M&A in a time of uncertainty

As the COVID-19 pandemic continues to impact the U.S. business environment, many of our clients are asking questions about how the current level of uncertainty and a potential economic slowdown will impact the M&A market and processes as a whole.

Below are some factors to consider as you assess your M&A alternatives and priorities for your business:

Economy

As COVID-19 continues its unprecedented interruption among everyday life, the U.S. economy is experiencing a time of great uncertainty. One of the biggest unknowns is the duration of the disruption – will it last weeks, months or longer? And what will the mid-term and long-term impact be on the overall economy? A short-term recession may be likely, with nearly all segments of the economy feeling the impact.

Questions that may be addressed as time goes on include:

  • What will be the impact of the new fiscal and monetary policy? Will further actions be needed?
  • How long will it take for the economy to recover?
  • Which sectors will be most impacted, either positively or negatively?
  • What will be the new “normal”?

Typically, M&A activity declines when there is economic uncertainty. However, financial distress, motivated sellers and lower valuations could lead to increased levels of M&A in the near future.

Sellers

Up until recently, the U.S. M&A market was experiencing one of its most robust periods of activity. To that end, interested sellers may have missed the window of opportunity to go to market while valuations were high, significant credit was available, and many strategic and financial buyers were interested.

At this time, unless you are in the midst of a sale process (i.e., already in the market or in discussions with buyers), it may be prudent to wait until the economy and your business are recovering, or have recovered, before going to market.

If you are currently engaged in a sale process, it may be reasonable to expect delays and changes to transaction terms due to the uncertainty in the economy.

Going forward, valuations may likely decline and may be below “expectations” in the near term. Yet, company owners that were waiting to sell to get a “market” price may now be motivated to take action. In addition, the need for liquidity and underperformance of certain business units may drive companies to sell certain non-core businesses or assets.

While there may be fewer sellers in the near term than there were just a few months ago, this may change as the economy and company earnings return to “normal.”

Buyers

Strategic, private equity and distressed situation investors all have capital (“dry powder”) to put to work.  Buyers that stood on the sidelines due to high valuations may now view this environment as a favorable buying opportunity, as valuations may recede from record highs.

There may be fewer buyers in the near term than there were a few months ago, as strategic buyers may be more focused on stabilizing their own businesses, putting M&A temporarily on the back burner. Similarly, private equity buyers may be cautious to close deals in this environment, as they may be working on issues within their own portfolio companies.

As the economy recovers, there may be pent-up demand for companies, non-core businesses and assets for sale as buyers gain more clarity on the new “normal” and extent of the economic fallout.

Lenders

Lenders may be more cautious and less aggressive with total debt/adjusted earnings before interest, tax, depreciation and amortization (EBITDA) leverage multiples. At the same time, credit committees may be providing additional scrutiny to leveraged transactions and doing more downside modeling (including “worst case” scenarios). Some sectors may fall out of favor with lenders given the impact of COVID-19 disruption.

Other items of note:

  • The low interest rate environment may continue to keep borrowing costs low
  • Lenders may ask buyers to structure more equity intro transactions and demonstrate availability of additional equity in reserve (should it be required) 

Budgets, projections and adjusted EBITDA

Budgets for 2020 and projections for 2021-2022 may need revisions as buyers and lenders may ask for the new budgets and projections versus the original budgets and projections pre-COVID-19. At the same time, these budgets and projections may need to be stress-tested to capture multiple scenarios, including “worse” and “worst” downside cases. Typical EBITDA adjustments – and any adjustments related to the COVID-19 disruption – may be scrutinized with more rigor and may require a detailed bridge analysis.

Valuations
  • Valuations across many sectors may likely be lower based upon:
  • Lower public company valuations
  • More conservative discounted cash flow and leveraged buy-out model assumptions
  • More conservative lending environment
  • Opportunistic private equity and strategic buyers looking for deals at a discount as compared to the beginning of the year and the recent past
  • Valuation gaps between buyer and seller may be more actively bridged with seller notes, equity rollovers and earn-outs

Due diligence

Due diligence may be more rigorous and take longer, as the need for social distancing may likely impact the diligence process, at least in the near term. To this end, buyers and sellers may need to be flexible as the extent of due diligence will be pushed to its limits. However, on-site due diligence requiring face-to-face interaction may ultimately be required at some point and may be difficult to replace with virtual technology.

A few other items of note:

  • Supply chain due diligence may be required and include stress testing and scenario modeling
  • Buyers may need to assess the existence and quality of contingency plans in place
  • Customer and supplier contracts and relationship due diligence may require more time

Legal documentation

Going forward, M&A documents may include:

  • Material adverse effects/change (MAE/MAC) provisions
  • Negotiated purchase price adjustments
  • Walk-away rights and break-up fees

Obtaining required consents from third parties such as landlords, lenders, and significant suppliers and customers may take longer than normal.

Other items of note:

  • Survival period on representations and warranties may be extended
  • Larger and longer-term escrows and lower caps and smaller baskets may be required for certain representations and warranties

Representations and warranty insurance

Underwriters may be more cautious in writing policies and may have exclusions for liabilities related to COVID-19. At the same time, pricing and term exceptions may increase.

A dip and then a recovery

The expectation is that there may be meaningful short- to mid-term reduction in M&A activity. This may be followed by an increase in activity with some sectors leading the recovery and others lagging, based on the level of impact COVID-19 has on a particular industry or specific business type.

For more information on this topic, or to learn how Baker Tilly Capital specialists can help, contact our team.

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