“Financial Due Diligence” (FDD) and “Quality of Earnings” (QoE) are often bandied around during a transaction —sometimes used interchangeably— but what’s the difference? In this post, I explore the key differences between typical FDD and QoE, including when each term applies and what they tell us.
FDD and QoE are both exercises in diligence, but they serve different purposes – and sometimes at the same time.
On the buy- and sell-side of a transaction, owner-operators, lenders, investors, and, at times, regulators will request that FDD or QoE is performed so that relevant stakeholders can gain assurance and mitigate their risk.
From an owner’s perspective, a QoE analysis may be required before attempting to sell a business so that a consistent earnings level can be established. Often times, this will be the number that drives a business’s valuation.
From a buyer’s standpoint, the interested party (ie, a lender or investor, depending on prior knowledge and size of the transaction) may not commit to a deal without undertaking and satisfying a proper FDD process.
In the most basic of explanations, FDD can be thought of as the house inspection prior to purchasing a new home, whereas QoE is more like a seller updating the insulation to make the house more energy-efficient.
However, buyer beware: QoE can be like the amazing pool photos in the online property listing when in reality, your dream home turns out to have a mere leaf ridden puddle.
So, what’s the difference between FDD and QoE?
FDD: Placing Value in Quantity or Quality
An FDD review is like a financial audit with the key difference being that FDD is designed to identify the commercial and economic risks versus the financial reporting risks, though they certainly overlap.
In a full FDD exercise, each key financial risk area is analyzed, including historic and projected balance sheets, income statements, cash flows, and financial controls. The latter is especially true for regulated businesses like banks, insurers, or payment processors.
Robust FDD requires a tailored analysis that matches the risk concerns of the lender or investor with the business’ overall risk exposure.
For example, a large retail business that has a few small corporate account credit customers is unlikely to pose a material risk of misstated corporate account revenues or credit risk from the related accounts receivables. The overarching risk to an investor or lender would be overstated retail cash revenues, seemingly robust financial controls, or having the perception that the mechanisms of its merchant services agreements are not volatile (for example, charge-backs, cash reserves and/or hold-backs).
In this case, it may be more appropriate to perform a “proof of cash” analysis rather than a cash collectability review of corporate account credit customers.
QoE: It’s All About the Add-Backs
While a robust QoE may form part of the investor’s or lender’s FDD, a QoE can equally stand-alone to provide information on a target’s “normalized” earnings. Sometimes, a QoE will be the precursor to an investor’s or lender’s valuation.
A QoE analysis differs from FDD in that it focuses mainly on two areas: income statement and balance sheet (usually working capital items).
The format of a QoE is a re-statement exercise that starts with the audited historic results and then walks through various adjustments, in the form of either add-backs or deductions, to present alternative results.
These adjustments are usually for non-operating events such as restructuring costs, or non-recurring income items such as dispositions of assets, the purpose being to represent the profitability and net working capital, or net asset position as though those adjustments had, or had not, taken place.
Contrary to an FDD exercise, which is very fact-driven and relies on analyzing and assessing the business based on actual events that occurred, the QoE can be subjective (and is widely considered so).
This means that when assessing QoE, robust assumptions and logic for adjustments must be thought through, documented, and evidenced to gain credibility when shared with third parties.
Alternate: Excessive questionable material adjustments may result in a poorly executed QoE assessment causing investors or lenders to expand their FDD and dig deeper into the target’s affairs.
In my own experience, I’ve seen instances of well-performed, seller-prepared QoE reviews used by investors and lenders to supplement their own FDD. In these instances, sellers were actually able to reduce the volume —and therefore, cost— of the buy-side FDD.
So, Who Does the Work?
FDD and QoE are usually delivered in various formats depending on the complexity and size of a transaction, and the risk concerns and sophistication of the investor/lender or seller/borrower.
These are specialist analyses that require a high level of financial expertise and understanding of commercial issues such as the financial implications of complex contracts, contingency liabilities, reporting standards, and other accounting nuances.
In practical application, much of the source documentation and financial reporting will be provided by the seller to the preparer of a QoE of the FDD report. And in the case of an FDD report, the seller will usually engage an advisor to broker the process and manage the information flow through the use of a “Virtual Data Room” (VDR).
The Devil’s in the Diligence
Because of the risks involved, transactions are rarely completed without some form of FDD.
More sophisticated parties may require a lower level of FDD if they have their own internal capabilities, whereas other, lesser sophisticated parties may require a deeper dive. Sometimes, only a focused piece of FDD is required (for example, a standalone QoE) because an interested party has existing knowledge of a target (for instance, like in a management buyout situation).
But it’s never possible to be aware of every financial risk of the business. And most investors or lenders need an expert opinion on ways to mitigate potential risk – whether that means assessing a potential reduction in valuation, change of deal structure, escrowed proceeds, or deferred consideration.
In a seller prepared QoE, I often find this quote from Maya Angelou appropriate: “If you don’t know where you’ve come from, you don’t know where you’re going.”
At the end of the day, a seller needs to be armed with the knowledge that can allow them to communicate a business’ value. And ultimately, a QoE analysis is the tool that can validate what the business is capable of producing and areas where it can enhance future value.
Nick Welch, BFP FCA, FMAAT is a Managing Director with GlassRatner (a B. Riley Financial company) based in Miami who specializes in domestic and international transaction services, including FDD, business valuation, refinancings, bankruptcy and restructuring, litigation support and turnaround management.