M&A POST COVID 19
By Melvin J. Howard
It may be a public health crisis above all, but the COVID-19 outbreak has quickly become a profound and unprecedented business disruption, poised to wreak global havoc at levels no financial model, economic forecast or business plan could have predicted, and with no clear end in sight. Whether it be pandemics or other calamities, the time is now to start preparing every business for a world in which these disruptions are the new norm.
The M&A market flipped upside down in a matter of weeks, and would-be sellers face a market they haven’t seen in nearly a decade. M&A is inherently an industry where a sizeable portion of the work could be done remotely. Heavy travel, in-person meetings, and face time in the office were all pretty typical when working on a middle market M&A deal. I would imagine that remote work and virtual meetings will become at least a bit more widespread now that we have all been forced to rely on it during lock-downs.
That said, I do not think M&A will see a broad shift to remote work anytime soon. The size and complexity of these transactions makes it difficult to truly substitute for the rapport built between parties by meeting face-to-face, or the in-person collaboration of a deal team. If there is one thing sell-side advisors love, it is add-backs. One-time expenses, an owner's season tickets, supplier quality issues, Hurricanes , they are all (justifiably) fair game to be added back to improve a company's EBITDA. On top of the uncertainty, the high volume of SBA loans offered under government stimulus programs has out-prioritized traditional commercial loans for many banks, creating a near-freeze on M&A financing in the near term. While the availability of debt financing for M&A transactions is expected to improve as uncertainty settles, it is very likely that lenders will not come back to the table offering the highly aggressive leverage levels that were the norm for the past 5+ years.
The M&A market has been weighted in favor of sellers since at least around 2013, and valuations for middle market companies have been hovering near record highs for roughly the last 4-5 years. A number of factors have contributed to record valuations, including high leverage levels, record levels of undeployed private equity capital ("dry powder"), and the relative scarcity of attractive middle market companies available for sale. While the scarcity of assets for sale and the availability of private equity "dry powder" are unlikely to change substantially due to COVID-19, I would expect that leverage levels will likely come down.
MAXIMIZE CASH FLOW
With the new COVID-19 reality, companies need to reassess their situations and pivot appropriately by maximizing cash flow, re-forecasting earnings and defining mid-term and long-term activities and strategies. Companies should analyze profit and loss (P&L) statements to understand revenues, costs and expenses and reassess sales seasonality for products or services. Mostly importantly, companies need to project a short-term (13 weeks) and midterm cash-flow analysis. Collecting receivables, using available credit facilities and making rational expense decisions are all necessary in uncertain times. Companies should look where sales or other income sources are coming from and their profitability and review cost of goods sold. Some of these expenses could be reduced. A review of fixed versus variable overheads is need to evaluate what decisions need to be made. Net income and profit margin should also include variable levers to configure as needed, such as with labor, materials or advertising.
DEALS ARE STILL GETTING DONE
Buyers with available funds may find that the current environment provides opportunities that would not have existed before the pandemic. In particular, strategic buyers with deep industry expertise will look for transactions that will allow them to add a new product, service, or acquire new technology or a set of skilled employees, or some combination of these. Private equity buyers have a lot of available funds to invest and will need to deploy capital, especially if they perceive this to be a buyer’s market. One of the pandemic's principle effects for M&A transactions has been to lower seller valuation expectations, motivating sellers to be more flexible than they were only a few short months ago. As a result, valuation expectations are materially lower for sellers, making it easier to structure a transaction that makes sense for both parties.
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