Middle-market M&A continues in a downturn

Yes, we are clearly in a recession. 21.4 million jobs have been lost. Consumer spending is down 7.5% as of April 1. $669 billion in PPP and $600 billion in Main Street loans are being extended by the government. What does this mean for middle market M&A? The first weeks of the coronavirus crisis paused deal-making. Financial buyers had to redirect their focus and energy to the health of their portfolio companies at the expense of new deal activity. Strategic buyers were conserving cash and shoring up operations. Deals in progress were re-evaluated, and some were put on hold.

But now, like the spring flowers of Mother’s Day, deal activity is beginning to perk-up.

Should we look back to the Great Financial Crisis as the roadmap for the next year? Not necessarily. Granted, there are similarities between the two financial crises: high unemployment, low consumer spending, and low consumer confidence. However, the differences are profound. In this crisis, the entry into the recession was fast and brutal, and there is less uncertainty on how the recovery will unfold. The world has endured financial crises in the past; this self-imposed, albeit justified, grinding halt of the global economy is unprecedented.

The most significant difference between the Great Financial Crisis and Covid-19 Crisis is today’s greater access to capital. Before this downturn, U.S. private equity firms had $740 billion of dry powder to invest compared to $392 billion in 2008. Some of that money will be used to shore up the balance sheets of existing portfolio companies. But, the remaining cash needs to get deployed, as private equity players only get paid when the money is out the door and invested successfully.

Amidst the financial crisis of 2008, it was more difficult to get deals done because the credit crunch made the banks unwilling to provide loans for leveraged buyouts. Today’s debt market is different. The government is desperately providing support for healthy banks to lend. Private debt funds, which largely focus on M&A transactions and have become much more integrated into the fabric of financial sponsor transactions over the past decade, structurally have more flexibility than banks. Their reach has more than doubled to $176 billion since the Great Recession.

We went into 2020 with 98% of participants in a Deloitte survey expecting deal multiples to increase or stay the same. The 2% seems prescient now. The impact of COVID to deal valuations will not be consistent across all industries. For example, hospitality and oil and gas deals will be negatively impacted, while the underlying use of and customer trends for technology and peace of mind financial products companies should support close to historical valuation levels.

Valuation methodologies will need to be reconsidered and segmented as B.C. (“Before Coronavirus”), D.C. (“During Coronavirus”) and A.C. (“After Coronavirus”)

• B.C. valuations will influence seller expectations
• D.C. financial and operational performance is relevant, as experts are predicting the continuation of the pandemic into 2021. Those firms that can adapt and thrive in this environment will emerge even more valuable. Also, private equity firms will show their true stripes – who supported their portfolio companies during this episode and who did not?
• In the long term, A.C., buyers will continuously look back at how companies performed during and coming out of this economic shock

Deal structures are changing, too. We anticipate that more earn-outs will be used to share risk. Larger equity backstops will be required in leveraged deals.

Transaction diligence has also changed and will take longer as the result of new due diligence issues that have arisen, how due diligence is conducted, and the time it will take to obtain necessary regulatory and other third-party approvals for transactions.

In May 2020, as global economies slowly re-emerge from lockdown, we may have entered into a new normal, and financial buyers are again looking for deals. Sponsors are not going to ignore M&A in this recession, they are just going to be even more deliberate in the deals they do.