By Christopher Parisi
Christopher Parisi is a Managing Director at Carl Marks Advisors, an investment bank providing financial and operational advisory services to middle market companies. He can be reached at cparisi@carlmarks.com.
Only a couple of months ago, the M&A market was the strongest we had seen in years. Valuations were at record highs, company earnings were strong, and private equity and strategic acquirers were sitting on enormous amounts of dry powder to invest. Goldilocks was living her best life. Then 8,000 miles away from New York somebody got sick, the porridge went ice cold and the entire world stopped, taking the M&A environment with it.
Over the ensuing six weeks, deals in progress have been paused, deals under LOI have been extended, and you’d have to be a bit of a masochist to launch a new deal right now. Some financial sponsors are talking about expanding their investment considerations to include debt or other types of rescue financing for companies especially hard hit by the crisis. Still others are talking about buying corporate debt at significant discounts or even doing minority equity investments. However, to the extent that these types of alternative investments are being considered, we haven’t seen anybody pull the trigger yet.
Expand the Playbook
The reality is that right now, everybody – strategic acquirers, financial sponsors, and institutional and private lenders – is singing from the same hymn book. Corporate America is focused on keeping its employees safe, its balance sheets well capitalized and reducing expenses as much as possible. Understandably, investors are focused on making it through the health crisis, but near-term survival cannot be the only focus. They need to expand their playbook to include planning for recovery and success afterwards.
While none of us knows for sure what a post-coronavirus world looks like, we know it won’t look the same. But the Global Financial Crisis and 9/11 both prove the value of a long-term perspective for investors. The societal and economic impact of these events permanently altered the corporate landscape. Those that fared best at the end of these economic downturns were those who thought hard about how to position themselves to rebound effectively once the crisis had passed. It’s no different this time, and investors need to wade through the current uncertainty and imagine what comes after the crisis has passed.
Reacting Quickly to a Health – not a Financial – Crisis
Nearly every financial crisis throughout history has been a function of too much leverage in the system. It often takes years, sometimes a decade, to wash that excess leverage out of the economy. Like a forest fire burning open pinecones to drop its seedlings to the scorched earth below, green shoots eventually emerge—but it takes time.
Right now, as investors plan for the road ahead, it’s critical to recognize that we are in a health crisis, not a financial crisis. The current situation was caused by a virus, not excess leverage. Financial sponsors have been assured by lenders that there is no crisis afoot in the financial system, and access to liquidity will not be an issue in the immediate term. And while deal multiples have been frothy for some time, leverage has been mostly reasonable. It is only recently that we’ve begun to see leverage multiples of 6.0x+ on deals.
The 2008 Global Financial Crisis taught us that the need to react quickly cannot be underestimated. Federal banks across the globe acted quickly and provided significant follow-on support a decade ago. Today, it’s important to recognize that while the market was well-positioned prior to the pandemic, policymakers realized this is absolutely a black swan and there has been even swifter and greater action by central banks. Given this, we should be set up for a reasonably robust economic recovery once the health crisis has been effectively managed.
The Role of M&A
Another lesson from the Global Financial Crisis was that companies that did the best placed greater urgency on two strategic initiatives: divesting underperforming businesses and using available funds to make acquisitions earlier in the recovery phase. This would suggest that the M&A market will be robust in the crisis aftermath.
Financial sponsors are currently redoing their models with greater troughs to the downside. While we’ve never seen an event like this before, the consensus remains that a significant amount of deal activity will resume in the second half of this year and into 2021. With over $1 trillion in dry powder in private equity coffers, the incentives to transact will overcome any instinct to sit on the sidelines. Once funds get their portfolio companies stabilized, they are likely to begin building a pipeline of new platform initiatives and strategic add-ons for existing investments.
A New Deal Environment
Mergers and acquisitions have always been the fastest way to transform a business to meet the changing landscape and market opportunity. This time will be no different and expect that activity to come sooner rather than later.
The crisis will change consumer behaviors and resulting business models will need to change accordingly. That creates opportunity that is most quickly acted upon through acquisition. In the 1960’s Toyota ushered in the era of “just-in-time” inventory to minimize working capital tied up on warehouse shelves. The 1980’s accelerated the globalization of supply-chains, primarily established in Asian countries today. Each of these were pursued in the name of efficiency and, ultimately, lower costs. The current crisis is exposing the vulnerabilities of these efficiencies – from the unavailability of toilet paper to accessing basic healthcare PPE and pharmaceuticals (which are largely produced in China). Perhaps resilience and preparedness will be given greater priority in the world going forward. Near-shoring or Made in the USA, already in vogue, may be worth paying for too. We expect to see investment and consolidation in areas of supply chain and logistics.
The new M&A environment won’t only be about how to do things differently. It will also be about new products and services. While a complete digital transformation may be premature, the Covid-19 crisis is certain to accelerate the shift. Acquisition strategies will examine how businesses can work effectively at a distance without sacrificing intimacy or productivity. Consumer products companies which rely more on e-commerce channels than on brick and mortar retail will prove to be even more valuable.
To be sure, some of the deals that made sense in February 2020 will still make sense in the second half of 2020. But the world, and the deal environment, will shift in ways we don’t fully understand yet.
We’re still in the cauldron. But waiting for the storm to pass to begin planning for the future isn’t the right call. The eventual winners are planning for the future today. And while nobody has all the answers, certain risks need to be taken by companies to emerge stronger and with a better product offering for their customers. As difficult as it is to imagine what exactly the world will look like after the COVID-19 crisis abates, the M&A ecosystem must be prepared to have an active, engaged role in shaping it.
