If we are now truly able to see the light at the end of the COVID-19 tunnel, what will the M&A landscape resemble when we emerge from our pandemic bunkers?
It’s likely that fundamentals for a healthy M&A market will not change — willing sellers, buyers with capital to invest and an intersection of value expectations. But perceptions of value will look much different.
Pre- and Mid-Pandemic Patterns
Before the pandemic took hold, the market was fueled by an increasing number of baby boomer shareholders driven by the need to convert their private investments into lower risk, liquid assets. Private equity buyers, armed with large committed funds and banks eager to lend, provided a growing audience for acquisition opportunities.
Fast forward to March 2020, where some deals in process were completed, others were delayed and others were shelved. The market paused, but it did not grind to a halt as some had feared. As 2020 proceeded, deal volume increased in the second half of the year but remained well below the activity in the prior four years.
What about valuations? The private market is loosely correlated with public company markets. What we observe in the public markets is a growth in value metrics beyond pre-pandemic levels. As of today, the S&P index is up around 17% compared with the levels of one year ago! Private company valuations are harder to discern, but it seems the sustainability of current earnings and cash flow will be the primary drivers of value, rather than simply relying on traditional metrics such as EBITDA multiples.
Private Company Deals of the Future
So, what is the outlook on the market going forward? A few observations:
- The factors driving the supply side of the M&A market have not changed. A large backlog of shareholders seeking transition and liquidity remain at the ready.
- Plenty of capital is available. Many private equity groups and mezzanine funds have capital they need to deploy, and banks want to lend into the right deals.
- Cash flow and growth prospects will drive valuations. This is no different than in the past, except that this is where the pandemic, and the ability of a company to potentially withstand another, will have its greatest deal impact.
Regarding valuations, companies seem to fall into one of three general categories:
- Companies that saw a “COVID bump.” Examples include businesses that supply pandemic related products, such as plexiglass, toilet paper, exercise equipment, etc. One of the primary value drivers here will be the ability to hold onto those gains in earnings. If a company’s earnings revert to pre-pandemic levels, incremental earnings related to the pandemic are bound to be discounted. However, there are companies that have grown in the past year that will retain that growth due to, for example, changes in consumer behavior (casual apparel) or gains in market share that are defendable (PPE distributors).
- Companies that suffered pandemic damage. At the other end of the spectrum are those that have suffered as a result of the pandemic. Restaurants and retail stores are obvious examples. Others include companies that were previously considered non-cyclical. These companies have suffered considerable declines in value. Deals involving companies falling into this higher risk profile will confront greater equity requirements and lenders less willing to fund transactions as aggressively as they might have before the crisis.
- Companies that have maintained performance in the face of the pandemic. Our view is that these companies will find markets friendly and valuations healthy once the pandemic fades. Typically, these companies were deemed “essential” and often exhibited an ability to improvise and adapt to new rules and shifting markets.
The ranks of companies considered “cyclical” have grown in the past year. New risks have been exposed. For example, in the past no buyer of a company that services K-12 schools would have asked: “What happens if schools close?” Deals will undergo greater scrutiny. In the past decade, one of the primary questions asked in acquisition due diligence was, “How did the company perform in the Great Recession?” In years to come, the question will be, “How did the company manage through the COVID-19 pandemic?”
Contact Jim Lisy at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.