Conducting due diligence in a downturn - Unlocking value and avoiding hidden risks

During a downturn or recession, M&A opportunities are rife, with valuations low and more businesses in financial distress. Successful acquisitions made during such times, therefore, can deliver huge value, helping buyers not only to survive and perform more strongly during the downturn, but also grow faster than their competitors once the economy begins to recover.

However, while the rewards can be greater, so can the risks, with an unsuccessful deal potentially having an extremely damaging impact on a business’ operations, cash flow and capital position.

Just because valuations are low and many inherently viable companies will be distressed and more open to an acquisition, not all deals will represent good value and it’s important to remember that a valuation may simply be low because it's an accurate reflection of the company’s worth.

In a downturn, businesses that are chasing deals will need to place an even greater emphasis on getting their acquisitions right, ensuring that due diligence is thorough and that all potential targets are exhaustively vetted to confirm that they are very likely to deliver value. Extended due diligence timelines may be necessary and buyers will likely have to make changes to their existing due diligence processes to reflect the current economic picture.

What due diligence should look at during a recession

Cash flow analysis of the target
Steady, reliable cash flow is absolutely vital for any business to maintain resilience during an economic downturn or recession. Surviving a downturn will mean that the company needs to have the cash in the bank necessary to sustain losses and maintain liquidity. Without this, even a company that has performed strongly remains vulnerable to economic uncertainty.

If a company is unable to plan for the future during a downturn using its own capital, then it may be forced to borrow at high interest rates. If cash flow is weak then borrowing under these conditions could ultimately mean it finds itself unable to pay its liabilities and is at risk of insolvency action.

During due diligence, buyers should closely examine cash flow. In particular, it will be important to look at aspects such as how quickly the company invoices and stays on top of its receivables, customer payment times (if these have got longer during the recession then it may indicate that the company’s customers are being impacted by the recession and that its cash flow may be at risk), whether the company can produce detailed cash flow forecasts, its profit margins and outgoings.

Strength of customer base/supply chain
One of the greatest risks that companies face during economic downturns is the domino effect that can be caused by customers running into financial distress. Even if a company has continued to perform well during a downturn, this situation could quickly have a highly damaging impact on its cash flow.

Customers may be forced to make slower payments or seek alternative payment terms, something that can begin to eat away at a business’ financial position. Ultimately, if a customer falls into insolvency then the business may be left with bad debts that it cannot recover in full, if at all. This can put the business itself at risk of being unable to pay its own liabilities and potentially facing insolvency action itself.

On the other side of the supply chain, what if the business’ suppliers were to fall into financial distress? This could impact the delivery of a product or service that is vital to the business’ operations, again, putting its cash flow position at serious risk.

For these reasons, buyers should look closely at economic volatility across a potential target’s supply chain. Even if the business is performing solidly and seems to be seeing out the downturn, could the industry that it, its customers or its suppliers operate in be adversely impacted by the economic volatility, creating a domino effect of late payments (and potentially insolvencies) that put the company at risk?

Is the customer base and product/service offering resilient?
It isn’t just businesses that are impacted by economic uncertainty, downturns and recessions also have major impacts on the spending power of consumers, as seen by the impact of the ongoing cost-of-living crisis in the UK.

While most businesses are likely to see some reduction in income during a downturn (particularly if it lasts for two consecutive quarters and becomes a recession), buyers should be wary of businesses in sectors that are particularly susceptible to changes in consumer sentiment.

For example, during the current cost-of-living crisis, consumers have cut down massively on non-essential spending, which has had a huge impact on a wide array of businesses across numerous sectors, from hospitality firms such as pubs to retail businesses such as home furnishing manufacturers.

While such businesses could make for solid distressed acquisitions that begin to deliver value once the economy starts to recover, these are inherently riskier transactions. For buyers operating more cautiously with their M&A plans, it will be vital to consider the likely impact that the downturn and a potential recession will have on demand for the company’s products or services.

If demand will be impacted, then this will naturally have a significantly detrimental effect on the business’ cash flow, something that may persist for the duration of the downturn or recession. However, if the products or services are more resilient and recession proof, then the acquisition is likely to deliver value that will materially improve the buyer’s operations here and now, as well as in the medium to long-term.

