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Conversations with experts across a range of fields have yielded differing opinions on the potential impact of the COVID-19 coronavirus on upcoming transactional activity. In general, there is agreement that markets will be affected. However, what continues to be debated is whether there will be a pause in M&A activity, or if the dry powder that private equity firms have been sitting on for so long will support deal-making even in the current environment.
Anticipate a heightened due diligence process
No one can project the impact of coronavirus on deal-making with certainty. However, businesses considering a transaction, or those already engaged in a sale, should expect the due diligence process to shift its focus toward greater scrutiny in subjective areas such as:
- Pro forma EBITDA adjustments
- Sensitivity analysis of projections
- The overall strength of the balance sheet
- Volatility in specific industries
- Logistics and timing
While both buy- and sell-side due diligence focuses on normalizing historical earnings, the current practice of layering in pro forma adjustments to reflect the current run rate of the business is widely accepted in the marketplace. However, there is tension depending on which side of the transaction you are on.
For a buyer, the question is how much credence you should give to these adjustments and what level of discount should be applied. If you are the seller, you are probably thinking about the amount of credit you can claim, especially in a competitive process. Pro forma adjustments must be defensible, backed up by supporting calculations, and, where applicable, include customer and supplier contracts and similar documentation. The best case is to be able to demonstrate actual performance in the most recent periods, reflective of the expected future run rate.
Expect multiple scenarios in projecting financials
Financial projections should be detailed, especially over the next 12 to 24 months, and include a variety of scenarios as well as sensitivity analysis. Bridging historical results, and including pro forma adjustments for the projections, is critical. It’s extremely important to assess all the possible scenarios impacting the business and provide a realistic outlook. This will go a long way toward satisfying buyer scrutiny. At the same time, it will alleviate additional stress a seller may feel when being challenged on the assumptions.
The ability of the seller’s balance sheet to withstand changes in the business cycle will be important in assessing how much leverage the business can take on. Short-term, a more conservative view may be warranted. Higher liquidity levels and some excess capital could prove to be a wise choice. In this environment of business disruption and uncertainty, breaching covenants may not be met with the same levels of understanding as one has become accustomed to.
The impact on specific industries
Industry will react differently. We should expect hospitality and travel and leisure to be hardest hit initially. This may trigger a domino effect in consumer spending on nonessential items, especially if the volatility and uncertainty continue for extended periods. Healthcare and other recession-proof industries will fare best.
For both buyers and sellers, it’s important to give careful thought to the industry in which you operate and how you might mitigate risk areas. While so much is unknown and outside of one’s control, proactively addressing potential issues upfront, while being flexible and nimble, will ensure a more favorable outcome. These actions may not prevent a change in EBITDA multiples or lower valuation ranges, but it’s better to take an offensive posture rather than a defensive one to make the most of this potentially tough situation.
Logistics and timing
Finally, as we are seeing more and more states enforcing social distancing and limiting meetings and in-person interaction, note that for most transactions, the human element and in-person meetings are a critical piece of getting through the process. Videoconferencing and conference calls are not a substitute for that, so expect delays in closing deals, as well as the launch of new sale processes, which will impact the timing and completion of due diligence.
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Claudine Cohen, Principal, Transactional Advisory Services Northeast Market Leader
646.625.5717
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Claudine Cohen
Managing Principal, Value360 Practice
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This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.