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*COVID-19

A Shift in Investment Strategies Post-Coronavirus — COVID-19 Virtual Roundtable

In this week’s COVID-19 virtual roundtable, nine Axial members gathered over Zoom video to discuss the shifting investment landscape in a post-coronavirus market. Topics included new and innovative capital structures, how government stimulus funds are impacting the private capital markets, and what’s happening with transaction dynamics.

Thank you to the below Axial members who participated in the discussion:

Video

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Audio 

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Show Notes 

Introductions – 00:00-11:20

Government stimulus as an offset to distressed deals – 11:46

  • Based on stipulations that come along with the funding, PPP funding is extremely hard to deploy effectively in some industries. One of the most problematic conditions is that the funds must be deployed within eight weeks
  • For businesses that are impacted more immediately and will be able to resume normal operations once this slows down, PPP funding is extremely helpful to keep employees paid over the next eight weeks, but if a business expects a longer-term issue vs. a temporary business halt, they will have no accessible funding in the latter half of the year
  • In services businesses where you have engineers and technicians that are sitting on the sidelines, PPP funding allows you to keep them on the sidelines for a couple of months, and hopefully they’ll be able to get back to work by the time the funding expires
  • The PPP structure presents a major issue in the health club industry — gyms are all closed right now and everyone is on unemployment, but when clubs can open back up, they will be taking huge revenue hits and it will be too late to use the funding
  • Permanent Equity released a program before the CARES Act was announced where they are offering a more flexible long-term capital solution
  • There is still a lot of capital demand that was not fulfilled by government funding
  • This government funding is seen by many as a short-term fix versus an actual solution
  • The Economic Injury Disaster Loan is a more attractive option in the sense that it’s a 30-year payback versus the PPP which has an extremely short payback period for any funds that aren’t forgiven

Transaction likelihood – 24:20

  • In 2008/2009, there was a quick freeze in lower middle market transactions, but ultimately, a lot of deals ended up getting done
  • That said, you could get on planes during that recession — lenders could travel to audit companies and buyers could do on-site diligence — which is a major differentiator
  • Axial is hearing from buyers and investors that they want to submit LOIs and move forward on deals, but they’re just not likely to close on something before they can get in-person interaction
  • The main street lending program will be a competitor in the lower middle market because interest rates and the timeline are attractive if someone doesn’t want a partner

Safe Harbor program as a creative capital solution – 31:20

  • Permanent Equity rolled out a program called Safe Harbor as soon as the crisis began, offering minority equity and debt (historically were interested only in majority stakes)
  • They encourage businesses to take “less-expensive” government money if it makes sense, but if a business is interested in having a long-term partner, this is a win-win
  • There is no formulaic execution; you need to assess what each company needs right now — there are some situations where it makes a lot of sense to look at past performance, but that may be totally irrelevant for a lot of companies now
  • Some of the things being explored: contingency payments, different forms of earnouts, seller notes with downside protection

Case studies in transaction dynamics – 34:44

  • Lock 8 is currently under LOI, and they’re hopeful that the deal will close — LOI was signed post-quarantine, but 1) they had met with the company fairly extensively prior to lockdown and 2) it’s mostly a remote workforce, so there’s not really an “HQ” to visit; if those two things were not true, it could be less likely that they would move forward
  • Integrity Square is working on a deal with a special situations group, and the seller is nervous that they’re going to reach the close date and the buyer will not actually deploy the funding
  • A lot of the contingencies being put into play are more likely reduce the reality of a close
  • Senior debt is being replaced with mezz and larger equity checks
  • Black Lake went under LOI in late February, has pressed pause and isn’t expecting to go after financing until at least the beginning of summer
  • Frisch Capital works with independent sponsors; they’ve encouraged them to continue to find sellers and lay the groundwork for deals even if they don’t anticipate going after capital immediately
  • Coughlin Capital has changed the way they generate leads — they’re doing more direct outreach to business owners

