The role of financial due diligence in the small and mid-cap sector

In prin­ci­ple, the iden­ti­fi­ca­tion and assess­ment of risks is very important in every tran­sac­tion and in every segment in order to avoid nega­tive surpri­ses for the buyer. In the small and mid-cap sector, howe­ver, there are special features that need to be taken into account. While tran­sac­tions in the large cap segment are in most cases based on audi­ted annual finan­cial state­ments and a granu­lar basis of figu­res, tran­sac­tions in the small and mid-cap segment are often based on an inade­quate, not very detailed basis of figu­res and some­ti­mes on unau­di­ted annual finan­cial state­ments. For these reasons, it is important to take a special look at the figu­res as part of finan­cial due dili­gence. Tax opti­miza­ti­ons (e.g. due to wron­gly deva­lued invent­ories or formed provi­si­ons) must be unders­tood in order to deter­mine the actual profi­ta­bi­lity of the company to be purchased.
Inade­quate or non-exis­tent control­ling instru­ments often make it impos­si­ble to reco­gnize at first glance which products / services are gene­ra­ting profit or cash flow. This often requi­res digging deeper into the available figu­res and using assump­ti­ons to deter­mine an indi­ca­tive view. In addi­tion to the inade­quacies in the figu­res, other aspects also play a role in finan­cial due dili­gence in the small and mid-cap segment to ensure that the tran­sac­tion can be successfully imple­men­ted in the end. It often starts with the fact that it is helpful for consul­tants to speak the same language as the mana­ging part­ner on the seller’s side. By the same language, we mean both the German language and a lingu­i­stic ability in terms of content, which we ensure through the compa­ra­tively high commit­ment of very expe­ri­en­ced team members. Last but not least, it is also important to under­stand the seller and his situa­tion, but at the same time to obtain all the infor­ma­tion neces­sary for due diligence.

As alre­ady mentio­ned, tax opti­miza­ti­ons can often be found. To this end, invent­ories are some­ti­mes writ­ten down to an exag­ge­ra­ted extent or provi­si­ons are formed. Accoun­ting methods are often chan­ged in the decisive valua­tion year in order to drive up the purchase price. All these effects must be unders­tood in detail as part of the due dili­gence process in order to deve­lop a view of sustainable profi­ta­bi­lity. Other typi­cal findings in small and mid-cap tran­sac­tions are often the combi­na­tion of private and busi­ness matters. We have expe­ri­en­ced seve­ral times that expen­ses that were actually incur­red for private purpo­ses can be found in the company’s profit and loss account. In some cases, rela­ted parties are also paid, but they do not (or no longer) provide the full service to the company. We have also found various assets in the balance sheet that defi­ni­tely do not belong to the busi­ness purpose and company. This entire combi­na­tion of private and busi­ness must be clearly sepa­ra­ted and elimi­na­ted before the tran­sac­tion is completed.

One trend that has been going on for some time is the buy and build stra­tegy, in which a nucleus is purcha­sed as a plat­form invest­ment and then expan­ded into a larger group via (some­ti­mes smal­ler) acqui­si­ti­ons. I also see this forward-looking trend as  the trend in the small and mid-cap segment. Finan­cing is some­ti­mes easier than for large-cap tran­sac­tions and purchase price expec­ta­ti­ons are also compa­ra­tively more reali­stic than in the large-cap segment. I suspect that it will take until 2024 for the sales price expec­ta­ti­ons in all segments to more closely reflect reality again.

About Jochen Reis

Jochen Reis is a part­ner at Rödl & Part­ner and has been head of tran­sac­tion consul­ting at the Esch­born office for around 10 years. The team at the office compri­ses more than 20 tran­sac­tion specia­lists with a focus on small and mid-cap tran­sac­tions (approx. 120 projects last year). Our clients include both finan­cial inves­tors and corpo­ra­tes who prima­rily make acqui­si­ti­ons in the SME sector in Germany and abroad. Before joining Rödl & Part­ner, Jochen Reis worked at pwc for 13 years, mainly in tran­sac­tion advi­sory in the private equity sector in the large-cap sector.

jochen.reis@roedl.com

Rödl & Part­ner is the agile caret­a­ker for medium-sized global market leaders and is repre­sen­ted at 110 of its own loca­ti­ons in around 50 count­ries. In addi­tion to tran­sac­tion consul­ting, Rödl & Part­ner offers services in the areas of audi­ting, tax consul­ting, legal advice, corpo­rate and IT consulting.