The Quality of Earnings Analysis

Ryan Murphy, Managing Director, Acquisition Due Diligence

In the mergers and acquisitions (M&A) world, ensuring a seamless transition and minimizing risks are paramount, particularly in lower middle market transactions. One indispensable tool in this process is the Quality of Earnings (QoE) review. Most regard this comprehensive financial analysis as the most critical step in the due diligence process as it provides the information necessary to effectively push the acquisition across the finish line. Below, we outline three reasons why the QoE process is an essential component of any lower middle market M&A transaction.

1. Clarity and Transparency – The QoE analysis offers clarity and transparency regarding the financial health of the target company. In the lower middle market, where information may be less readily available compared to larger corporations, a QoE analysis provides potential buyers with a deep dive into the target’s financial statements, KPIs, and the underlying drivers of performance metrics while highlighting any irregularities and discrepancies. This level of scrutiny is essential to quantify specific risks and identify potential deal-breakers so they can be addressed during the final closing and documentation process.
2. Optimal Deal Structuring – The information revealed during the QoE process enables buyers to make informed decisions about pricing and deal structuring. The comprehensive information provided by the analysis helps buyers understand the most granular drivers of the company’s sustainability and profitability. This, in turn, helps buyers to effectively allocate risk and determine the appropriate purchase price and deal structure, mitigating the chances of overpaying or facing post-acquisition surprises.
3. Building Long-Term Trust – In lower middle market M&A, relationships are often more personal, making trust a critical factor. Armed with detailed metrics and business drivers that are supported by the company’s internal financial records, the buyer and seller are able to leverage trust and credibility to better understand the business and negotiate final deal points that benefit both sides. By demonstrating a commitment to thorough due diligence, buyers can create a foundation of trust that can lead to collaborative negotiations, a smoother closing, and a more successful outcome post-closing.

In conclusion, the lower middle market is characterized by its unique challenges and opportunities. In this context, obtaining a Quality of Earnings analysis is not just a best practice but a necessity. It empowers buyers to make informed decisions, minimize risks, and build trust, all of which are crucial elements for a successful M&A transaction in this market segment. At LCG Advisors, we specialize in lower middle market due diligence, are passionate about working with lower middle market PE firms and business owners, and enjoy the opportunity to create a positive experience and add value to each of the transactions in which we’re involved.