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The Importance of Strong Customer Due Diligence in Distressed Investing
For a Buyer, it cannot be emphasized enough that strong due diligence is critical. The current M&A market has been described as extremely active and flush with available cash, but, there is no reason to overpay for a business. Thorough due diligence can reveal significant financial and operational issues which may warrant a price reduction or a holdback until an uncertainty manifests.
Some of these issues may include:
• Poor levels of working capital available in the business for continued operations.
• Deteriorating margins on products over time.
• Declining EBITDA as a percentage of sales year over year.
• Poor accounts receivable and inventory turn-over.
• Obsolete assets.
• Obsolete technology and financial management systems.
In a distressed situation, the due diligence period may be compressed from a typical M&A transaction time of 6 to 12 months down to 60 to 90 days. In distressed situations, focusing on the vitally important areas becomes imperative.
One area that must be considered is the relationship of a target business with its customers. This is especially true for businesses that require significant investments in order to obtain and retain customers. Should a critical customer be lost soon after the conclusion of the transaction, a strong acquisition may convert quickly to a distressed emergency case.
Potential due diligence questions regarding customers include:
• Who are your Top 20 customers over the past five years and what were the sales to each?
• Has a significant customer been lost during the last five years? If so, why?
• Are there specific contracts with each customer? What is the contract’s duration and terms?
• May we meet with your customers?
• What is the current order backlog by customer?
• What is the customer-by-customer profitability over the past 12 months?
• When were the last price increases implemented and how strong was the push-back from the customers?
One area for consideration, particularly in manufacturing, is customer returns. Should a problem develop following acquisition regarding items manufactured pre-acquisition, a Buyer may face a serious problem. Consider inquiring regarding:
• What is the return policy of the company and what is the potential value of returns outstanding?
• Which customers have made returns over the past 2 years and how were they resolved?
Strong customer due diligence cannot eliminate risk when investing in a distressed company. However, it can help minimize potentially expensive surprises and smooth the path towards strong future operating results.