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Navigating Complexities in Industrials M&A, A Conversation with Don Levy, MD at Kroll
61 Plays3 months ago
Don Levy, Managing Director in Transaction Advisory Services at Kroll, joins David Waldstein, Managing Director, Industrials, Aerospace & Defense at Alantra, to discuss common challenges in M&A processes in the Industrials sector, emphasizing key issues such as time, financial projections, and sell-side due diligence.
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Transcript
Introduction: Meet David Waldstein and Don Levy
00:00:06
Speaker
Hi, my name is David Waldstein and I'm a managing director at Elantra focused on industrials and specifically aerospace and defense and power generation. I'm pleased to be joined today by Don Levy of Kroll. Don, thank you for joining our podcast. To start, perhaps you could provide the listeners with some background on yourself and on your practice.
00:00:28
Speaker
Yeah, sure, I appreciate you guys having me on. Excited to to talk through some of these issues here with you guys. So I've been with Kroll for about 12 and a half years now, primarily focused on financial diligence, which most people know is quality of earnings, quality of working capital, really any types of financial analysis our clients need some assistance with as it relates to acquisitions and sales primarily in the in the private markets.
00:00:55
Speaker
Prior to joining Kroll, I spent some time in restructuring and turnaround work with BDO Consulting, and toward the kind of tail end of my tenure there, I got into the financial due diligence, which propelled me to Kroll.
Current M&A Market Challenges
00:01:10
Speaker
At the time, I figured I'd like to help my clients in a different way outside of an accounting firm, and that's what I found at Kroll, given we are not an accounting firm.
00:01:20
Speaker
We don't have any independence issues or Sarbanes-Oxley issues, and we're able to provide not just financial diligence services, but a whole suite of other types of financial services. So over the past 12 plus years or so, I focused primarily on financial diligence, but given my background and turnaround and restructuring, I have done some operations work as well. That's great.
00:01:44
Speaker
And as a result of all that background and the work you're doing, I'm curious to hear how you're finding the market from an M and&A perspective. Are you seeing anything in terms of consistent challenges companies are facing as they either come to market or are going through the process of being in market?
00:02:03
Speaker
Yes, so collectively with with our group and the various and these we work on hundreds of transactions a year. And I think it's been a bit of a mix from a level of deal flow perspective, it really all depends on the specific sector and the partner managing director.
00:02:19
Speaker
and their business specifically i personally have been pretty comfortably busy over the year. Hasn't really been a crazy year twenty twenty four in comparison to others call twenty one twenty two but it's been consistently busy and so i've seen a ah fair amount of flow in the hvax space specifically both on the residential services side as well as mechanical contract.
00:02:44
Speaker
And so that touches a various various end market. So we've worked with a number of other companies kind of in the A and&D space, general manufacturing and distribution. So I'd say really in general, it's it's just been a nice flow of business and M and&A
Understanding Project Accounting Complexities
00:03:00
Speaker
over the year. I mean, there are some sectors that I've worked in over the past years, which quite frankly haven't been as robust for me. For example, healthcare. care And I actually worked with you guys on a healthcare deal.
00:03:11
Speaker
but it was more consulting services company to the healthcare industry, not necessarily clinical type services. So I really think it's ah it's a mix across various sectors and obviously the partners in the various M and&A shops that we work with. Yes. And I know one opportunity in the aerospace and defense and power gen sector that we worked on together came across a relatively common challenge within the large manufacturing space and that being the challenge of proper project accounting. Maybe you could describe first what is project accounting and then further for our listeners when it's applicable.
00:03:54
Speaker
Yeah, yeah, sure. One question that I didn't necessarily answer specifically, and then I'll get right into the project counting, is just general challenges that we've seen in the M and&A markets, just in general, which I'm sure you've seen as well. I mean, I think there are a couple things that have been a little bit more consistent on others. I mean, one is time, of course, right? Time, as everyone knows, is a bit of a deal killer. So the longer a deal is in the market, in most cases, at least the ones that I've seen, the less likely it is to close just because things can happen with respect to financial results as time goes on. In some cases, companies aren't doing as well as their projections have been forecasted to.
00:04:33
Speaker
so That's a challenge. In many cases, sellers present pro forma adjustments to EBITDA, which may not necessarily come to fruition in the timeframe that's originally planned and therefore potential values decreased and buyers potentially request a revaluation. And I'd say in a lot of those cases, sellers are reluctant to revalue, which which has been a challenge that I've seen, especially with some of the larger deals.
00:05:00
Speaker
Now, as it relates to project accounting, it's really a concept where revenue is recognized based on a percentage of completion, right? and And when we talk about that, it's contract accounting for long-term type projects. So what exactly does that mean? The cost incurred to date on a project is really then taken as a percentage of the total estimated cost of that project.
00:05:26
Speaker
right And so it's it's a little bit more of a complex concept as it relates to revenue recognition. And then that percentage is finally applied to a contract value in order to report what your recognized revenue should be over a certain point of time of that contract.