How will the company fare during a recovery?
Not all businesses will see an uptick in performance in the wake of a downturn as the broader economy begins to recover. Some businesses may have seen greater demand for their products or services during the downturn (consider, for instance, the huge growth that e-commerce firms saw during COVID-19) and might experience a slowdown once the economy begins to recover.

Other businesses may be impacted by the lasting changes that downturns and recessions can have on consumer habits and regulation. Particularly if a downturn extends into a full recession, the aftermath can have a significant impact on both legislation and customer behaviour.

The 2008 financial crisis saw increased regulation of businesses across banking and financial services, creating a greater compliance burden for owners. While, even as the wider economy recovered COVID-19, brick and mortar retail businesses saw customer numbers remain lower than they were pre-pandemic. Even pub owners, such as Wetherspoons’ Tim Martin, have said that customers are yet to return to the bar in the numbers they did before COVID.

Consider whether the nature of the downturn or recession could impact the business’ prospects in the long-term, beyond the short to medium-term economic shock, and potentially lead to lasting changes in either regulation, consumer habits or business trends that may have an adverse impact on the company.

This will also help with gauging how the target company might fare during different types of economic recovery, enabling buyers to run scenarios based on how a firm might respond to an l-shaped, v-shaped or u-shaped recovery.

If a buyer does decide to proceed with an acquisition during a downturn or recession, then running these scenarios in advance as part of the due diligence process can form the basis for setting various targets and objectives for the company based on the various recovery scenarios.


An insider’s view – The key steps for due diligence in a downturn
Julie Wilkinson is the founder and director of Wilkinson Accounting Solutions, an accounting and consulting firm providing bespoke advice on leading and growing businesses.

Julie spoke with BSR to provide some expert insight on the key areas that due diligence should examine during a downturn or recession. Regarding the one key issue for buyers to examine, Julie says that looking at a target’s EBITDA trends is vital to gauging whether the business looks set to be as successful as it has been in the past. She also recommends closely reviewing one-off incomes that could be distorting a target’s financials during a downturn, such as grants they may have received.

When it comes to red flags for buyers to look out for during due diligence, Julie identified one particular warning sign: overtrading. In other words, while the business may seem to be expanding, does it have the resources to support this? Julie says that a business paying more in dividends than it is making in profits is one crucial sign of overtrading, as it will indicate they are using cash from other sources, such as loans received.

One of the core considerations for buyers during recessions and downturns is trying to gauge whether an acquisition will perform well once the economy begins to recover and whether it can add value in the long term. On this issue, Julie advises requesting the vendor to produce forecasts and a business plan for the future, which can then be compared against at least two months of actual results. This can enable a buyer to gauge how close the target company is to its forecast and provide confidence in their accuracy.

Finally, on the key issue of finding out whether a low valuation is attributable to the downturn or simply an accurate reflection of the business, Julie says the key is to dive deep into its financials and review past trends in detail. When looking at a target’s accounts, go beyond the high level numbers, an example of this would be turnover, such as the trend of income per customer, product or project. Warning signs could be if income is being generated from fewer clients, meaning a higher risk of lost revenue in the future. This can help provide genuine insight into the impact that the downturn has had on the business and whether this has resulted in a low valuation, or whether its value was already low to begin with.

Due diligence considerations relating to the buyer’s business
During a downturn, most companies will be far more cautious in terms of how they operate and deploy their capital. For that reason, when planning acquisitions during uncertain economic times, buyers’ due diligence processes should also focus on the likely impact that the capital expenditure of an acquisition would have on their own business.

For businesses seeking acquisition funding, this will be important as lenders will also be performing rigorous due diligence. This means that would-be buyers will need to be able to prove they have the financial resilience to navigate the downturn, as well as a solid acquisition strategy detailing the types of businesses they would target and how they would deliver value and growth.

Solid financials and a viable, well-presented, clearly thought-out M&A strategy will be vital to convincing lenders that the business is primed to make acquisitions that will deliver value, both during the downturn and over the medium to long term.

