COVID-19 has thrown cold water on what was, just months ago, a white-hot dealmaking market.
The pandemic and the government-mandated business closures that followed have created widespread uncertainty that has led to a big chill. Sellers whose businesses have faced significant disruption have largely been hesitant to transact over concern that the market might demand lower-than-2019 valuations. Buyers who are chasing anything but businesses sturdy through the disruption are having trouble projecting what future-year revenues might look like given the pandemic’s effect on … well, everything.
So, where does that leave business owners who want an exit? Or buyers who are either cash-saturated or eager to put their still record levels of dry powder to work? We talked to several leading dealmaking professionals in the Northeast Ohio region ahead of the Smart Business Dealmakers Conference to find out what’s next for the M&A market.
Pause in the market
Back in December 2019 — which, in pandemic time, might as well be eons ago — the outlook was incredibly positive for M&A in 2020. Deal activity was expected to continue to be high, company revenues were expected to break record levels and any words of criticism from buyers were typically around the too-high valuations. Then came March. Shutdowns closed businesses off from customers and their supply chains, as well as travel and in-person meetings, often freezing diligence and, in many cases, dealmaking processes.
“If a company was in a late-stage deal, they may have taken a pause to reassess, or the deal may have slowed, but in most cases, it is still moving forward,” says Joe DiRocco, regional president at Fifth Third Bank. “For those in early stages, it really depends on the company and their goals. Some have been cautious and choose to hold, while others look at this time as a unique opportunity.”
For some private equity firms and investors, the initial response to the pandemic was to protect current investments to help them survive. That may have also led them to pause their search processes.
“Our priority right now is to just stabilize what we have,” says Bob Campana, CEO of Campana Capital. “If a unique opportunity comes up, certainly we’ll entertain it. We’re still on offense, but stability is the most important thing.”
While Stewart Kohl, co-CEO of The Riverside Co., says the firm’s ability to look for deals has been relatively unaffected by the pandemic, what has been affected is the availability of new deals. Kohl says around the third week of March, about when the shutdowns began,
“There was an immediate chilling of the market. Sellers who had started processes, in many cases, withdrew them. People who hadn’t started the process already weren’t going to start it with that much uncertainty, and that prevailed in April and May.”
The effects of the pandemic on businesses, however, have been uneven, and that’s kept values and activity high in some sectors. Chris Adams, president and CEO of Park Place Technologies, says some businesses are booming right now, and there’s a lot of activity and M&A in those industries.
“It depended on where the business sat relative to how COVID affected them,” Adams says. “I think there was also some constriction in the debt markets. So some of the neutral deals, where they were OK businesses, I think what happened there, from talking with investment bankers, is the buyers tried to push the price down to try to take advantage of COVID. So the sellers said, ‘Let’s just sit back and wait six months to a year,’ and they often would use the debt as an explanation for that. But from what I can tell, the good businesses are still doing pretty well.”
Deals at a discount
Signs of a thaw, however, are starting to show in the frigid M&A market.
“It was absolutely dead from March through May, and we saw no transactions at all,” says Steven Ross, president of Squire Ridge Co. LLC. “We clearly saw deal activity start to pick back up in June, and we have been seeing a steady flow of deals over the past four to six weeks.”
Owners might now be more willing to sell, but there’s still the matter of at what price. There’s concern on the sell side about a potential loss of value from the disruption, and that, on the buy side, is being seen as an opportunity to find deals at a discount.
“The companies that can’t make it through this cycle, who probably didn’t have the right balance sheet to push through a downturn like this, those companies will be available,” says Jon Pinney, managing partner at Kohrman Jackson & Krantz LLP. “We probably won’t see distressed sales pick up until the fourth quarter and into 2021. The cycle from default to some type of distress workout or liquidation, it takes a lot longer than people think. Looking back on 2008, we were still working on a lot of distressed transactions in 2011 and 2012. But you’ll see the first real signs of it, probably the earliest signs, in the fourth quarter and then throughout 2021.”
But to determine whether a company is actually distressed or has just experienced temporary hardship requires diligence. And the diligence process, like everything else, has been challenged by the disruption.
“For companies where they have those significant challenges — an inability to forecast and an inability to leverage their historical supply chain — if they’re not able to represent that their receivables are collectible because their customers are struggling, that’s a tough situation to sell a business in,” says David Dunstan, managing director of Citizens Capital Markets.
He says when there’s a lot of uncertainty, companies are better off waiting, unless there’s a compelling reason to continue, such as teetering on the brink of bankruptcy. But for those that are somewhere in the middle, making the call is more difficult.
“From a diligence standpoint, it creates new challenges trying to advise,” Dunstan says. “If you’re the diligence provider to the buyer, giving them comfort that the receivables are collectible, that the inventory is saleable, that the forecast is valid, is going to be really tough unless the company has a clear path back to normalcy.”
For companies in a good position, however — those with recurring revenue, contracts, in a sector that’s less affected — there could be a clear path to diligence. But for those that aren’t, it’s expected to be very difficult, and that could manifest in the value.
“There’s no other way for a buyer to really account for some of these uncertainties except for with purchase price and then structuring earn outs and other things to make up for it once things do return to more normalized levels,” he says.
And diligence has been affected in other ways. Social distancing protocols and restrictions on travel and occupancy have forced many deals to be done around a digital table. Teleconferencing has replaced dinners, and in at least one case, camera-saddled drones have done facility tours in place of in-person visits.
For some, deals can still get done without the handshake. But something is lost when interactions happen via the internet.
“We have learned that we can do a lot more through technology,” says Umberto P. Fedeli, president and CEO of The Fedeli Group. “But I also think we also are losing something. It’s very hard to build rapport. And in business, culture is probably among the most important ingredients. It’s hard to have that same feel when you can’t meet people and talk to them and see them face to face. Some people are fine. There are others who feel really out of place.”
Because diligence is so challenged at the moment, there’s a more compelling reason for both buyers and sellers to get professional support before going to market.
“I say, for sellers, get the lawyers involved as early as possible,” says Jayne Juvan, chair of M&A, securities & capital markets at Tucker Ellis LLP.
She says it’s now more important than ever for sellers to make sure that their company’s house is in order before going on the market. That means partnering with legal counsel as trusted business advisers very early on. And on the buy side, she says it’s important to do a deep dive and make sure that buyers are comfortable with the quality of the asset being targeted.
“Have you done background checks on the executives, for example, who own the business, who are selling it to you?” Juvan says. “In a heavily regulated industry, is there any misconduct that has criminal implications that, even if it’s a pre-closing liability that you’re not assuming, could cause you to get swept up in a governmental investigation? Partnering with legal counsel in order to make sure that you truly understand what you buy is key.”
M&A has been complicated by the COVID-19 pandemic in a lot of ways. Navigating these new complexities will take knowledge, patience and, in many cases, guidance, to reach a successful outcome. But even though the disruption has changed even the most basic aspects of a deal — a handshake, for instance — some things remain the same.
“Be opportunistic,” says Squire Ridge’s Ross. “If a company was a business you would have wanted to own before COVID-19, rest assured it will be a company you want to own post-COVID-19.”