00:05:47
Speaker
And really the basis of the method is to ensure that you're accurately matching. Your revenue to the cost that you're incurring now the applicability of this it's really general applicable like I said and in long term construction type contracts and projects.
00:06:02
Speaker
That can span multiple months or years, and this is across various sectors. Of course, A and&D, where they're manufacturing, call it large equipment type projects, any real construction type project. And it doesn't necessarily have to be what people think of as construction, like building a building or a project site.
00:06:23
Speaker
It's really any type of construction project that spans a longer period of time and again it all comes back to essentially matching your cost to your revenue. And i know when we face some of these challenges together. It was foreign and the business that was making very large components and assemblies that took long periods of time to complete.
00:06:46
Speaker
When it becomes a challenge, what are the most common mistakes or improper accounting that you see? Yeah, so there are definitely a number of ways and I can tell you I'm currently working on two deals specifically that are in the mechanical contracting space. They provide products and and components to the A and&D space. They provide components to the HVAC space and various other types of mechanical businesses that need these components. So that being said, some of the issues that we face is
00:07:21
Speaker
Perfect example is we have a client that's seeking to acquire a target that's recognizing revenue based on billing, just straight billing. So it's almost as if it's a cash basis, which is totally incorrect. If you're looking to report.
00:07:37
Speaker
on an accrual basis of accounting in accordance with GAP. right So in those situations where there are errors, what we do is we come in and we assess the percentage of completion accounting and the respective revenue recognition for each project over that project life.
00:07:55
Speaker
and What does that do? That, number one, allows us to see what the revenue that should have him been recognized over each of the years that we're assessing in our diligence is. and Secondly, there's a balance sheet component to it. right so You have billings in
Impact of Project Accounting on Deals
00:08:11
Speaker
excess of costs and then costs in excess of billings. so One's an asset, one's a liability. What does that mean?
00:08:18
Speaker
You're essentially reporting an asset when you've incurred more cost than you've built, right? On the flip side, you're reporting a liability when you've built more revenue or more fees than the cost that you've incurred.
00:08:36
Speaker
And so in the in the industry it's referred to as over and under billings. And so that then plays into, you know, networking capital and how to treat those things from a networking capital perspective, right? So revenues obviously are the aspect of adjusted EBITDA, which impacts value and deals. And then the asset and liability side of this with the over under billings is it going to have a direct impact on your work capital.
00:09:01
Speaker
And it's not just that there's a lot of complexities that go into project accounting just in general, especially with these very large contracts. They're evolving on a day-to-day basis. There are change orders that can play into things. If change orders aren't necessarily worked into the calculations accurately, you're going to have misstated revenue and over under buildings, of course.
00:09:24
Speaker
if Project managers aren't timely in submitting paperwork or whatever it is that they're using from a technology perspective as it relates to costs and billings they're going to be errors. So the analysis that we do essentially ties all that together compares it to what was what is being reported.
00:09:42
Speaker
And then provides us with the necessary adjustments that we illustrate through our quality of earnings and our quality of working capital analysis do you see this negatively or or perhaps positively affecting a process and ultimately affecting value.
00:09:57
Speaker
when done either correctly or incorrectly as the case may be? It really depends. It could be both positive and negative. In addition to just doing that job level analysis, what we do is also like a hindsight gross margin analysis. And that's actually very telling with respect to whether companies are recognizing margin earlier in a jobs life or later in a jobs life. From a deal perspective, if you're pushing margin out to the future,
00:10:25
Speaker
you're likely going to have a negative adjustment because what we do is we look at the project over its life and we want to see a consistent margin. And so what we'll do is we'll adjust it so there's a consistent margin and in some cases you're either pushing margin backward, in some cases you're pushing margin forward. It really all depends on what the company has been doing from a revenue recognition and a margin recognition perspective.
00:10:52
Speaker
So we can go either way i mean i've seen it go both ways and in different deals in the couple deals and i'm working on now it's actually a negative impact. Because the company was recognizing more margin later in the job. And obviously as you know all of us are focused more on the later years right so we're pushing margin into the earlier years it's gonna negatively impact your trailing twelve month period.
00:11:17
Speaker
So i'm interested to hear if you've had some cases or or horror stories as a result of the accounting treatment or perhaps improper accounting treatment throughout the course of a process. Yeah everyone likes to think that they're doing it the right way but then when you have a second set of eyes and a third set of eyes when it comes to these m and a processes.
00:11:37
Speaker
You know, you pick up on errors, unfortunately, because again, this really isn't the most straightforward ah accounting concept. And there are a lot of nuances that factor into kind of improper revenue recognition when applying it to like real life situation. We have the benefit of hindsight coming into these situations. It's a third party kind of looking in. We're not doing the dayto day to day.
00:12:02
Speaker
So when we come in and we look at these things and we say, well, there's a pretty significant negative impact, the company's obviously not going to be happy about that. But sometimes it's really impacted a deal. Sometimes it's not as material. You know, it really all depends on the level of sophistication with the respective accounting group and the finance group within that company.
