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The Path Forward: Ten Takeaways from Q2

For the past 12 weeks, we’ve been in listening mode. Since the formal declaration of the national emergency in early March, we tapped our network to gather as much information as possible about the state of the M&A markets. Our weekly virtual roundtables became the venue for our members to share what they were seeing on the ground, covering topics such as the debt markets, business development, transaction structures, and sometimes taking deeper dives into specific sectors or end markets. 

Click here to access the recordings of all the virtual roundtables.

As we approach the close of an eventful Q2, we’ve compiled the top ten takeaways from our members over the past three months.

1- Lack Of Guidance On Government Funding

While PPP funding provided immediate aid and relief to many businesses that desperately needed it, it also caused some headache for private equity investors and their portfolio companies. From the affiliate requirements that prevented many PE-backed businesses from receiving funding to the restrictions around use of funds, there has been a lot of uncertainty and a general lack of guidance around the program since it was introduced in April.

That lack of guidance, two months later, has introduced another unanticipated side effect into the investment world. Because of the uncertainty around what expenditures will be forgiven, or the inability to materially change a business’ cost structure post transaction, some deals are being put on hold until there is more clarity. 

2 – Flexibility Is Key

Some businesses simply got lucky that they were in the right space at the right time, but the companies that have truly shown growth and success in the past few months are those that were able to pivot. Diversifying supply chains, shifting manufacturing capabilities, changing end markets and acquiring businesses to do all of the above are just a few ways that businesses have successfully transitioned during this time period. 

Many deal professionals believe that in the coming months and years, buyers are going to ask companies “how did you react to COVID?” Companies that were proactive and thought outside the box will come out on top.

3 – In-Person Meetings Are A Must

A lot of parts of the deal making process were “digitized” during this period without a hiccup. Actually closing a deal was not one of them. While plenty of investors and debt providers hung an “open” sign soon after lockdown, many have since admitted that they were not actually willing to close a deal without an in-person handshake. It’s quite possible that fewer face-to-face meetings will be needed during a deal process in the future, but it’s just about unanimous that buyers need at least one in-person meeting with management before they’re comfortable writing a check. 

4- The New Due Diligence Norms

While management meetings are still needed in some capacity, many deal professionals agree that being on lockdown has exposed a lot of inefficiencies in the remaining stages of the due diligence process. 

For one, the order of operations as we know it has been turned on its head; many of the steps that used to be pushed to the end of a process are able to be easily frontloaded, allowing for fewer roadblocks and a more efficient timeline. Additionally, there is a tremendous amount of opportunity to incorporate more virtual diligence — from adding video site tours to front-loading some quick meet-and-greets with employees — which will speed up the process as well as saving time and budget for everyone involved.

5 – Digital Is Here To Stay

It’s no secret that the lower middle market has not been quick on the draw when it comes to digital adoption. While some firms have been ahead of the curve, most deal professionals have been hesitant to steer away from their traditional phone-call and handshake rituals. Until COVID.

While most can’t wait to get back on the road and return to their heavily in-person practices, many admit that a lot of the digital solutions they’ve been forced to adopt will remain in their day-to-day lives in some way, shape, or form. Virtual meetings & events are not a one-size-fits-all replacement, but they do remove geographic and travel constraints for attendees. And video calls — while not always a perfect solution — do allow participants to build better rapport with some “face-to-face” contact. 

6 – The Debt Market Is On The Rise

The debt market has been one of the major areas in question throughout most of Q2. Lenders were being forced to turn all of their attention to their portfolios, and with uncertainty at an all-time high, new debt was near impossible to find. 

In today’s market — three months after quarantine began —  leverage is down and the price of debt is 200-300 basis points higher, but if a firm is hard-pressed to access the capital, they can likely find it. Furthermore, lenders and buyers alike are confident that as travel continues to become more accessible, so will debt. 

7 – Structure Is King

One thing that everyone agrees on in a post-coronavirus environment is that forecasting is fuzzy. There is no longer a proven method for calculating reliable financials, and this puts both buyers and sellers in a tricky situation. The only way for a transaction to move forward? Both parties must be willing to share risk and take a chance on one another.

Earnouts are going to be a big part of dealmaking for the foreseeable future. Other tools that will also likely make frequent appearances? Seller notes, rollover equity, deferrals, and hold-back escrows.

8 – Expect A Lot Of Recaps

In addition to structuring transactions more creatively, a lot of buyers are making the decision to put more equity into deals. Because the debt market has been a major hangup for a lot of firms, if a buyer is able to take less leverage and put more (or all) equity into a deal, they have the ability to strike while the iron is hot. From there, the plan is to recapitalize when the market picks up in the second half of the year/2021.

9 – Valuations May Not Change Substantially

In the early days of the pandemic, the overwhelming opinion was that valuations were going to drop fairly significantly. However, as the fog cleared and a new normal began to develop, many deal professionals have decided that valuations may remain somewhat unchanged. 

Buyers don’t want to pay much higher prices for businesses that are finding success during the pandemic, so it makes it more difficult to offer significantly less for a company that hit a snag for the exact same reason. Not to mention, if a business owner knows that they will be able to get a materially higher valuation as soon as COVID clears, buyers are at risk of losing all of the inventory on the market for the next 6-12 months. 

10 – Expect Big Things In 2H

While much of the market was forced to push pause in Q2, it has created a lot of potential for the remainder of the year. There is still an abundance of dry powder that needs to be deployed, and many businesses need capital more than ever. Furthermore, as travel opens up, the debt markets emerge from a slumber, and buyers are able to press play on their many paused deals, the stage will be set for plenty of closed deals in the second half of the year.

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