Negotiating contract terms – 45:30

  • Buyers are trying to negotiate things on behalf of business owners (i.e., leases, debt) at the LOI stage because they feel they’re better equipped to get good deals, but sellers don’t want to be left with deals that they didn’t champion if the deal blows up
  • From the buyer perspective, they want to safeguard themselves, but at the same time, you should be further down the line than just an LOI before these conversations happen
  • It makes more sense at the purchase agreement stage, and there should be some sort of binding commitment where the buyer needs to follow through or is held liable

Transaction case studies revisited – 50:33

  • Sellers are calling Right Lane to revisit past offers that now look attractive. Right Lane would like to honor, to a reasonable extent, previous offers, so Eric is going to be driving around the country to do site visits, and he’ll work with whoever is open for business to get the debt that is needed and will just be very cognizant about how he’s structuring the deals
  • Over the past six weeks, Lock 8 has had multiple deals come back that they thought were long dead
  • Business owners have been reaching out directly much more in the past couple of months
  • Intermediaries seemed to take a pause in March, but have picked back up significantly over the past few weeks
  • From the intermediary perspective, they recognize that strategic buyers are going to be few and far between in the near future, so they’re reaching back out to financial buyers to (re)learn what everyone is working on since it oftentimes looks different these days
  • With strategic buyers out of the market, financial buyers are excited and looking for increased deal flow over the coming months

Dislocated valuations – 56:27

  • This is actually a good reset for multiples that were getting completely out of hand in a lot of sectors
  • The issue at hand is going to be around how sellers react to the adjusted multiples
  • Intermediaries are going in low with valuations because they don’t want to suggest a low number that ends up being lowballed even further
  • Buyers that are flexible are going to be the ones who close deals right now; taking some of the chips off the table but not all will win you more deals
  • A big question: what is the multiple based on now? 
  • The industry should do a better job educating business owners about all of the different options out there

Seller psychology – 1:08:35

  • For the baby boomer founders, they were thinking they’d be able to end their career on a high note, and then they were hit with a lightning bolt
  • It’s quite possible that these owners think that taking outside (minority) capital means that they have to relaunch their careers and can no longer think about retirement, in which case they may think their only option is to close their doors
  • This is a good opportunity for buyers to let them know that they have options, and it doesn’t have to be all or nothing

Axial COVID dashboard – 1:11:05

  • This dashboard houses data from the Axial platform since March 13th when the U.S. declared a national emergency
  • Since then, there have been 90 new buyers who have joined the Axial platform
  • More than 3,500 NDAs have been signed
  • LOI and closed deal activity has dropped substantially
  • There’s a lot of top-of-the-funnel activity, but very few closures
  • Here is the link to the dashboard

What’s the market going to look like when it kicks back up? – 1:13:16

  • There will be a profile shift in the buyer market: lower number of strategics
  • There is a certain amount of comfort in selling to a peer, so a lot of sellers are now hesitant to go to market because they’re intimidated by private equity
  • The independent sponsor firm structure may skyrocket in the next 18 months because it is a “less scary” version of PE
  • Independent sponsors have always really focused on relationships and they have always had to put significant focus on deal structures, which will ultimately help them as a buyer type going forward

The herd mentality – 1:22:20

  • Right now, the person who is getting on the road and trying to close new deals can be looked at one of two ways: they’re either a genius who is going to make a lot of money, or they’re a fool
  • People are hesitant to be the only one out there, and while everyone is excited to get deals done, they’re not actually doing them
  • Once there are a couple of initial closed transactions in May or June, that may open the flood gates and get everyone else more comfortable with moving forward on things

Past Roundtables

Roundtable 1: How Coronavirus Is Impacting Lower Middle Market M&A Activity

Roundtable 2: Portfolio Company Crisis Management

Roundtable 3: Distressed Investing

Roundtable 4: PE Business Development Post-Coronavirus

Roundtable 5: Healthcare M&A Activity and Opportunities

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