M&A transactions are down double-digits since the start of the year. According to DealLogic, Americas-targeted M&A volume in Q1 saw the deepest year-on-year decline of 50 percent—pretty steep for a market filled with so many opportunities and significant capital still waiting on the sidelines. But not surprising, say attorneys at Bass, Berry & Sims and Hirschler Fleischer.
“Right now, people just don’t know what companies are worth,” says Bass, Berry & Sims’ Kris Kemp, whose areas of focus include M&A transactions, securities offerings and representation of private equity and venture-backed companies.
Experts agree, companies and investors alike are now looking at valuation benchmarks from pre-March 2020 and factoring in the Covid-19 pandemic at very different ratios, thus creating a significant bid-ask spread. On one hand, sellers are holding on to some semblance of pre-pandemic valuations with hopes that as the economy reopens, their numbers will move up, while on the other, opportunistic buyers are focusing on getting the best deal possible by painting a less-than-rosy picture of the impact of Covid on the target acquisition.
While this large of a spread isn’t conducive to M&As, attorneys from both Bass, Berry & Sims and Hirschler Fleischer say there are great potential deals out there, on both sides, if companies prepare properly.
The 2020 crisis is many ways different from the downturn caused by the Great Recession, but the attorneys agree sellers who want to get the most out of an M&A transaction need to focus on the same factor that was top of mind then: shoring up liquidity and operations.
Ryan Thomas, chair of Bass, Berry & Sims’ private equity team and a recognized expert on M&A, says having the capital necessary to have options should be the priority for all companies, but particularly for those hoping to go through a sale process. “It’s critical to make sure you have enough capital that lets you do that while you operate your business and not put yourself into a position where you have to take an offer at the end of your cash runway,” he says.
That includes tapping into additional sources of funding, as needed. He says companies that have access to additional funding, whether through the PPP or any other aid package, should err on the side of getting it “because every deal is not guaranteed. It’s probably better to save your business if that’s what you need to do to keep it together so it’ll be more attractive down the road than to risk a deal falling through and then not being able to hold things together [because] you didn’t get the loan,” he says.
Lisa Hedrick, an M&A attorney with Hirschler Fleischer, cautions, however, about the source of funding because her firm has found that large acquirers or private equity funds who are in the process of acquiring a company are having negative reactions to a target who has acquired a PPP loan.
“I have one deal for example,” she says, “where the buyer really didn’t want to move forward with the deal because the target had gotten a PPP loan and, even though they were not going to be on the loan paperwork at all, because it was the way the transaction was structured and everything, they just didn’t want anything out there that would ever connect their name with some company that had gotten a PPP loan because of the negative press.”
She notes there is still a need for clarity about the guidance that the SBA has published regarding what happens if you close the deal in the middle of your loan period or while you’re asking for forgiveness.
“If you sell your company in the middle of this, it can push deals three, four months down the road until a borrower has already gotten their forgiveness,” she says. “I think it’s putting in some roadblocks. I don’t think that they’re insurmountable, but it’s definitely causing buyers to pause a little bit more and think through what the implications might be and frankly think through what the mechanics might be.”
Nevertheless, she says companies that have already received PPP funding and are looking to sell should not necessarily rush out to pay it back early. “There’s nothing that says you can’t pay it back at closing, just like you would another debt instrument,” she says. “If the deal doesn’t go through or the deal gets delayed for some reason, you still might have the eligibility to use the funds, apply for forgiveness. But if the deal closes in the middle of it, you could just pay it off.”
“You can always try to negotiate a way to handle different scenarios in the definitive purchase agreement itself and still get the deal done,” says Andrew Lohmann, EVP of Hirschler Fleischer and co-chair of its M&A practice group. “We have advised boards and stockholders of target companies that have received PPP loans, particularly in an equity sale context, to definitely not let a buyer wait until actual approval of forgiveness has been received, but to try to get the deal closed as soon as the eight-week period is over, and if there’s any concern about risk over the final calculation of forgiveness, that’s risk allocation that you can handle in a purchase agreement.”
