Quality of Earnings Analysis in PE Due Diligence

Every company you look at in PE will present an adjusted EBITDA number that makes the business look better than it is. Your job on the deal team is to figure out what EBITDA actually is. That's the Quality of Earnings analysis.

What Is a QoE?

A Quality of Earnings report is the financial due diligence deliverable that reconciles reported EBITDA to "true" maintainable EBITDA. It strips out one-time items, challenges aggressive add-backs, and identifies run-rate adjustments that affect what you're actually paying for.

The QoE is typically prepared by an accounting firm or specialist transaction advisory provider hired by the PE buyer. It costs $150-500K and takes 3-6 weeks for a mid-market deal.

The EBITDA Bridge

Management will present their adjusted EBITDA with add-backs. Your QoE examines each one:

Legitimate add-backs: - One-time restructuring charges (verified by invoices) - Litigation settlement costs (non-recurring, documented) - Owner-related personal expenses run through the business - COVID-related disruption costs (increasingly scrutinized)

Suspect add-backs: - "Non-recurring" consulting fees that appear every year - Cost savings from initiatives not yet implemented (synergy add-backs) - Revenue "run-rate" adjustments for contracts not yet signed - Excessive capitalization of what should be operating expenses

Run-Rate Adjustments

The most dangerous game in QoE: the run-rate adjustment. A company books a large contract in Month 11, then annualizes it to inflate EBITDA. The QoE team must verify: is this contract real? Is the margin sustainable? Does the customer have a history of churn?

Conversely, run-rate adjustments work in the buyer's favor when cost-out programs have been implemented mid-year. If a company eliminated $3M of SG&A in July, only $1.5M shows up in the calendar-year P&L, but the run-rate impact is $3M.

Red Flags

Experienced deal team members look for patterns:
Revenue recognition timing: pulling forward Q1 sales into Q4 to hit targets
Working capital manipulation: stretching payables to inflate operating cash flow
CapEx vs. OpEx classification: capitalizing expenses that should flow through the P&L
Related-party transactions: above-market contracts with entities owned by the seller
Customer concentration: if one customer is 30%+ of revenue, that's a pricing power problem

The Impact on Valuation

If management says EBITDA is $25M but your QoE finds it's actually $21M, the difference at an 8.0x multiple is $32M. That's $32M of value that doesn't exist. This is why the QoE directly affects the purchase price in final negotiations.

Interview Angle

When asked about due diligence, demonstrate that you understand the QoE isn't just accounting — it's the foundation of the entire investment thesis. "The QoE determines what you're really paying for. If adjusted EBITDA is $25M but maintainable EBITDA is $21M, I'm not paying 8x $25M — I'm paying 9.5x real earnings, which changes the entire return profile."