The impact of the COVID-19 coronavirus has brought disruption to virtually every aspect of daily life. This, of course, includes the economy and the unprecedented swings we are experiencing in the stock market.
Every market downturn and subsequent correction is different, and we expect that market conditions will follow this axiom. However, we do not think this market decline will be a repeat of the Great Recession of 2008. We anticipate that although smaller businesses will bear the brunt of the coronavirus impact, large financial institutions will remain well-capitalized, so capital and liquidity will remain in the market.
Many have argued that we were already moving toward a downturn coming into 2020 and COVID-19 simply exacerbated existing market stresses. Some are questioning whether the White House’s proposed tax payment deferrals and direction for the Small Business Administration (SBA) to provide $50 billion of new loans to small businesses will counter these stresses. And what does this all mean for the private equity and broader M&A markets?
Let’s go back a few months and see how we entered 2020. What has happened since then? Where should we go from here?
2020: Looking back
Entering 2020, the transaction market was enjoying substantial tailwinds following a strong 2019. Per data from Bain & Company’s Global Private Equity Report 2020:
- Private equity dry powder was (and remains) at record levels with $2.5 trillion of capital and more than 60% of it less than 2 years old.
- Corporate balance sheets were healthy, with over $2.2 trillion of liquid assets across corporates.
- While credit markets began to tighten, debt remained available and rates were (and remain) near historic lows. Many companies had already built war chests to combat any unexpected downturn scenario.
- For sellers, valuations were at elevated levels. In 2019, more than 55% of transactions had valuations exceeding 11x EV/EBITDA.
Currently, the disruption in the marketplace has tempered the enthusiasm of deal-makers and created a significantly more volatile transaction market.
- Coronavirus concerns have already reduced production in Asia and parts of Europe. This impact has begun to have global repercussions given the reliance on international manufacturing and supply.
- The uncertainty over the spread of the virus has limited travel, manufacturing, and productivity and should adversely affect both consumer demand and consumer confidence.
- The global macro environment remains volatile with substantial economic and geopolitical uncertainty.
- Credit markets have tightened despite continued low rates, so many companies are challenged in closing debt financings to finance transactions.
- Unresolved trade issues related to Europe and China are dampening growth expectations and will continue to have ripple effects throughout the global economy.
- Political uncertainty in the U.S. is intensifying what was already likely to be a volatile year, following historical election-year trends.
How should financial sponsors respond to the volatility we are currently seeing in the marketplace? What will be the impact of the coronavirus on M&A activity in the year ahead?
For many industries, the question should be less of when the downturn will arrive and more about the best ways to respond when it does. Based on a recent Bain survey, over 40% of private equity managers have already begun altering their strategies in anticipation of a downturn. Some companies are drawing on their credit lines to build a cash cushion that will help them weather a downturn and a slowdown to their businesses. Private equity firms like Blackstone and Carlyle have begun asking some of their companies to begin drawing down on credit facilities to prevent capital shortfalls that could occur in the coming weeks.
If consumer confidence and demand continue to trend downward, the return of international supply capacity will not resolve the issues for many industries and markets. Financial and strategic buyers must conduct deeper, more thorough due diligence on each transaction. They need to understand scenarios that account for slower growth, supply chain disruptions, financing challenges, etc., and apply what is learned through the diligence process to these scenarios.
To do this, private equity firms and other financial sponsors contemplating transactions should:
1. Contemplate more severe downturn scenarios and model out the impact on the target business.
2. Consider ways to recession-proof each business, and focus on rightsizing and restructuring (both operationally and financially) each business to weather the potential storm.
3. Fully assess transaction and capital structure (tax, legal, covenants, etc.) to identify areas of weakness and/or opportunity.
4. Understand whether and how to best utilize material adverse effect clauses in purchase agreements to protect against additional downside risks.
5. Conduct detailed reviews of the target’s workforce. Understand the composition of full-time, part-time, and contract workers and the benefits structure the company has for each class of employee.
6. Assuming valuations will pull back, focus on add-on acquisitions that will strengthen a company’s core operations.
For new platforms, recession-resistant companies and those with strong recurring revenue models will drive transaction demand. While each company will likely face challenges this year, the fundamentals that drove a strong M&A market over the recent past remain in place. This should mitigate the shorter-term headwinds.
We do not expect this to be a 12-month-plus decline in activity, despite COVID-19 and other fears in the market. We anticipate a short (Q1-Q2 2020) but sharp drop in growth followed by an easing of market pain and a return to growth and market normalcy in the second half of 2020.
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