The coronavirus outbreak has impacted just about every aspect of daily life on a global scale, and middle market M&A is no exception. With half of us in the M&A community doing our best to hold back our inner Patrick Bateman as we navigate a world with no sports, and the other half content making banana bread and frothy coffee while perfecting their yoga skills, I think all of us are united in wondering exactly what COVID-19 means for M&A. Like with many things related to this current crisis, it is hard to tell exactly what the post-coronavirus M&A landscape will look like, other than to say with certainty that there will be changes. So, in the absence of any true clarity on the future, I will do what any good media commentator would do and guess, speculate, and prophesize with ten predictions on how COVID-19 will impact middle market M&A both in the near term and for the foreseeable future.
1. Remote work and virtual meeting will increase
Ok this one is a bit of a softball, cut me some slack. I figured I should start slow. M&A is inherently an industry where a sizeable portion of the work could be done remotely, yet until COVID-19 the industry hadn’t fully embraced remote work to the extent of our tech company and venture capital brethren. 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 in our industry now that we have all been forced to rely on it during lockdowns. And you know what? In most cases it works exceptionally well. Post-COVID, I could see entire stages of the transaction process that were almost always conducted in person (i.e. management presentations, in-person diligence meetings, etc.) being done virtually in some, if not most cases. That said, I don’t 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. However, I think COVID-19 will absolutely show M&A professionals how virtual work can be used efficiently and effectively.
2. Everyone will want to know "how did the business perform in 2020"
Literally right up until early March 2020, when bad news about the coronavirus started to overwhelm the media cycle, there was one question that was basically a guarantee from every buyer in every middle market transaction for the past 10+ years: how did the company perform in 2008? The Great Recession was the benchmark “stress test” for just about every business that was in operation at that time, but by 2020 it was getting a little dated, a bit tired. Well, luckily now there will be a new, fresh low point for buyers to model as their downside case. Going forward, how a business performs this year will likely impact its attractiveness to future buyers. A company that mostly holds performance or grows through COVID-19 will be viewed as resilient and less uncertain, and therefore more attractive as an acquisition. Companies that see a performance dip this year (which, unless you make masks, toilet paper, or adjustable dumbbells, will probably be most) will need to explain and justify the downturn to get buyers and lenders comfortable with the downside risk (just like they have been with 2008 performance for over 10 years). It's safe to say that “How did the business perform in 2020?” will be a question that sellers and their advisors will be fielding for the foreseeable future (well, at least until the next disaster).
3. Buyers will see a lot of “COVID-19 EBITDA adjustments” in future deals
If there is one thing sell-side advisors love, it’s add-backs. One-time expenses, an owner’s Packers tickets, supplier quality issues, tornados, they are all (justifiably) fair game to be added back to improve a company’s EBITDA. To any private equity folks reading this, start preparing now because the COVID-19 add-backs are coming. You will be arguing against them for the next 2-3 years, at least. I mean, a global pandemic has got to be just about the definition of a one-time or unusual event, right? We can’t possibly be due for one of these again for a while so we will just go ahead and normalize that slow 2020 performance…there, much better.
4. Previously cycle-resistant sectors will be reevaluated
Overall, I think this point may be one of the more impactful thinking shifts that comes out of the coronavirus outbreak. This crisis is creating an economic downturn that is fundamentally different from any recession in recent memory. This is true bottom-up economic pain, created not just by over-leverage or a Wall Street overreach, but by a paralyzed economy. Producers can’t produce, consumers can’t consume, and employers can’t employ. The pandemic and subsequent lockdowns have exposed and/or created previously unforeseen risks, and this is causing some sectors which were previously viewed as cycle-resistant to be hit hard by the current crisis. Sectors such as dental and non-critical medical providers, fast casual dining, and education product/service providers, which were viewed as relatively recession resistant, are now completely shut down or generating fractions of their typical revenue. On the other hand, industries that were previously viewed as highly cyclical, such as construction, continue to operate more-or-less normally under “essential business” exemptions and are less impacted. It is clear that the economic downturn resulting from the coronavirus outbreak will be very different from the downturns that came before it, and it will very likely cause many middle market observers to adjust how they think about cyclical versus non-cyclical market sectors.
5. Lenders will likely be less aggressive for some time
The previously unforeseen risks that this crisis has revealed will be especially concerning to lenders, whose entire livelihood depends on an ability to identify and price potential risk. Lenders ranging from alternative debt funds, to community banks, to the largest financial institutions in the world saw commercial loan portfolios go from healthy to troubled almost overnight as shutdowns impacted businesses across all industries. Banks, which are also likely to face defaults on consumer loans and mortgages, will be hit hardest. 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 unpredictable, sector-and-business-agnostic risks exposed by the coronavirus outbreak will be especially difficult for lenders to effectively underwrite on a case-by-case basis, so it would be reasonable to predict that this risk will be accounted for by an overall more conservative approach to leverage.
