By Ray Newman, Global Head of Transaction Advisory Services, Duff & Phelps, Kurt Steltenpohl, Managing Director, Transaction Advisory Services, Duff & Phelps, Nicole Kennedy, Director, Transaction Advisory Services, Duff & Phelps

About 150 years ago, Louis Pasteur uttered the immortal words “Chance favors the prepared.” Never have those words been more relevant in business than in the current economic environment. The COVID-19 pandemic has upended the way most businesses operate and the landscape for acquisitions and divestitures. This is pushing organizations to identify new ways to generate cash flow while reducing expenses, leveraging strategies and operating models that will stand the test of time.

In the current crisis, most businesses have quickly established a cash forecasting model and evaluated cash optimization scenarios. They have managed their businesses to pre-existing revenue stress scenarios, each with the associated liquidity and cost control measures to create stability.

Immediately following the outbreak of the pandemic, many companies furloughed or reduced the workforce in one or two waves, and remaining employees experienced salary reductions.  Management postponed payments to vendors and generally increased days payable outstanding (DPO) by 5 to 15 days.  To minimize fixed and facility costs, management shut down production lines for two to four weeks and issued notices to all property landlords of a potential inability to pay rent.  In fact, most companies did not make rent payments for one to three months.

Organizations without a pre-existing plan can conduct a self-assessment to determine the impact on its business and take action:

Workforce Impact	·         Observing guidelines on COVID-19 ·         Business designation: essential vs. non-essential service ·         Remote workforce capability
Cash Flow	·         Paycheck Protection Program – instituted in response to the COVID-19 outbreak ·         Revolver/borrowing ·         Demand impact/customer access
Operations	·         Supply Chain ·         Cost Evaluation ·         Operating Model changes

As the quarantine began, management’s priority was to ensure the health and safety of its employees while maintaining continuity of operations by accommodating remote work arrangements to the extent possible yet complying with essential and non-essential business designations by local authorities.

Companies’ initial financial actions were to draw down on any available borrowings (e.g., lines of credit, revolvers, etc.) to ensure access to immediate liquidity. Management teams also calculated applicable ratios to understand incumbent concerns of the ability to meet debt covenants. There is now an ongoing debate between lenders and borrowers on what constitutes an extraordinary or non-recurring “loss” as defined in numerous loan agreements, which is the crux of establishing compliance or not.  Successfully defending a loss due to lost revenue may determine who will be running the business through these challenging times:  management or the bank.

The next step requires a detailed analysis of revenue, costs, and expenses, and “outside the box” thinking to identify unique approaches to preserve earnings by reducing costs without jeopardizing revenue.  To do so, companies are analyzing their prerequisite cash forecast model (e.g., 13 weeks, 26 weeks, etc.) to understand the business’ primary financial and operational levers to reduce costs in the near term:

• Financial
  • Business Incentives – Obtain access to tax abatements/exemptions, wage subsidies and other incentives/loans offered by local, state and federal government.
  • Insurance – Review business interruption insurance coverage to see if they will cover losses resulting from the pandemic.
  • Working Capital – Identify opportunities to improve liquidity by shortening the order-to-cash conversion cycle and lengthening the procure-to-pay to vendors, especially lease, parking, and other fixed overhead payments
• Operational
  • Sourcing – Analyze spend categories and evaluate vendor agreements to determine if there are more cost-effective options for purchasing raw materials and identify potential supply chain disruptions. For upstream sourcing costs, companies can migrate long-standing single-sourced vendors to a competitive process and renegotiate contracts including trading off cost for term length.
  • Footprint Reduction – Identify non-essential or surplus facilities and rationalize operations. This could include vacating or transferring operations to more efficient and profitable facilities.
  • Product Rationalization – Analyze profitability of low demand products and identify opportunities to discontinue unprofitable products/services and to reduce customization options that contribute to low profitability

Survival beyond the immediate steps depends on the platform for recovery.  Management may need to revise its operational roadmap, either accelerating planned operating model changes or adding new ones to ensure a viable platform for the post-recovery marketplace.  For instance, the pandemic was merely the catalyst for retailers to finally align the storefront operational cost structure to the online eCommerce trend, many of them now using bankruptcy as a vehicle to do so. For manufacturers, the cost benefits of a majority global supply chain have been diminishing for a decade, and they may now shift more onshore to reduce cost and risk. For others, building capabilities in telehealth for clinics, contactless curbside pickup at restaurants, and cashless payment in general will streamline costs, enable revenue and meet new customer expectations, all of which require internal investment or a shift in acquisition strategy. The best companies are using the current ‘downtime’ and availability of management, office, and production resources to position competitively for a strong recovery.

The final step should include an evaluation of the results generated from the prior steps performed. This will help management determine if any additional steps should be taken (or prior steps repeated) in order to optimize cash flow and preserve the economic health of the business. Continual re-evaluation is key to success as it will allow for real-time changes to adapt to the changing environment.

Amidst the change activity on the shop or retail floor, the landscape is also shifting in executive offices and board rooms. Transactions being conducted during this period are colloquially referencing “EBITDAC” (earnings before interest, taxes, depreciation, amortization, and coronavirus), and the SEC released guidance on COVID-19 related expenses and disclosure. One time/or non-recurring adjustments were always part of an adjusted EBITDA analysis, but with the pandemic’s wide-spread effects, adjustments are taking numerous routes and management teams are evaluating additional potential adjustments:

Additionally, transaction diligence priorities for both buy- and sell-side are focusing on the following:

1. Validating adjustments to normalize ongoing operations and expenses;
2. Appraising the business and valuation model to ensure it accurately reflects COVID-19 realities;
3. Evaluating the commercial environment and business strategy (position in the market, their customers and suppliers and the impact on these entities);
4. Securing terms with lenders that are favorable given the current environment;
5. Conducting cyber examinations that also includes work from home analysis; and
6. Assessing insurance coverage and the necessary inclusions of business interruption and representation and warranties.

The business environment is becoming more complex while the shape of the recovery remains uncertain.  Most clearly, company action to reduce risk is paramount for success, and preparation is the key.

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