Management Adjustments in Due Diligence: How to Evaluate and Challenge Them

Management adjustments are EBITDA modifications proposed by the target company's management or sell-side advisors. They represent items that management believes should be added back or removed to arrive at a normalized, sustainable earnings figure.

For Transaction Services teams, particularly on the buy-side, evaluating management adjustments is one of the most important judgment calls in the engagement. Accept an unsupported adjustment and the buyer overpays. Reject a legitimate one and the team may miss context that the seller's representatives will challenge.

Types of Management Adjustments

Supportable and Common

Some management adjustments are standard and easily verified:

• Transaction costs: Legal, advisory, and accounting fees related to the current transaction. Verifiable through invoices and engagement letters.
• Owner compensation above market: Private company owners frequently pay themselves above-market rates. Adjustment to market compensation is standard, supported by compensation surveys.
• Completed restructuring: Costs associated with a restructuring that is verifiably complete. Severance paid to terminated employees, lease termination fees for closed facilities.

Judgment-Dependent

These adjustments may be legitimate but require analysis to assess:

• Unfilled positions: Management claims that recently approved but unfilled positions will generate savings or revenue. The question is whether the position was truly a one-time role or an ongoing need.
• New contract impact: Management adjusts for the full-year run-rate of a recently signed contract. Valid if the contract is binding, questionable if it is a letter of intent.
• Operational improvements: Cost savings from newly implemented processes. The TS team must verify that the improvements are real and sustainable.

Aggressive and Speculative

These adjustments raise red flags:

• Projected synergies: Savings the buyer might achieve through integration. These belong in the buyer's valuation model, not in the QoE. TS teams should not validate synergies as QoE adjustments.
• Market growth assumptions: Management adjusts EBITDA for revenue growth that has not yet materialized. This is a forecast, not a normalization.
• Planned but unimplemented initiatives: Cost savings from initiatives that management intends to implement but has not yet begun. Without execution evidence, these are aspirational.
• Duplicate adjustments: The same economic event adjusted in multiple ways. For example, adding back a one-time cost and simultaneously adding a run-rate savings for the replacement solution.

The Evaluation Framework

Step 1: Inventory All Management Adjustments

Create a complete list of every adjustment management has proposed. Include the description, amount, period, and stated rationale. On sell-side engagements, these are typically presented in the VDD report or management presentation.

Step 2: Request Supporting Documentation

For each adjustment, request the underlying evidence:

• Invoices, contracts, or agreements supporting the amount
• GL entries or sub-ledger detail showing the item in the financial statements
• Third-party evidence where applicable (compensation surveys, vendor quotes, legal settlement agreements)

Adjustments without documentation should be flagged immediately. An adjustment that cannot be tied to source data is an adjustment that cannot be defended.

Step 3: Independent Verification

Do not rely on management's calculations. Independently verify the amount using the target's financial data:

• Trace the adjustment to specific GL entries
• Verify the timing and period accuracy
• Confirm the amount matches the supporting documentation
• Check for related entries that management may not have included (offsets, tax impacts)

Step 4: Assess Recurrence

Apply the non-recurring standard rigorously. Does this item truly occur outside the ordinary course of business?

Questions to ask:

• Has a similar item occurred in prior periods?
• Is the underlying cause likely to recur?
• If removed, would the resulting EBITDA be representative of ongoing operations?

An item that appears in 3 out of 4 years is not non-recurring, regardless of how management characterizes it.

Step 5: Categorize and Present

Classify each management adjustment into one of three categories:

1. Accepted: Supported by documentation, independently verified, and meeting the non-recurring standard.
2. Modified: Partially supported. The adjustment concept is valid, but the amount or timing requires modification based on independent analysis.
3. Rejected: Insufficient documentation, fails the non-recurring standard, or speculative.

Present the results transparently in the QoE report. Clients and counterparties respect a TS team that takes clear positions with supporting evidence.

Documentation Standards

Every management adjustment evaluation should be documented with:

• The adjustment as proposed by management (description, amount, rationale)
• The documentation provided in support
• The independent verification performed
• The TS team's conclusion (accepted, modified, or rejected) with reasoning
• The impact on adjusted EBITDA

This documentation is part of the engagement audit trail and may be referenced in purchase price negotiations or post-closing disputes.

Impact on Deal Economics

Management adjustments can represent 10 to 30 percent of adjusted EBITDA on private company transactions. At a typical EBITDA multiple of 8 to 12x, each million dollars of unsupported adjustments translates to $8M to $12M of potential overpayment.

This is why the management adjustment evaluation is high-stakes analytical work. It requires experienced professionals, clean underlying data, and the time to do it thoroughly. TS teams that compress data preparation time through automation can allocate more time to this judgment-intensive workstream, directly improving the quality of the final deliverable.