Thomas agrees that sellers that have obtained or are considering obtaining a PPP loan should, at the very least, expect the buyer will request it is paid back before the deal closes, but not to let that derail them from taking funding if needed.
“They may decide they want to have it paid back because they don’t need it anymore once they buy the company,” he says, noting that he does not see it as a deterrent to a deal, though. “In fact, it’s probably a positive thing just because, hopefully, it allows you to maintain the business and employee base better.”
Kemp agrees and says companies should look at the loan as a form of insurance: “If you’re going to go through the sales process, you need to make sure that you have a backup plan with liquidity and access to capital in the event that your trip down the sales process isn’t successful. If you don’t have that backup plan, you run the risk of being forced to either take capital at a later date on unreasonable terms or forced to take a deal that your equity holders aren’t happy with.”
“The best advice is focus on the issues at hand,” says Lohmann. “And for the last eight weeks, that has been shoring up the operations, trying to manage the employment issues, dealing with the new laws that have been passed, taking advantage of certain tax benefits and the paycheck protection program for companies that qualify…Don’t take your eye off the ball of just running the business during this time.”
They say in addition to all this, sellers should have the discipline—which most have been forced to have during this crisis—to come up with a relatively drastic cost-cutting plan or efficiency plan to demonstrate that the company has adapted to the changing reality and that it is being proactive on dealing with the possibility of a prolonged downturn.
“If a company has been thinking up until 60 days ago that the time was right to go to market, they should be strongly thinking about those kinds of [cost-cutting] actions to become more attractive,” says Lohmann.
Thomas notes, however, that while important for the outlook of the company, those efficiencies may or may not be captured in a sale transaction. “I am seeing buyers be skeptical of anything that has happened on the positive side in the last 10 weeks and being reluctant to provide enterprise value attributable to this most recent kind of fluid situation. But I think it’s just a requirement that you have to have pivoted and addressed the new reality if you want to go out to market and sell yourself as an ongoing company versus a distressed company.”
For companies struggling with a significant ask-bid spread, Kemp suggests sellers can look for a way to bridge the valuation gap via an earnout, for instance, until the company is in a position to get to what is agreed as normal again and then get the full payment.
Lohmann agrees that there will be an increase in earnouts for deals that resume or pop up after the economy starts to recover. “Anytime there’s uncertainty on valuation, you’re going to see more conditions for contingent purchase price tools like an earnout. Because there’s been so much uncertainty with the pandemic, even for a target that thinks it’s recovered, it’s going to be unknown whether that was just purely Covid related or showed some bigger risks with the company,” he says.
Overall, both Bass, Berry & Sims attorneys believe quality assets with a good long-term trajectory that fared the pandemic reasonably well present great opportunities for interested buyers—but to get the best value, they need to muster up the competitive process.
“I’m aware of a few situations now where there’s actually multiple lenders interested, and they’re warming up to deals again,” Thomas says. “There’s still appetite out there from private equity and from strategic companies that now more than ever they need to find ways to grow, and M&A is probably better than organic in the near term.”
The buy side may look a bit brighter as potential buyers sniff out deals across industries. But there remains considerable risk.
Attorneys at Bass, Berry & Sims say buyers shouldn’t wait too long before moving forward on a target. They say many of their clients have weighed whether it would be better to wait and see if they can get a better deal should the target’s value continue to decline amid growing bankruptcies, but, in a lot of cases, “when you’re a public company and you’ve got a strategy to execute, if you don’t attack the opportunity and try to get it now, even if you have to pay a little more than you might down the road, you’re letting others dictate the situation,” says Thomas. “If it’s important to your growth strategy, you really kind of have to take the bull by the horns and just step in and do it because otherwise, yes, there’s a scenario where you could get this thing at a better deal if you wait. But there’s also probably even more scenarios where you lose the deal, or it goes away. And if it goes away, then that business gets dispersed to a bunch of other people rather than you, and you just missed some big opportunity for something strategic.”
Plus, according to Lohmann, buyers will need to account for a host of new due diligence considerations in the process.
