Most deals that were ongoing as of mid-March 2020 (~60%) seem to be trying to keep things moving more slowly or have postponed next steps temporarily for now, book-ended by only a few that have proceeded to or toward a closing (~15%) and some that terminated the process altogether (~25%). We expect this latter category to likely increase in the next few months.
New deal flow in general has fallen off dramatically since mid-March, with 70% of respondents reporting a decline of greater than 30%. Many respondents indicate that deal flow has dropped off even more dramatically than the survey question referenced, with very few inbound opportunities in April 2020 (compared to a time of year when new opportunities are typically high).
Most respondents (nearly two-thirds) say it is too soon to tell what the impact of COVID-19 has been (and will be) on the quality of the deals they are seeing. Those who did respond with specifics seem to highlight two ends of a spectrum, ranging from an increase in troubled/low quality deals to only seeing better-quality companies that have been less impacted by the pandemic. We believe it’s logical that those two segments would be the only ones pushing forward in this current environment, at least until people have better visibility on how rapidly markets and the financing environment will recover.
Almost all respondents believe valuations will be lower in general, with 62% believing the decline in multiples will be greater than 15%. There will be a small number of premium companies that will continue to see strong valuations, as high-quality opportunities are expected to be far more scarce and competition for those will increase.
Respondents believe there will be multiple structural features implemented to creatively get deals done in response to the challenging market. In general, respondents indicated that the increase in the number of earnouts and contingent payments will be most significant, and that the use of seller notes will also become more common. Features like hold-backs and higher escrow levels will be used but not as frequently.
About the survey
Dunn Rush and Co. has commissioned a survey conducted online by JustJump Marketing among more than 1,100 of the Firm’s contacts in the private equity sector across the U.S., in an effort to better understand how the uncertainty surrounding the COVID-19 pandemic is impacting the M&A activity and outlook in the middle market (companies valued under $250 million). Below are some of our key takeaways and findings:
Status of deals that were in-process:
Most deals that were ongoing as of mid-March 2020 (~60%) seem to be trying to keep things moving more slowly or have postponed next steps temporarily for now, book-ended by only a few that have proceeded to or toward a closing (~15%) and some that terminated the process altogether (~25%). We expect this latter category to likely increase in the next few months.
Deal flow trends:
New deal flow in general has fallen off dramatically since mid-March, with 70% of respondents reporting a decline of greater than 30%. Many respondents indicate that deal flow has dropped off even more dramatically than the survey question referenced, with very few inbound opportunities in April 2020 (compared to a time of year when new opportunities are typically high).
Quality of new deal flow:
Most respondents (nearly two-thirds) say it is too soon to tell what the impact of COVID-19 has been (and will be) on the quality of the deals they are seeing. Those who did respond with specifics seem to highlight two ends of a spectrum, ranging from an increase in troubled/low quality deals to only seeing better-quality companies that have been less impacted by the pandemic. We believe it’s logical that those two segments would be the only ones pushing forward in this current environment, at least until people have better visibility on how rapidly markets and the financing environment will recover.
Impact of the COVID-19 pandemic on valuations:
Almost all respondents believe valuations will be lower in general, with 62% believing the decline in multiples will be greater than 15%. There will be a small number of premium companies that will continue to see strong valuations, as high-quality opportunities are expected to be far more scarce and competition for those will increase.
How will transaction structures be impacted?
Respondents believe there will be multiple structural features implemented to creatively get deals done in response to the challenging market. In general, respondents indicated that the increase in the number of earnouts and contingent payments will be most significant, and that the use of seller notes will also become more common. Features like hold-backs and higher escrow levels will be used but not as frequently.
What will be the biggest challenge to close transactions going forward?
Unsurprisingly, respondents indicated that the single most important factor in closing a transaction in the coming months will be gaining a clear understanding of the impact of COVID-19 on a business. Additional comments emphasized two aspects of this – not only the financial impact during months of widespread closures of non-essential businesses, but more importantly how the pandemic has changed or will change a company’s business model going forward. Other significant factors that will present challenges in getting transactions closed will be bridging the gap in valuation expectations between buyers and sellers and dealing with uncertainty in the debt financing market.
When will activity and valuations return to pre-pandemic levels?
There is no clear consensus on when deal flow and valuations are likely to return to pre-March levels, with the most common answer (36%) being mid-2021. Votes for year-end 2020 and year-end 2021 each received 27% to create a sort of bell curve. But the clear takeaway is that no one believes this is a 3-month return to normal activity, and few think it will recover even in 6 months.
Will buyers consider the financial impact of COVID-19 to be an add-back?
Although a significant number of people responded that “it depends” on the circumstances, 85% of people who did answer the question will consider the impact of COVID-19 to be a non-recurring event or add-back when looking at new deals. Many respondents did however comment that the appropriate amount of any add-back would be relative to the go-forward normalized business. The nature of the pandemic is likely to have fundamentally impacted the operations and markets for many companies’ products and services in a way that will require deeper analysis.
Will PE Firms delay selling portfolio companies due to the effect of COVID-19?
The pandemic has caused most PE firms to postpone the timing of the sale of their existing portfolio companies who may have considered a near-term process by anywhere from 3 months to a year or more. Less than 30% of these companies are continuing to prepare for a possible near-term transaction.
Summary:
The COVID-19 pandemic has clearly disrupted middle-market M&A deals negatively. There are fairly wide ranges of opinion on what the depth of this decline has been or will be, and how long it will take for the market and individual companies to recover from the market downturn. But there appears to be optimism that transactions can still get done, albeit on longer diligence timetables and with more buyer-friendly transaction structures that shift more of the post-closing risk onto sellers (earnouts and contingent payments).
With regard to transaction volumes and valuations, it is our opinion that there will be a significant drop in the number of transactions completed between now and the end of 2020. To the degree the U.S. economy can begin the reopening process in the next few months, we believe the middle market M&A transaction environment should recover to a more “normal” environment by mid-2021. Between now and then, it seems likely that the majority of businesses that decide to enter the market will be in one of two opposite categories: either companies in distress that can’t defer to a later date for one reason or another, or companies whose businesses have not been impacted (or have thrived) in the aftermath of COVID-19’s impact on the consumer and business environment. This is probably intuitive, but distressed businesses will likely see significant declines in value due to the compounded effect of lower multiples on weaker financial results. Conversely, stronger companies will likely continue to command high valuations due to the scarcity of such opportunities at this time (essentially benefitting from a classic over-demand and under-supply dynamic).
We hope that you found this report and its findings useful—we continue to monitor and track the market and welcome the opportunity to talk with you about our insights and commentary on the business climate and economic implications. We know these are uncertain times, but we look forward to better days ahead.
* This survey was conducted online within the United States by JustJump Marketing from April 21-24, 2020 among approximately 1,100 U.S. adults ages 18 and older.
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