The Flight to Quality: Why Rigorous Diligence is Non-Negotiable in Today’s Mid-Market M&A

Flight to QualityIn our recent M&A report, we explored the tangible impacts of tariffs on M&A activity, highlighting how external forces can reshape deal dynamics and valuations. That theme of navigating external pressures continues to dominate the M&A landscape, but the focus is sharpening. Today, amidst persistent inflation, shifting interest rates, and lingering economic uncertainty, a clear trend has emerged in the mid-market: the undeniable ‘flight to quality.’ This is especially true in dynamic regional economies across the country. For both buyers seeking resilient investments and sellers aiming for premium value, this environment underscores a critical truth: superficial assessments are out, and deep, rigorous due diligence is the industry standard. Leading M&A advisors have observed that successful transactions increasingly hinge on a company’s ability to demonstrate resilience, operational soundness, and verifiable financial performance. At ClearRidge, we see this playing out every day. According to two recent studies, over 70% of mid-market deals in the last year now require third-party Quality of Earnings (QoE) reports up from 58% just a year prior underscoring a new era of deal diligence.

What Does the ‘Flight to Quality’ Mean in Practice?

It means that buyers, whether strategic corporations or private equity firms, are more discerning than ever. Gone are the days (if they ever truly existed for prudent investors) of acquiring based solely on top-line growth or optimistic projections. Today’s buyers are focused on:

  1. Predictability and Resilience: How has the business performed through recent disruptions, like supply chain snarls, changing credit environment or commodity price cycles? Are earnings sustainable? Can the business survive potential economic headwinds or manage growth challenges? Buyers increasingly require evidence of resilience, including stress-tested financials and robust scenario planning.
  2. Margin Stability: In an inflationary environment, especially with tight labor markets, can the company protect its margins? Does it have pricing power? Are its costs well-managed against volatility? Margin preservation and cost discipline are now deal-critical.
  3. Operational Soundness: Are processes efficient? Is the supply chain robust? If the owner exits, is the management team capable not just of maintaining performance, but driving future growth? Buyers are seeking evidence of operational redundancy, documented succession plans, and scalable systems.
  4. Verifiable Financial Performance: This is where the rubber truly meets the road. Buyers will invest considerable resources in quality of earnings and due diligence to prove out reported business and financial data.

The Elevated Role of Due Diligence and Quality of Earnings (QoE)

This heightened scrutiny places an immense premium on thorough, insightful preemptive due diligence. It is a fundamental component of risk mitigation and value validation. Central to this is the Quality of Earnings (QoE) report. While standard financial audits confirm adherence to accounting principles, a QoE engagement dives deeper:

  • Validate EBITDA: Assess the sustainability and accuracy of reported earnings (Earnings Before Interest, Taxes, Depreciation, and Amortization), often the basis for valuation multiples.
  • Identify Adjustments: Uncover non recurring items, accounting anomalies, or necessary adjustments (both positive and negative) to normalize earnings.
  • Analyze Key Trends: Examine revenue quality, customer concentration, margin drivers, and working capital requirements.
  • Provide Credibility: Offer an independent, detailed analysis that gives buyers confidence in the financial information presented.

Recent research shows that seller-initiated QoE can reduce transaction timelines by up to 23% and defend higher valuations. In today’s market, a proactive, seller-initiated QoE can streamline the M&A process, build buyer trust from the outset, and often defend a higher valuation. For buyers, commissioning their own QoE is an essential tool to understand precisely what they are acquiring and identify potential risks or synergies specific to the target and its operating environment.

Implications for Sellers and Buyers

  • For Sellers: The message is clear: preparation is paramount. Sellers should begin preparing 6-12 months before a potential sale, focusing on clean financials, robust business documentation, and a pre sale QoE analysis to identify and address potential issues proactively. Early preparation not only streamlines the process but also maximizes valuation and reduces the risk of deal failure.
  • For Buyers: While quality comes at a premium, rigorous diligence is essential to uncover hidden issues, validate resilience, and ensure strategic fit. Buyers should implement a three tiered diligence approach: financial, operational, and strategic; to pressure test assumptions and understand the true value and risks of the business. Relying solely on seller representations is riskier than ever in today’s market.

Navigating Forward

The mid-market M&A landscape remains active, fueled by dynamic regional economies and ongoing strategic shifts, but the rules of engagement have adapted to the prevailing economic climate. The ‘flight to quality’ isn’t about market paralysis; it’s about informed decision making. Success hinges on transparency, preparation, and a deep understanding of business fundamentals that are tested and proven through rigorous diligence. Whether you are a business owner considering a sale in today’s demanding market or an acquirer seeking strategic growth opportunities built on solid foundations, navigating this environment requires expertise and meticulous analysis. At ClearRidge, we partner with clients to provide that clarity, leveraging our deep experience in M&A advisory, due diligence, and Quality of Earnings analysis to help you achieve your strategic objectives, even amidst uncertainty.

Thinking of Selling Your Business or Planning a Strategic Acquisition? At ClearRidge, we specialize in advising business owners on mergers, acquisitions, and exit strategies. Contact us for a confidential consultation to explore your options and maximize your company’s value. Schedule a Consultation Today  

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