As the coronavirus (COVID-19) accelerated into a global pandemic, the first quarter of 2020 was an unprecedented time for businesses. The decisions required of stakeholders to navigate through the coming months are absolutely pivotal. With the type and magnitude of issues steadily evolving, employee safety is prioritized, and a lengthy list closely follows. This includes: managing cash flows, supply chains, customer needs, forecasts like banking covenants, and for many market participants, assessing current acquisition or divestiture plans.
Many strategic buyers have shifted their focus towards ensuring their own viability. Further, private equity buyers are looking to stabilize their current portfolios as a first priority. However, depending on the status of the transaction and the business' ability to weather the shock of COVID-19, there are varying impacts and opportunities for mergers and acquisitions stemming from the pandemic.
At a high level, these fall into two categories: companies with transactions that were already underway, and companies looking at the pandemic from an opportunistic perspective.
Either way, both buyers and sellers who previously had an M&A strategy remain hopeful and are looking for signs of market stability to eventually move deals forward, deploy capital, and initiate searches again.
The pre-COVID-19 transaction stage
The current status of mid-market deals is largely dependent on the stage of the transaction when the effects of COVID-19 were first felt by the company being acquired. Early-stage transactions preparing to go to market are largely being put on hold until some signs of recovery are evident. In some cases, shareholders have transitioned from an external divestiture process to a management buy-out (MBO). Transactions which were being marketed, or in early stages of due diligence, are largely being put on hold as well.
With employees not working, owners in quarantine, and operations suspended, it's incrementally more difficult (if not impossible) to complete confirmatory due diligence. Face-to-face meetings, facility tours, gathering information to answer questions, conducting customer and supplier diligence, and completing environmental studies are all necessary activities for transaction closings—all of which have been hindered.
More positively, many transactions that were close to completion or in the later stages are closing absent any material COVID-19-related issues. So far, the banks have helped facilitate these closings by continuing to issue term sheets at pricing and valuations similar to what was originally negotiated—albeit amid delays—as they focus on serving existing clients first.
Overall, while many deals are on hold, once some stability is evident, both buyers and sellers expect to be active M&A market participants again.
Opportunities and challenges: Buy-side and sell-side
Prior to COVID-19, buyers seeking acquisitions sat on record amounts of dry powder, running into intense market competition and high valuations. While the effect of COVID-19 on market valuations is not yet certain, the current situation could present an opportunity to deploy capital in a time with much less competition. For many private equity buyers trying to continue moving deals ahead, earn-outs become a key tool to bridge valuation gaps or manage uncertainty, as might be expected. A more recent adaptation, however, is to delay starting the earn-out calculation period for 12-18 months after closing. The approach explicitly acknowledges that medium-term results will suffer abnormally, and provides both buyer and seller with a bit of extra comfort to move ahead.
Similarly, from a seller perspective, owners that were previously seeking a divestiture may soon become buyers. If their business is able to weather the next few months, where their competitors cannot, it could present an opportunity to buy, integrate, and take a larger business to market in one to two years.
Merger activity could also be an effective means to navigate the crisis period by sharing resources and providing access to capital. However, potential mergers will still present traditional challenges in untraditional times. This includes valuation and integration, along with the previously mentioned due diligence issues.
As uncertainty has stalled many deal processes and banks are still looking for opportunities to place capital, this can pose a beneficial opportunity for businesses with owners seeking to exit quickly and management seeking to buy and operate the business through a leveraged management buy-out.
Among other benefits, selling the business through an MBO circumvents explaining forecast adjustments, due diligence, and strategic decisions to an outside party who is unfamiliar with the business.
What the future holds
The chart below depicts a significant decline in M&A activity in the first quarter, albeit continuing a trend observed through the second half of 2019. The second quarter of 2020 will likely see even more reduced activity as quarantines and lockdowns will be prevalent throughout North America for the bulk of the quarter.
Moving forward, due to the unprecedented nature of the global pandemic and response, broad uncertainty will levy a significant toll on the M&A market for the near future. Past major disruptions like the financial crisis in 2008-2009 resulted in a rebound in M&A activity fairly quickly. However, a potential rebound will greatly depend on the ever-changing government and business decisions in response to the effects of the virus, along with the new reality that government measures are creating.
As such, the timing of an increase in activity is still widely unknown. Conversely, as interest rates were slashed in both the U.S. and Canada, with the Bank of Canada rate now at 0.25%, there will still be significant available capital to be deployed.