U.S. M&A activity slowed sharply in the second quarter due to the economic shock resulting from the COVID-19 pandemic. Activity – especially involving lower-to-middle market businesses – is expected to remain muted for the duration of 2020 and throughout 2021 unless more effective therapeutics and/or vaccines are developed that facilitate a more bullish sentiment than currently prevails.
Although evidence is currently obscure, M&A markets appear to reflect wider bid-ask spreads among would-be sellers and buyers. Sellers are too fixated on what their business might have transacted for in 2019 while buyers expect to pay less as a result of declining performance and higher uncertainty regarding the magnitude and duration of the current economic malaise.
Numerous industries lack sufficiently motivated strategic buyers willing to overlook concerns for their existing businesses to say nothing of the integration of new business. On the other hand, certain financial buyers seem to have returned to the market looking to deploy capital at attractive valuations when and where acquisition financing is available at reasonable terms and pricing.
Would-be sellers face a dilemma: sell now for a seemingly compromised valuation; or wait for a recovery in market appetite that is not guaranteed to occur in the foreseeable future. Sellers are also faced with weighing the potential dilution of their future transaction proceeds if political regime/legislative change threatens the currently favorable tax environment. A modest consolation in the near-term for certain sellers may extend from the forgiveness of PPP loans under the CARES Act. As an aside from the current topical focus, sellers are advised to study the requirements and documentation for PPP forgiveness under change of control transaction events.
We believe that in the current environment, contingent payments (e.g., earnouts and/or clawbacks) and seller financing will be employed to a greater extent than in the past in order to bridge a widening bid ask gap in deal value. Contingent deal consideration is typically structured such that a portion of transaction consideration is contingent upon the buyer’s achievement of specified post-transaction performance thresholds. The current environment requires careful seller scrutiny of such terms.
When reasonably structured and negotiated, contingent consideration results in a symmetrical risk for buyers and sellers. While the economics can vary, earnouts often provide an incremental tranche of deal value that reconciles to that debated 0.5x to perhaps 2.0x turn that comprises the typical bid-ask spread (usually EBITDA based). For the buyer, contingent consideration acts as an insurance policy to insulate against downside future performance. For the seller contingent consideration can deliver deal consideration over and above that at the closing table, thus facilitating upfront liquidity while allowing for potential upside versus a straight all-cash closing. Sellers are advised to be careful about their unwillingness to entertain contingent consideration in the current environment because doing so can be a signal to the buyer of the seller’s concerns about near-term performance (i.e., actions speak louder than words). As always, every transaction is unique, requiring careful assessment of contingent consideration for purposes of productive negotiation.
In theory, sellers may have to provide more financing in the post-COVID environment in order to achieve acceptable terms and pricing. We use the qualifier “in theory” because the high yield and leverage loan markets that are an important source of acquisition financing improved sharply as the third quarter progressed with more capital being raised at tighter spreads than the second quarter.
An additional concern that has slowed M&A activity is execution. Conducting due diligence during a pandemic is inherently difficult and fraught with its own complications. It is easy to imagine how due diligence would have ground to a complete halt in an era before electronic data rooms and Zoom Video meetings. Nonetheless, travel prohibitions and social distancing protocols have stymied due diligence as most buyers require site visits and face-to-face meetings in order to consummate a purchase agreement. However, issuing a non-binding LOI remains quite doable, and some buyers are eager to secure the optionally and potential exclusivity obtained by an LOI submission.
M&A in most industries is pro-cyclical. Challenges notwithstanding, M&A activity should gradually improve if the economy continues to do so and as buyers and sellers adjust expectations to the current environment and business earnings “normalize” in 2021 or 2022.
