Do lenders require a quality of earnings report to finance an acquisition?

Required, expected, or unnecessary

A quality of earnings report, or QoE, is an accounting firm's analysis of whether a company's reported earnings are real, recurring and correctly adjusted. It is not an audit: it gives no opinion on the financial statements, and an audit does not produce the adjusted EBITDA a lender sizes on. The difference is set out in quality of earnings vs audit. Whether a lender makes one a condition depends on three things: the kind of lender, how much leverage the deal needs, and how far the seller's EBITDA travels from the reported figure.

The more the price and the loan depend on adjustments, the more the report earns its cost. On a deal where the reported EBITDA is audited, the add-backs are few and the lender is lending well inside the cash flow, a QoE can add cost and a step to the closing without changing a number in the credit memo. At lower-middle-market size that is the exception: most acquisition financing is sized on adjusted EBITDA, and most lenders want it tested. How lenders read the gap between reported and adjusted figures is on seller financials vs tax returns.

What the report settles: one EBITDA figure

Every acquisition lender sizes the loan on a cash-flow figure, and every sell-side advisor presents the most generous version of it. Between the two sits a list of add-backs: owner compensation above a market salary, one-time legal costs, a discontinued product line, pro forma savings from a plant consolidation. Without a QoE the lender works through that list alone, and each item it rejects is an argument conducted after the price has been agreed. With a QoE, an independent accountant has already tested each one, and the lender starts from a figure that has been through a proof of cash.

In this example the report trims adjusted EBITDA from 1,200 to 1,120. Senior cash-flow lenders to lower-middle-market companies commonly lend 2x to 3.5x EBITDA. A lender at the top of that range would have sized the loan at 4,200 on the seller's figure and sizes it at 3,920 on the tested one. That is less debt, but it is debt the lender will actually commit to. The alternative is worse: the same reduction found by the lender late in underwriting, after the buyer has spent on legal work and the seller has planned around a closing. How lenders move from earnings to loan size is on how much debt a business can carry.

A report that rejects most of the seller's adjustments is not a failed report. It is the report doing its job.

What a lender reads first in a QoE

A QoE can run long. A lender reads it in a particular order, looking for the numbers that feed the loan:

• The EBITDA bridge. Reported earnings to adjusted earnings, line by line, with each adjustment accepted, reduced or rejected. This is the page the loan is sized on.
• Pro forma adjustments. Savings or revenue that have not happened yet, such as a price increase or a consolidation. Lenders discount these hardest; see lending on run-rate EBITDA.
• Proof of cash. Whether deposits in the bank statements support reported revenue. A business whose revenue does not reach the bank is a different credit from the one on the P&L.
• Net working capital. The normal level of receivables, inventory and payables, month by month. It feeds the working capital peg and tells the lender whether the business will be handed over with enough to run on.
• Trend in the latest months. Whether the trailing twelve months are better or worse than the last full year, and why.
• Customer concentration. How much of the earnings depends on a few customers. See customer concentration in an acquisition.
• Debt-like items. Customer deposits, deferred revenue, unpaid bonuses, deferred capital spending and old payables that the buyer may inherit and the lender will treat as debt.

The lender will size on the tested figure, and the buyer can use the same findings to reopen the price before signing the purchase agreement. That is why the QoE belongs before the purchase agreement is final, not after.

Who pays, and who can rely on it

In most lower-middle-market deals the buyer commissions a buy-side QoE after the letter of intent and pays for it. Many sellers now commission a sell-side report before going to market, to support the price and shorten diligence. Lenders read a sell-side report, but they know who paid for it, and on larger or leveraged deals they may still ask for buy-side work, or for the sell-side firm to answer their own questions.

Reading a report is not the same as relying on it. Accounting firms limit who may rely on their work in the engagement letter, and a lender that wants to rely on the report will ask for a reliance letter addressed to it. Raise this before the engagement is signed: a report the lender cannot rely on can mean a second round of work at the worst possible moment. It is also worth asking the lenders in the process whether they have views on the firm and scope before engaging anyone.

Timing matters too. Commissioning a QoE before any lender has seen the deal risks paying for a report on a business no lender will finance at the agreed price. The better order is the letter of intent, lenders' indicative terms, then the QoE, with its findings flowing into the final commitment. That sequence is laid out in the steps from LOI to closing.

What a QoE does not do

A quality of earnings report tells the lender what the business earned. It does not tell the lender whether to lend. That decision still runs through the lender's own underwriting:

• Leverage and coverage are still tested against the lender's own requirements, on the lender's own view of taxes, capital spending and the new owner's costs.
• The lender still reads the management team, the industry, the buyer's or sponsor's track record and the equity beneath the loan.
• Collateral, guarantees and covenants are negotiated the same way with or without a report.
• A lender may accept the QoE's figure and still size below it if the trend is down or the business depends on the seller.

What the report removes is the most common source of delay and re-trade in an acquisition loan: a disagreement about what the business earns. Midas Partners builds the financing model and lender package on the same adjusted figures, with the bridge from reported to adjusted EBITDA shown line by line, so lenders see each adjustment before they see the ask. Software does the analyst work and a senior banker checks every page before the client approves it. A fuller treatment of how lenders use a QoE across all debt is on quality of earnings for lenders, and the term is defined in the glossary.