Backers, such as private equity firms, are also likely to take an active role in performing due diligence on potential acquisitions. This can help to make the process far less laborious, with some large private equity firms operating dedicated due diligence teams for companies within their portfolio.

In addition to helping attract backing from investors, due diligence that focuses on stress-testing the buyer’s own financials and M&A growth strategy can also be vital to reassuring the buyer themselves that the strategy is viable and likely to deliver growth, helping to eliminate any lingering doubts.

Buyers will also need to identify and plan for the tax implications and possible risks that acquisitions may incur both before, during and after the transaction has closed. For example, the tax implications of different types of deal structures, with buyers perhaps more likely to favour deferred and performance-based considerations during a recession or economic downturn.

In addition to these tax considerations, which will need to be reflected in the sale and purchase agreement, buyers operating during downturns or recessions will also need to be doubly careful about ensuring their historical taxes, correspondence with HMRC and various warranties and indemnities are kept well organised.

Of course, tax compliance is vital for any buyer, but during a downturn the consequences of not complying with the rules, even if it’s a completely honest mistake, can be particularly costly for a business’ cash flow and capital position.

How can buyers mitigate risk if they do opt to proceed?
Even if a buyer has performed an extensive due diligence process and opted to proceed with an acquisition, there is no way for risk to be entirely eliminated from an M&A transaction, particularly during a downturn or recession. However, there are steps that buyers can take to mitigate any lingering risks in the unfortunate event that things don’t work out as planned.

In terms of ensuring that the sale price reflects the risk inherent in a deal conducted during a downturn, the most obvious measure, is to negotiate a valuation based upon a most-likely-case scenario (rather than best-case or worst-case), but which is structured in such a way as to incorporate variables and reflect scenarios in which the expected results are either not achieved or over-achieved.

There are several ways to do this, most notably to structure the deal with deferred considerations to be paid in instalments, but conditional upon the company achieving certain performance-related goals within set timeframes, for example, revenue growing by a certain amount within the first year post-completion.

This will mean that, should the acquisition fail to perform as hoped, the buyer is not tied into an acquisition price that reflects a value that simply wasn’t delivered.

In order to mitigate post-transaction risk as much as possible, buyers should also ensure they have solid warranties and indemnities (W&I) insurance in place. W&I insurance provides protection on both the buyer and seller side during M&A transactions and can be particularly advisable if conducting a deal during times of heightened economic risk.

Sellers will provide a buyer with guarantees (warranties) about the business, which help buyers to identify information presented during the due diligence phase that may be inconsistent with these warranties. If the buyer subsequently suffers losses that are covered by the warranties, then the insurance enables them to bring a claim against the seller for the duration of a warranty period.

For buyers with lingering concerns about the financial resilience of an acquisition target (concerns that are likely to be particularly acute in a downturn), W&I insurance policies remove the risk that sellers won’t be able to pay in the event of a claim.

While W&I can be taken out on either the buyer or the seller’s side, policies are typically taken out by buyers as they afford them greater protection, while helping to maintain the relationship with the seller even if a claim has to be made.

Such policies can also help buyers negotiate a more favourable deal structure by providing benefits to sellers such as quicker access to sale proceeds, a cleaner exit and ultimately enhancing the sale value by enabling the seller to allow full warranty provision.

Finally, having W&I insurance in place can be helpful if buyers are seeking outside funding for an acquisition, as it will provide lenders with a greater sense of security in the transaction and their investment.

For buyers operating during times of downturn or recession, solid due diligence processes are arguably the most important aspect of an M&A strategy, helping them not only to avoid and mitigate risk, but also to more fully realise the huge value that can be inherent in deals struck during downturns.


Given the wealth of opportunities that present themselves during a downturn, it is well worth a buyer’s time to develop as strong a due diligence process as possible. Once this is in place, a buyer can begin to target numerous acquisitions, in the knowledge that their due diligence process is effective in flagging up risks, ascertaining a business’ true value and identifying acquisitions that will deliver the most value in both the present and over the longer term.

If you need help from a specialist accountant to assess a potential target, from an operational and/or financial perspective, complete this form for a free consultation.

Also read: Intellectual Property in M&A – The key due diligence considerations

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