Impact of Pandemic on Mid-Market Transactions
Overview
The Mergers & Acquisitions (M&A) market for both buyers and sellers of all sizes has been extremely strong since the 2008 financial crisis. The M&A market was fueled by low-interest rates which encouraged leverage/debt financing for transactions and were a strong tailwind to the financial markets and equity values. The momentum in the M&A market was expected to continue at least through the first part of this decade. All of sudden we were hit by an event that no one had predicted. The Coronavirus which started in China and was initially thought to be a local pandemic quickly became a global pandemic. Before we knew the entire world was at a stand-still. Business, financial, social activity came to grinding halt. All of a sudden, the world had changed.
It is important to remember that this is a public health crisis and a human tragedy rather than a financial or M&A market event. The disruptive forces blocking M&A activity, however, will likely trigger a resurgent uptick in deal-making when the public health crisis passes and the economy stabilizes.
Expected Type of Recovery
The recovery and stabilization of the economy will depend on various factors – easing of restrictions, availability of a vaccine, possibility & severity of a second wave, and the type of industry. Economists have been discussing the potential scenarios for the economic recovery as highlighted by the chart below.
We at Distinct Capital feel that the economy will recover one way and that businesses, depending on the type of industry in which they participate, will recover differently. For example, the economy and industries closely tied to it may exhibit the U-shaped recovery, but some businesses will be more V-shaped and others more L- shaped. There will not be a “one-size fits all” type of recovery. It will be important for business owners to understand their situation and take appropriate measures to position their business for recovery.
M&A Post Pandemic
Post-COVID-19 there will remain an abundance of capital (funded private equity, wealthy family offices & public companies with strong balance sheets) in the market to acquire public and closely held companies. These well-funded companies will be motivated to deploy capital to pursue growth or deliver financial returns. Low-interest rates and favourable fiscal policies will provide a strong tailwind for the resumption of robust M&A activity. Also, the lower Canadian dollar will create a favourable acquisition environment for foreign investors, especially for cross-border deals.
In a post-pandemic world, buyers must understand not only the direct impact of COVID-19 on the target but also management’s response to the crisis and the pandemic’s effects on near and long-term operations. There will be changes in how we conduct transactions post-pandemic with enhanced scrutiny for some items:
Due Diligence
Revenue Impact and ability/pace to recovery
EBITDA Normalization with focus on sustainable EBITDA
Vendor & Supply Chains with focus on the ability to continue operations with minimal disruption
Employees & Contractor retention and continuity
2. Agreements
Calculating and settlement of Net Working Capital Targets
Calculating of Earn-outs and other financial metrics
Material Adverse Change / Force Majeure Clauses
Representation & Warranties
3. Reduction in in-person meetings
In order to deploy the capital, acquirers must find a way to solve questions and issues around valuation. This is going to be the key issue to resolve.
Impact on Valuation
How do you determine the base EBITDA / Cashflow for moving forward? 2020 is pretty much a write-off for most industries. Future earnings will be more difficult to predict. The impact of the lockdown will continue to be uneven across geographies, industries, and companies. Issues that will impact the valuation of your business are:
What is the Baseline EBITDA/Cashflow? Some scenarios are:
Average of last 3 years EBITDA / Cashflow (not including 2020)
2019 or trailing twelve months as of February 2020 EBITDA / Cashflow
Current trailing twelve months EBITDA / Cashflow normalized for pandemic effect
2. What is the timing of the Recovery & Expected Growth Rate?
3. Balance Sheet Strength
Also, valuation multiples will be compressed compared to pre-pandemic multiples for most industries. Sellers will be required to bear more of valuation risk through greater use of:
1. Earn-out / Contingent Payment – receive higher value on a future date upon achieving agreed-upon financial metrics
2. Seller Financing
3. Merger – this will provide strategic equity financing and some upfront value to the seller
So, if you were planning on selling your company in 2020 or 2021 and are considering changing those plans as a result of the COVID-19 pandemic we would advise you otherwise. Markets are driven by supply and demand. As previously discussed, demand and capital are still in abundant supply. Acquirers will find a way to achieve valuations in line with pre-shutdown levels (with more risk transferred to the seller in the form of earn-outs and seller financing) in order to put capital to work and keep markets moving.
Seller Perspective
For business owners looking to sell, for most businesses now is a good time to start getting ready with succession planning. There is a time lag of 2 to 4 months and sometimes even longer before you can even market the business for sale. The planning to prepare the business for sale will not only help with marketing the business but also with strategic planning and operations of the business, in the event of a delay. As mentioned above, most businesses will have their valuation multiple negatively impacted but there are creative ways to recover some if not all the value lost.
Buyer Perspective
For business owners looking to buy to grow their business, this is a perfect time for companies with a strong balance sheet. As previously discussed, there has been an erosion of value for most companies. This is the perfect time to buy assets at a lower price, especially distressed assets.
In Closing
The outgoing Bank of Canada Governor Stephen Poloz said in his final speech that the Canadian economy is entering “unknowable times,” adding that the policymakers who will follow will be working in “unparalleled uncertainty.” The “Un” words - Unprecedented, Uncertain & Unclear - is the reality of the economic outlook not only in Canada but all over the world. There is also uncertainty in waiting. We need to keep moving forward as best as we can.
At Distinct Capital Partners, just like your business, we too have been impacted by the pandemic. A few of our inflight transactions continue to move forward albeit at a slower pace. Some of the transactions were put on hold. However, as of late, we have begun to see an increase in inquiries and have started active conversations with businesses like yours regarding getting prepared to move forward with a transaction. Our in-depth M&A experience will help you navigate the “unknowable times” to achieve the best results for you and your company.