“Our advice,” he says, “is once people resume or begin a new deal, there’s now a whole of additional issues to conduct diligence on, the financial diligence on the effects of Covid-19: Did the target have workplace issues? Did they have employees in the workplace who had Covid? Did they have to shut down even without a governmental shelter-in-place order? Did they have to close the business because they had infections? Did they lay off people and give them severance? Did they comply with things like the Warn Act, which requires certain notice if you’re laying off more than 50 people in many situations. So, there’s existing laws to comply with what everyone’s confronted with and then there’s the new stimulus act and the Families First Coronavirus Response Act, and all of that needs to be complied with in real time, and we expect buyers to certainly be conducting diligence on certain employment laws and tax laws that didn’t exist 60 days ago, and that’s going to add time to getting a deal completed.”
All seem to agree that waiting to weather the storm to potentially scoop up a better deal later carries its own set of risks. The Bass, Berry & Sims attorneys say not everything is perfect right now, but a “good enough” mentality is the one that will close deals right now.
“On the buy side a year ago, what Ryan and I were hearing from our clients was ‘I’m participating in a lot of processes, and I’m trying to be financially disciplined in my valuation approach, but it’s awfully hard because there’s a lot of money out there chasing deals,’” says Kemp. “So, now really is the right time to buy because there’s not as much money out there chasing deals.”
They say that while sellers recognize that the bid-ask spread is larger than it should be, if they are presented with a reasonable offer, given all the other uncertainties, they are likely to give it thorough consideration.
“They will go through the thought process of saying, ‘Sure, maybe I could get another 5 or 7 percent three months from now when there’s even more clarity, but do I really want to run the risk of losing the bird in hand when it might also be a lot closer to 90 percent lower?” says Kemp.
When asked about their projections for the rest of 2020 and how Covid will affect M&A activity, here’s what the attorneys had to say:
“I think it’s going to be pretty busy,” says Thomas about the second half of 2020. “I’m seeing signs that deals are coming back to life again, as long as people still trend towards reopenings and things like that, or there’s not some massive spike that kind of scares people. There’s a lot of pent-up demand for transactions, so I think that’s going to manifest with some pretty good M&A activity probably over the mid- to late summer extending into the fall until there’s some sort of other wave 2 or whatever sort of hits at that point. Who knows what’s going to happen then with the election, but I do see a fairly active M&A environment probably in the near-term, absence of a curveball.”
“Pre-pandemic, I heard expressions of concern that there would be a slowdown starting in the tail end of the second quarter, as investors waited to see what would happen with the national politics and how that might change the likelihood of success with a certain bet,” says Kemp. “That’s a bit of a headwind that’s going to be there no matter what. But I agree with Ryan, I think there is going to be some pent-up demand and too many opportunities that have been forced to sit on the sidelines for the first half of year for people to just wait for clarity on the presidential election. I think there will be demand to go ahead and get deals done while they can get done. So, I’m also predicting a healthy rebound in M&A for the second half of the year.”
“We had a good number of transactions pending when the Covid situation hit. Most of those unlike downturns like the one in 2008-09 where deals completely died, most of the deals that we’re seeing and hearing about are on pause; they’re not termination,” says Lohmann. “In terms of pricing new deals, my guess is EBITDA or multiples of EBITDA or some sort of multiple of revenues will still be a factor. I think multiples will come down a little bit just because of the uncertainty or the additional risks, and where sellers can try to help shore up their value is really to try to express to the buyer how they’ve weathered this storm better than their peers or better than other companies, how they’ve adapted.”
“We certainly anticipate eventually there will be a round of distressed or a wave of distressed M&A,” says Hedrick. “I think we’re also going to see companies spinning off divisions that are underperforming or aren’t as strong just to help bolster their overall strength. So, I guess that would be what I’d invite companies to start thinking about strategically: where can they shore up some of their performance or spin off aspects that aren’t performing as well to help kind of build that better company…Do everything you can to mind your current business and make sure everything is in order, that you’re complying with all the new laws, that if you have soft spots in your performance that you can figure out ways to sort of bolster that, whether it’s pivoting or rescaling it.”