiring for lending. The reason banks want this deep dive performed is to gain a better understanding of the businesses — and the financial performance of those businesses — they're lending to. The likes of higher interest rates and other factors are injecting additional risk into transactions, so banks want more certainty before they grant access to financing. A QofE report provides that higher level of certainty about a company's financial performance.

QofEs are useful tools for healthcare sellers and buyers as well, so how have they become so problematic in transactions? What's important to understand is that the QofE report generated by one accounting firm can differ from another. There's so much data and information analyzed to produce the QofE report, which lends itself to different levels of interpretation and/or different factors considered for a QofE. When firms are producing a QofE report, it's not unusual — and one could argue only natural — to see them take an approach that favors their clients. 

What's happening is we're seeing QofE reports sometimes weaponized by private equity groups (PEGs) and increasingly weaponized by strategic buyers to retrade deals to gain a better acquisition price. How this typically happens is once a seller and their company is under an exclusive letter of intent (LOI) with a buyer, that buyer will then pay for a QofE during the due diligence period. The cost of a QofE can generally run anywhere from $50,000 to $250,000, depending on the firm conducting the analysis. After the QofE report is generated, the buyer then uses the information from the report to try to secure the lower acquisition price.

This strategy also involves tiring out the seller. To put together a QofE, the accounting firm requires substantial amounts of data — to the point that it can feel invasive while also taking a considerable amount of the seller's time and resources. On average, the creation of a QofE adds an extra month of due diligence to a transaction. 

After the seller has been bombarded with excessive amounts of due diligence, the buyer comes back to the seller, QofE report in hand, to state there is a material deficit in the seller's EBITDA. Any pushback by the seller is typically met with a response along the lines of "the numbers are what the numbers are." The buyer then lowers their initial offer from the LOI to reflect the QofE findings and thus what the buyer argues is a more "accurate" price. 

These "bad actor" PEGs/strategic buyers know going into the LOI that the seller's EBITDA (i.e., earnings) will not hold up to the scrutiny of the QofE and are thus relying on the resulting analysis and report to lower the price. The seller now must decide whether to move forward at a lower price or back out of the transaction, thus essentially wasting all the time and work they have put into the deal. It's a "rock-and-a-hard-place" situation. Unfortunately, I have seen this happen time after time when sellers accept unsolicited offers without representation from a healthcare M+A advisor. 

A Good Offense is the Best Defense

What can sellers do to avoid ending up in this situation? I want to reiterate that the QofE is subjective and can be debated or changed. This is something most sellers do not know. That's why sellers should strongly consider having a QofE performed on their business. An experienced healthcare M+A advisor knows what firms can help their seller clients secure a QofE. Generating QofE reports typically falls beyond an average CPA's capabilities.

For a majority of VERTESS' deals, and essentially always for larger clients, we're working with our seller clients to get those QofE reports created. The benefits of taking the initiative and making this investment are significant. In fact, I'd say it's become a gamechanger for sellers.

Initially, that report provides great insight into a company's financial shortcomings. If completed far enough in advance of bringing a company to market, a seller will have time to change and correct accounting deficiencies and irregularities that could be leveraged against the seller during negotiations with a buyer. Thanks to forecasting and modeling, a seller's advisor can help a seller preemptively alleviate most of the pain that can come from a QofE. By getting in front of and addressing any problems ahead of going to market, we typically avoid encountering the kinds of issues with accounting that can cause a deal to fall through.

It might sound counterintuitive, but when we bring a company to market with a QofE report in hand, this makes the seller more appealing to buyers. While this report hamstrings the ability for a buyer to leverage a QofE of their own against a seller, it's important to understand that the top priority for most buyers — a majority of whom are good people — is to get a good deal done. Receiving a completed QofE from a seller provides greater certainty about a deal since an accounting firm has already completed the deeper financial dive. This QofE also helps a buyer make a more appropriate and fairer offer for the company. 

To better understand why buyers appreciate when a seller gets their own QofE, consider this scenario where a buyer does not receive a seller's QofE: A buyer allocates significant time and resources researching a company, makes an offer, spends more time getting the company they're interested in acquiring under an LOI, and then proceeds with arranging for the QofE. That's a big risk for the buyer because the QofE could reveal the buyer made an offer that requires a significant change to the offer price — one that may lead to a seller backing out of the transaction. The QofE may reveal such significant accounting issues and deficiencies that the buyer loses interest in the acquisition opportunity. Now the buyer not only misses out on an acquisition, but it has also lost the money spent on the QofE on top of significant wasted time and resources.

It's also important to understand that buyers will likely still proceed with getting a QofE completed even if a seller presents a report of their own. This is just a natural part of due diligence. Once the buyer receives the QofE report, it's commonplace to see the two firms that developed the "same" QofE — one for the seller, one for the buyer — to review one another's reports and then discuss and debate the findings. If a seller lacks their own QofE, it becomes much more difficult to challenge the information from a buyer's QofE report.

Key Takeaway: Strongly Consider Getting a Quality of Earnings Report 

While not every seller needs to invest in a QofE, QofE reports are becoming an increasingly important aspect of healthcare M+A transactions, especially those involving larger transactions. The cost of receiving a QofE is not cheap, but it typically delivers significant return on investment for a seller. A QofE helps a seller identify opportunities for accounting improvements, makes a seller's company more appealing to buyers, keeps bad actors (i.e., those looking to take advantage of sellers lacking deep insight into their financials) at bay, generally leads to better offers, and ultimately contributes to more successful transactions. 

If you are interested in learning more about how to obtain a proper QofE for your company or discuss other ways we might be able to assist you as you prepare your company for a transaction, please reach out to our team at VERTESS!