Impact of COVID-19 on Lower Middle Market M&A
As we approach the end of May 2020, the mergers and acquisitions market is in flux, and the number of closed transactions has dropped significantly. Just as the impact of the pandemic has varied significantly company to company, the impact on mergers and acquisitions will vary deal by deal. However, here are some general observations:
- Deals on hold. The uncertainty of the environment and the need to focus on their businesses’ response to COVID-19 caused sellers and strategic buyers to hit pause on many deals in April and at the start of May. Buyers have told us they are looking for transactions, but are taking a wait-and-see attitude to see how things shake out over the next few months. Sellers have told us they continue to work through the details to ensure their business is able to weather the downturn, and are evaluating how their businesses will perform over the summer. That being said, over the last half of May, we have increasingly seen a return to conversations about M&A. Assuming no major resurgences in virus cases, we expect momentum to continue to pick up over the summer.
- Fewer deals being closed. With deals on hold, the number of closed transactions has dropped significantly compared to same period last year. In March, the number of closed M&A transactions with total valuation less than $30 million in the United States dropped by 25% compared to March 2019. In April, the number of transactions dropped by 54% compared to April 2019.* Most of the deals closed in March and April were likely initiated months previously. Given the time it takes to close a transaction, it's likely that once deal conversations get restarted, we'll see an increase in closed deals several months later, leading to a potential uptick in closed deals by August and September.
- Financial buyers continue to look for transactions. Financial buyers, including lower middle-market private equity firms and search funds, continue to say they are looking for transactions. Some are looking only for add-on acquisitions, rather than platform investments, which should help drive more interest in smaller deals. Although private equity firms may be struggling to raise money now, those who have previously raised capital do need to put it to work. Financial buyers also have fewer constraints around managing day-to-day operating aspects of an existing business. Strategic buyers are also working through their response to the pandemic, and appear to be open to begin to discuss M&A activity and specific acquisitions. We are also hearing from both financial and strategic buyers looking for distressed and turn-around opportunities.
- Financing issues. Many lenders have been focused on executing PPP programs. As they start to look at new deals, some may take a more conservative posture in evaluating each transaction. If a lender is less willing to provide financing, buyers may need to initiate a transaction with greater amount of cash vs. debt financing, may look for smaller transactions, ask for a larger seller note, or ask a seller to retain some equity, with the assumption that as lenders begin to loosen lending criteria moving forward, there may be opportunities to refinance. As always, buyers who are able to close deals with cash, without needing bank or other financing, will have a significant advantage over other buyers who need to line up financing.
- SBA Financing. SBA 7(a) loans often play a role in lower middle market deals, providing up to $5 million in government-backed financing for qualified acquisitions. The CARES Act PPP program was run through the 7(a) infrastructure, and sapped existing 7(a) funding. There is a lobbying effort underway to ensure the next relief package includes additional funding for the real purposes of the 7(a) program. The language in the CARES Act currently states that all 7(a) loans signed before September 30 are eligible for payment deferrals….SBA lenders are telling us this will apply to new 7(a) loans issued for acquisitions, which could cause a significant boost to smaller transactions.
- Valuation and deal terms. The impact of coronavirus on each company will play a direct role in how valuation and deal terms change. For a business that has not been or will not be impacted by the pandemic, or which has seen sales increase, there may be be limited change to valuation or deal terms compared to pre-pandemic multiples, assuming there is a qualified and motivated buyer. For a business where there is significant risk that the business may not be able to quickly return to pre-pandemic levels, it’s likely a buyer would place greater emphasis on projections moving forward, and could look for some combination of deal terms that mitigate their future risk, including moving some portion of the transaction into contingent payments such as earnouts or royalty payments.
- Additional due diligence. More risk and uncertainty may result in more due diligence, which will also increase length of time to close. Moving forward, we would expect additional due diligence around issues including client relationships, revenue projections, safety and cleanliness, coronavirus-related termination and rehire of employees, supply chain disruptions, quality of receivables, and changes to working capital requirements. More due diligence will result in longer time to close. We’ll also likely see some additional terms based on due diligence work their way into reps and warrantees in a purchase agreement.
What should you do if you were considering an exit pre-pandemic, or need to consider selling now? Unsurprisingly, there is no one-size-fits-all answer.
As of end of May, we believe there may be opportunities to consider bringing certain businesses to market over the summer or in September, again assuming we do not see a resurgence in virus cases or receive poor economic news.
But in every situation, the best way to keep control of your exit is to understand all your options and your priorities.
To decide on your best course of action, it can be helpful to map out all the short- and long-term exit options, and understand the types of buyers who may be interested in your business today and in the future, how their goals may have changed, how they might value the business today and moving forward, and what key levers you can adjust to improve value. Then overlay your personal goals and timelines, your tolerance for risk, and your financial requirements.
If you would like to discuss, please do reach out. We are happy to discuss or answer any questions, and discuss timing and the current changing market. We have helped many entrepreneurs navigate decisions on timing and planning for an exit. You can set up a confidential, no-cost consultation here. https://calendly.com/sallyannehughes
*Data from Capital IQ
