The Critical Role of Quality of Earnings in Successful Transactions

Financial due diligence is an essential component of every successful M&A transaction. Among the various components of a quality due diligence process, a Quality of Earnings (QoE) report is a vital tool that provides a clear picture of a target company’s true financial performance. Whether you are the acquirer, an investor, or a private credit lender, utilizing an expert to complete a QoE report can make the difference between a strategic win or a costly oversight.  

What is a Quality of Earnings Report?

A QoE report is an in-depth analysis of a company’s financial performance, focusing on the accuracy of its earnings history. Unlike standard financial statements (even if audited or reviewed), a QoE report – as the name implies – focuses on the quality, rather than just the amount of earnings.  A QoE analysis will help identify one-time events, deviations from current accounting policies, excessive or deficient compensation, and any other reported results that might obscure the true economic performance of the company and adjust earnings as necessary.

The Strategic Value of QoE in M&A

1. Validating the Seller’s Financials and Cash Earnings: Sellers often present their financials in the best possible light, within the confines of the applicable accounting standards. A QoE report offers an objective analysis that can validate – or challenge – the earnings as presented within the seller’s financial statements. This ensures that the buyer is making an informed decision that is based on reliable and verifiable data.

2. Identifying Earnings Stability: Understanding the stability and sustainability of earnings is crucial for buyers. Are previously reported earnings based on a large contract that is non-recurring? Does the target company carry an unusually high attrition rate resulting in a hidden decline in recurring revenues? A QoE report can distinguish between recurring and non-recurring revenue streams, helping buyers assess whether the company’s reported earnings are likely to continue post-acquisition.

3. Negotiating Purchase Price Adjustments: Upon reviewing a QoE report, buyers can negotiate purchase price adjustments if the reported earnings are found to be overstated or reported expenses are understated. Does the seller own the real estate and charge the business rent that is materially above or below fair market rates? Does the owner of the business pay themselves through distributions that may otherwise become a replacement salary? Is historical revenue driven by close relationships that may be at risk of continuation post-acquisition? Understanding these items can be a tremendous negotiation tool and may result in favorable terms and ultimately protect the buyer’s investment.

4. Mitigating Post-Acquisition Risks: By identifying potential red flags before a transaction is completed, a QoE report can help mitigate these risks that may arise post-acquisition. The proactive approach can prevent future financial distress and support a smoother integration process.

QoE Reports in Private Credit Lending Transactions

While QoE reports are often associated with the acquisition of a business, a QoE report can play a fundamental role in a private credit direct lending transaction as well. The total private credit industry has grown from $1 trillion Assets Under Management (AUM) in 2020 to approximately $1.5 trillion AUM as of the start of 2024, with projections placing the industry at $2.8 trillion AUM by 2028[1]. With such rapid investment growth, there is an inherent increase in risk as the volume and value of transactions increase. Leveraging a QoE report can help identify and mitigate these risks before it is too late.

The Strategic Value of QoE in Private Credit

1. Assessing the Borrower’s Financial Health: Private credit investors need assurance that their borrowers have stable and sustainable cash flows to service their debt. As with an M&A transaction, even audited financial statements may not provide the entire picture of financial health. A QoE report can provide a clearer view of the borrowers’ ability to generate consistent earnings which is fundamental to the repayment of loans.

2. Understanding Cash Flow Adjustments: QoE reports help identify and highlight any adjustments to Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), which is a key metric in understanding a borrower’s ability to service its debt. By identifying non-recurring items or accounting adjustments, investors can better gauge the true cash flows available for debt obligations.

3. Evaluating Risk Exposure: Private credit investors may have limited recourse in the case of default, making it essential to thoroughly understand the borrower’s financial condition. In the event a borrower does default, is this a business that would provide any liquidation value? A QoE report can help uncover potential risks and provide a more accurate assessment of the borrower’s financial stability, allowing investors to make better and more informed lending decisions.

4. Enhancing Covenant Negotiations: With insights from a QoE report, private credit investors may have more insight to negotiate covenants more effectively. For example, a QoE report may inform the setting of financial covenants that can protect the lender’s interest through the term of the loan.

Conclusion: Leverage QoE for Informed Decision Making

In both traditional M&A transactions and private credit investments, the QoE report is an indispensable tool for making informed decisions. QoE reports offer a more transparent view of a target company’s financial health, help uncover potential risks, and support strategic negotiations.

Contact Information

Caroprese & Company has a proven track record of providing comprehensive and insightful QoE analyses, ensuring that our clients make decisions based on accurate and actionable information.  For more information or to speak with an expert regarding how we can assist in an upcoming or ongoing transaction requiring a QoE assessment, please contact Brandon Caroprese at bcaroprese@caroprese.com or via telephone at 973-475-8090.

[1] Morgan Stanley. Understanding Private Credit. June 20, 2024.