Making Sense of Adversity in the Due Diligence Process

This article explores the idea of how a business handles a far-reaching event, their adaptation and resilience, becomes a part of that business’ story.

Disasters are aesthetically unappealing. Few things can compromise an organization’s appeal as an acquisition target quite like global instability. Disasters warp balance sheets and future performance projections. They turn assets into liabilities. They stunt growth and create gaps in a business’ story. 

But a black swan event—rare, unpredictable, and far reaching like the COVID-19 pandemic—has the ability to revise the metric. How a business handled a far-reaching event, not necessarily just their performance during it, but their adaptation and resilience, becomes a part of the business’ story. And adversity can be an attractive asset. 

That’s not to say the raw ingredients that make a business attractive have stopped counting. But there’s no question that adversity will be a more important indicator in the foreseeable future for dealmakers and the valuation process. The key for sellers and buyers alike will be making sense of that adversity during the due diligence process.

The Narrative of Adversity

Storytelling is entwined with the due diligence process. It’s as much an exercise in sales as it is in disclosure. Transparency is key, but interpretation is also a big part of the process. A disaster environment calls for a narrative of adversity; one that due diligence analysis can help illustrate. 

A business’ pivot or behaviour during a crisis can come across as panicked. But according to a note sent by legendary VC firm Sequoia Capital at the onset of the pandemic, some of the most iconic companies were “forged and shaped during difficult times.”  

“We partnered with Cisco shortly after Black Monday in 1987. Google and PayPal soldiered through the aftermath of the dot-com bust. More recently, Airbnb, Square, and Stripe were founded in the midst of the Global Financial Crisis,” says the legendary VC firm. “Constraints focus the mind and provide fertile ground for creativity.”

And rapid evolution stands out. “Having weathered every business downturn for nearly fifty years, we’ve learned an important lesson—nobody ever regrets making fast and decisive adjustments to changing circumstances.” 

With the right storytelling, that quick pivot or act of agility becomes a competitive advantage. A recent McKinsey report pointed to a Chinese car rental company that saw revenues plummet 95 percent in February. They quickly looked at their customer-base and segmented it into small, precise groups, using social listening to identify and develop some new use cases.  

“Before the crisis, the company took up to three weeks to launch a campaign; that is now down to two to three days,” write the authors of the report. “Within seven weeks, the company had recovered 90 percent of its business, year on year—almost twice the rate of its chief competitor.”

The car rental company was able to put a plan into action that not just helped with its recovery but drastically increased its ability to innovate—its “adversity factor”—giving it a new competitive advantage. 

Bridging the Valuation Gap

A lot of businesses saw a swift and severe impact on their operations during COVID-19, hurting valuations and causing some would-be sellers to sit tight until a new valuation consensus emerged. But it didn’t take long. Some dealmakers adapted the classic middle market valuation metric EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and include a “C” (for coronavirus) on the end of the acronym. 

Adjusted EBITDA isn’t uncommon. Sometimes conveying the full profitability story means including non-recurring items like one-time legal settlements or special project revenue. The coronavirus’s global nature created all sorts of potential adjustments, like unforeseen levels of employee severance, lease termination costs and disruptions to supply chains. 

But for sellers, employing the “EBITDAC” playbook can obfuscate the real picture. The key to bridging the valuation gap may lie in emphasizing the things you’ve done right in the due diligence process as opposed to relying on add-backs. 

In the aftermath of a sweeping interruption like the coronavirus, having strong suppliers and clients – and illustrating not just the strength of your relationship but their strength as well – ups your adversity factor. Illustrating the strength of your cybersecurity infrastructure and its ability to withstand the uptick in remote work and personal device usage on corporate networks can also add to a business’s attractiveness. 

According to an article in New Jersey Business magazine, when acquirers see their purchase as a long-term investment, current year cash flows start to lose their weight. “If the business can demonstrate an improvement in operating results and growth potential, the buyer is likely to value the business for its scalability or resilience more than its short-term revenues.”

The Resilients

From a buyer’s perspective, the key is knowing what to look for in the aftermath of a black swan event. In examining deal multiples between 2000 and 2020, two decades that saw several historic bubbles and downturns, the Harvard Business Review found that during the 2008 financial crisis company value dipped quickly and bounced back rapidly. 

“History suggests, therefore, that there will be a relatively short M&A window that opens as the COVID-19 crisis ends, during which bargains will be had by those with the liquidity and the risk tolerance to move quickly, and who have done their homework in advance,” write the authors.

That homework will entail deciphering how a business’s adversity and evasive maneuvers during the current crisis could play out in the future. McKinsey analyzed over 1,000 publicly traded companies during the 2007 to 2009 crisis and identified a small group of “resilients”—a group that lost as much revenue as their industry cohort during the early stages of the slowdown but, by 2009, managed to see earning rise by 10 percent versus a near 15 percent loss by industry peers. 

According to the report, the key to these so-called resilients’ success was to create a safety buffer by deleveraging and divesting underperforming businesses, cutting operation costs, and focusing on growth. The ability to strategically invest in digital infrastructure and streamline operations and business units even as the world is crumbling around you shows a business’s adversity. 

Whether you’re sitting on the sell-side or the buy-side of the deal room, it’s important to ask the right questions and have the right answers. Because even in the midst of disaster, adversity can still win.

As Sequoia Capital pointed out, in some ways, business mirrors biology. “As Darwin surmised, those who survive ‘are not the strongest or the most intelligent, but the most adaptable to change.”

Illustration by Christy Lundy

Andrew Seale

Andrew Seale is a Toronto-based business writer who contributes frequently to Yahoo Canada Finance, The Globe and Mail's Report on Business and The Toronto Star.