6. Certain strategic buyers will be sidelined for some time
This prediction is probably my biggest stretch, because how strategic buyers approach M&A during, as well as after, this crisis will likely be something of a mixed bag. That said, I do not think they will be the reliable bastion of M&A activity that they occasionally are during down cycles. The fact that this downturn stems from restrictions and challenges at the operating level, versus at the financing level, makes me feel that financial buyers will emerge post-COVID better positioned to do deals than many strategic buyers. That said, I think strategic buyer activity will vary heavily sector-to-sector and case-by-case, as certain companies see opportunity to grow while others in harder-hit sectors just try to stay afloat. According to Bank of America CEO Brian Moynihan, “Aside from those with urgent needs, most companies have put deal making on hold in the near term." As with lenders, I do believe strategic buyer activity will pick up somewhat when uncertainty settles, however certain sectors will likely be slow or sidelined for some time. Travel, restaurant, consumer discretionary products, traditional media, and oil/gas transaction activity will likely be slowed substantially for some time, where traditionally in-person sectors like manufacturing and lower-tech industrial and business services will likely view M&A with added caution so long as the virus is a threat. Deals that do get done in these sectors will likely have added layers of diligence around distancing protocols, regional outbreak history, and contingency plans. That said, strategic buyers in certain sectors may find opportunity to grow or innovate through acquisitions. Technology, medical device, pharmaceutical, consumer staple, and telecommunication sectors all have the potential to benefit from the coronavirus pandemic, and are also some of the most likely sectors for innovative or growing middle market companies to catch the eye of a strategic buyer in the midst of the current crisis.
7. Private equity will likely be cautious in evaluating new acquisitions, but uncertainty may also create opportunities
While private equity will have some near-term challenges, they will likely be more limited in their downside exposure in this crisis compared to the 2008 Great Recession. Certain groups will likely have challenges with portfolio companies, but unless the fund is heavily weighted toward consumer, energy, or another hard-hit sector, this challenge will most likely be mitigated somewhat by portfolio diversification. Securing debt financing will also likely be challenging in the immediate term, but close relationships with alternative lenders and the ability to creatively structure low-leverage or all-equity transactions and then recapitalize later will enable some private equity firms to avoid missing opportunities due to lack of financing. Overall, middle market private equity firms are still sitting on record levels of liquid capital, and in this market more than ever, cash is king. The past seven years have been consistently a sellers’ M&A market, and middle market private equity buyers have bemoaned the high leverage and even higher prices for years. Many firms are seeing opportunity in the current uncertainty where creativity and certainty to close may become more valuable than simply being the absolute highest bidder. While some private equity firms may sit on the sidelines, I would expect a reasonable percentage of financial buyers to remain fairly active through the current crisis.
8. Previously record-level valuations will likely decrease to some degree
As mentioned in the previous paragraph, 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 (perhaps materially) from peak levels as lenders face mounting defaults and previously unforeseen credit risks caused by the crisis. Reduced leverage levels will likely cause middle market valuations overall to come down. I believe valuation reductions will be most dramatic for high-multiple companies. For example, a rapidly growing branded consumer product company that may have traded last year for 11x – 12x EBITDA with 6x – 7x leverage, may be valued at 8x – 9x EBITDA with 3x – 4x leverage post-COVID, whereas a manufacturing company that would have been valued at 6x – 7x EBITDA last year may still be able to trade for 5.5x – 6.5x EBITDA because its valuation was never necessarily based on a very high level of leverage. Overall these values are just speculation, but I would imagine we would see at least some contraction in middle market valuation multiples as we move through 2020.
9. 2020 (or at least its first 6-9 months) will likely be a slower year for deals, but deals will still get done
The uncertainty caused by COVID-19 has delayed or slowed many deals that were set to close in the first half of the year, and overall it is likely we can expect decreases in both total deal volume and value compared to the past several years. According to the Wall Street Journal, the value of announced mergers and acquisitions globally in the first quarter through the end of March 2020 is down 33% from a year ago to $572 billion, a seven-year low. In the U.S., the decline is even more acute at more than 50%. Considering that three of the past five years were among the top five on record for M&A activity globally, even a substantial reduction in volume does not mean we will see a year with next to no deals getting done. Uncertainty absolutely makes M&A harder, and this coupled with tightening lenders and underperforming strategic buyers will make getting any deal done in the first half of the year challenging, but some, through a combination of buyer creativity and seller flexibility, will happen. My outlook for the second half of 2020 is a bit rosier. Even if the threat of the coronavirus remains, I am hopeful that greater understanding of the virus and comfort with the world’s “new normal” will lead to an overall reduction in uncertainty and a clearer, hopefully more positive outlook for the future. Buyers, who usually look at acquisitions with a minimum of a five-year investment horizon, do not need things to be perfect today, but they do want to feel circumstances will improve in the future. If uncertainty can be reduced in the second half of 2020, I believe we will not only see deals that stalled in the first half of the year regain life, but also will see aggressive buyers emerge from the woodwork eager to do new deals.
10. It will mark a landmark year with many changes across life in general, and M&A is no exception
To quote Gandalf the Grey, “It sucks living in interesting times Frodo, but watcha gonna do about it?”…or something like that. I think the most concrete prediction that anyone can make is that 2020 is going to bring many changes, to how we live life, how we interact, and how we do business. Exactly what all of those changes look like is vastly more difficult to predict, but if people who work on middle market M&A deals know one thing, its how to expect the unexpected. When all of the dust settles on this, there will be changes, but there will also be restaurants, and sports, and concerts, and parties, and yes, M&A deals too. There are very likely some more bumps in the road ahead of us, but we are all in this together and it will pass, likely with a familiar but-at-the-same-time different M&A landscape on the other side.
- Long hair and beards will be widespread among respectable investment banking and private equity professionals in 2020
- The disposable straw will no longer be the mortal enemy that it was made out to be in 2019, since we will all have to sip our drinks through holes in our masks
- Many of us will suddenly think we are hedge fund masterminds because of that one week when our annualized day trading returns were 217%
- Offices may need to roll out weekly Bloody Mary bars since a lot of people will have discovered the joys of drinking at 10:20AM on a Tuesday
- Wearing shoes every day is going to feel really weird