00:12:23
Speaker
And yeah, there have been horror stories where it's killed the deal and it's unfortunate. But at the end of the day, it's, I think it's a life lesson and a lesson learned in general, you know, just as it relates to, okay, now we know what we were doing incorrectly. Let's fix that so that we can then come to market at a future date with accurate and reasonable results in numbers.
Preparing for Market Entry: Strategies and Expectations
00:12:47
Speaker
Yes. And that's a good point. It's interesting you say that about having the benefit of hindsight.
00:12:53
Speaker
I think when we experience some of these issues together, as in most cases, there is a sophisticated finance lead in these companies who are smart individuals, very experienced, and they believe they're handling the accounting for these long-duration projects correctly. What I would imagine they haven't spent a lot of time thinking about is, in the context of a transaction, how what they're doing is going to be viewed by somebody with an outside perspective. It really sounds like the moral of the story is to start preparing early so that these types of conventions are being properly considered before a process starts.
00:13:35
Speaker
right Definitely, not to go off on a tangent here, but that's really the benefit of cell side diligence. That's how we've come to work together over the years is through cell side diligence and kind of helping your clients prepare for the processes. And I think it's invaluable to them where we're finding call it issues, but It's about presenting those issues with a positive narrative so that we on the sell side can control that narrative and position our clients the best way we can, even though there could potentially be a negative issue, right? And if it's that bad, then maybe we hold the process for two, three, four months, whatever it may be, in order to fix the issue so that it doesn't necessarily come up as a company comes to
Market Outlook for 2025
00:14:25
Speaker
market.
00:14:25
Speaker
Well, this topic is an interesting one because I do think there is a consistency to it in that it's complicated enough. It comes up frequently. There are differences in the way people deal with it, especially in the manufacturing world and certainly in aerospace and defense and power generation. It's not uncommon for it to end up being a hot topic within a process. So to wrap, given where we're at in the year,
00:14:55
Speaker
how are you seeing 2025 shape up? And I guess based on the work you're doing, are there certain sectors that going forward, you anticipate seeing a pickup in activity? Yeah, sure. So, I mean, for 24, I'd say I expect a pretty consistent flow of deals through the end of the year, and we're in September, so we have about three and a half, four months left. I mean, specific to my practice, but overall, I think there's still a fair amount of uncertainty with respect to interest rates, of course,
00:15:23
Speaker
We have the fed coming up next week, I think, likely going to increase rates. We'll see if it's 25 bps or 50 bps. I think the industry is probably hoping for 50 bps, so that'll ease some of the debt service pressure.
00:15:37
Speaker
The other kind of areas that may impact M and&A is the outcome of the upcoming election, of course, right? And that'll obviously trail into 25, 26, and so on. I can tell you I have clients that have backed out of deals due to company's exposure with respect to China and the uncertainty around future of ah tariffs and that type of thing.
00:15:57
Speaker
But as it relates to 25 specifically, I can't see the level of deal flow being less than or lower than 2024. And if rate cuts start you know as early as next week and continue into 2025, I would imagine deal flow to increase.
00:16:15
Speaker
specific to sectors. I think that would have an impact primarily on sectors and companies that are heavily reliant on leverage and debt. And it really all depends on where in the life cycle that company is. Like I said earlier, I haven't seen all that much in healthcare, care maybe healthcare will pick up. I've seen a fair amount in A and&D and mechanical contracting and manufacturing this year that may stay at the same levels. It's really hard to tell. I wish I had a crystal ball like everyone else.
00:16:44
Speaker
You know, at the end of the day, PE groups and other investors have a ton of money that needs to be put to work. I'm sure there are a lot of companies out there that are just waiting to pull the trigger on potential processes. And we're seeing similar trends in terms of strong deal flow throughout the industrials. People certainly feel a fair amount of anxiety around the election.
Closing Remarks and Future Collaborations
00:17:07
Speaker
And in some cases they're taking a wait and see attitude. But I think overall,
00:17:13
Speaker
you know There's a very positive feeling that there'll be decreasing rates and overall optimism that is going to drive more deal flow, more opportunities, and not just in the coming months, but into next year and and even beyond. And I think the folks we're speaking with, whether it be our clients or others in the industry, are feeling quite a bit of optimism.
00:17:38
Speaker
Yeah, I definitely agree with you there on the optimism. I think people are looking at next year as what they thought this year would be. I think coming into 24, a lot of people, especially the bankers that I've been speaking to over the years, thought that 24 was going to be a little bit more robust than it was. And I think that's been pushed into 25. And I'm hoping that is the case for all of us. Don, I appreciate your taking the time and joining our podcast.
00:18:05
Speaker
Your expertise and perspective is something that we've always appreciated and respected. and Being able to share it with our clients and listeners, I think it's going to be valuable for a lot of folks. Yeah. I appreciate you guys having me on. and you know It's always a pleasure collaborating with you on things like this and deals and just general kind of information flow. so We look forward to staying in touch, of course, and potentially doing another one of these in the future.