Is this the “new normal”?
Our key takeaways:
- Tightening in the debt markets, as seen in lower leverage levels and more expensive capital, continued through 1Q 2020 and with the impact of COVID, will result in significantly lower new issuance and higher rates until the crisis is resolved. There are situations and industries that will be able to access capital, but those are the exceptions in the current market.
- Expect deal volume and overall valuations to decline as buyers prioritize their own liquidity over acquisitions until there is more visibility and market stability.
- The current situation with COVID will distinguish differentiated and strong businesses from more commodity-like business models. If companies are able to demonstrate stability or marginal contraction through 2Q 2020, they will be in a strong position to pursue strategic alternatives, whether a sale or financing, once the recovery takes hold.
- The current market for M&A transactions is effectively closed. However, we believe that once case numbers and fatalities peak and stay-at-home orders start to be removed, we will see a quick resumption of M&A activity. Given the continued imbalance of capital (too much) versus quality assets (too little), it is likely that valuations will return to pre-COVID ranges once investors are confident that the economic environment is stable.
- Debt market trends, however, will likely influence valuations, particularly for private equity buyers even after the M&A markets return.
- We’ll have a deeper discussion with additional market data on our webinar on Thursday, April 23, 2020. Register for the webinar here. A recording will be emailed to all registrants.
Longer-term observations:
- Ability to work remote will be rewarded and we likely won’t see a 100% return to the previous model of offices, commutes, and work travel (now viewed as petri dishes and sources of inefficiency)
- Technology will remain a greater part of our daily business and the current situation will force companies to leverage more technology, improve and optimize systems, and utilize more tech-enabled and remote employees
- The IT Services and HCIT spaces are likely going to be one of the primary beneficiaries of the changes, especially businesses offering digital transformation, outsourced IT support, security, and other managed services that provide operating leverage and greater transparency into the performance of a business
Is this the “new normal?”
First, and foremost, our thoughts go out to all our readers. We hope you, your families, and your colleagues are all healthy and weathering this unprecedented time. People should always come first in business, so we hope that you are prioritizing your team’s health and wellbeing. While Livingstone is focused, as always, on achieving exceptional outcomes for our clients, we are doing so from the confines of our homes having recognized our processes needed to change to reflect the current macro-environment.
To that point, I thought it prudent to offer a short synopsis of what we’re seeing from our vantage point and summarize the conversations we have been having with business owners, private equity investors, large strategic buyers, and financiers across the country.
The short version to the headline question is no, this isn’t the new normal. While we likely won’t return to the status quo as existed at the end of 2019 in a lot of ways, this is also an extreme situation in which we find ourselves today. Nobody really knows exactly what the future will look like, or when we’ll find ourselves in a more stable environment, but I think we can all agree that these are extreme times and the situation changes daily.
With that in mind, we are not going to do a heavy quantitative analysis of deal volumes and valuations. Given the rapid maturity of the pandemic and its impact on M&A and capital markets, there is still not enough data to draw meaningful conclusions. We intend to do that analysis over the coming weeks and share it on our webinar on April 23rd with additional commentary and observations on trends and potential strategies for businesses over the next 12 months. We will, however, share our observations to date in this article as a way of addressing the most pressing questions.
Is there a silver lining?
For those of you who have read our work before, you know we focus on IT Services and Healthcare IT (HCIT). We think this article is relevant to all businesses, but we will tend to focus on these sectors and tech-enabled businesses more broadly. And, for those IT and HCIT businesses, they may be among the companies less effected by the pandemic’s business impact than companies in other industries.
Where many employers have been adopting a more friendly stance towards remote employees, this pandemic is creating a forced adoption and revealing unforeseen positives and negatives to the scheme. An uptick in remote workers reveals relaxed privacy policies and procedures, presenting more opportunities for hackers to take advantage of organizations that are susceptible to cyber-attacks. Early evidence suggests criminals have already taken advantage of people seeking information on the pandemic via phishing and “social engineering” events. In addition, demand for web communication tools has dramatically increased, straining system availability. Poor performance or complete outages can interrupt operations, impacting both topline revenue and creating additional costs to repair the technology as well as the brand image.
Businesses should proactively remind remote workers about the critical importance of good digital hygiene when connecting to company networks, like logging out when not working or using networks, physically securing computers, following proper procedures about handling private data, and using robust passwords for devices and home Wi-Fi. Companies should also consider a heightened state of cybersecurity, including testing system preparedness for inevitable operational disruption. This all costs money and takes time.
For now, IT teams should prioritize immediate or short-term needs like business continuity and patches. For companies that are confident in their current foundational IT systems, this is also an opportunity to address longer-term digital transformation initiatives that may have been a lower priority when resources were being allocated to operational capacity in times when demand for a company’s products and services was higher. To help control costs, consider optimizing existing applications to work more efficiently in the cloud to (i) improve scalability, (ii) allow access to cloud-native database services, and (iii) leverage automation to increase efficiency.
All of this means there will still be robust demand for IT Services and technology throughout the pandemic response, and potentially an uptick in business in some sectors. Generally, we expect to see deal volume and valuations decline in the short term, but businesses that can demonstrate a financial and operational insulation from the current macro environment could differentiate themselves and realize pre-COVID valuations. The next question is whether there are any buyers willing to pay a premium when the current culture for many is one of value-hunting in a tumultuous market.
Private equity and sponsor-backed buyers
The Livingstone Debt Capital Markets team recently released their 1Q update on the capital markets. It is worth the read but the implications to us on the M&A side of the house is that while capital is available, it will likely be more expensive, and lenders will use a more discerning eye before making loans. The capital may also take a non-traditional form (structured debt, preferred equity, etc.) and the financial impact of the pandemic will have to be clearly understood.
To this last point, we don’t think most of us will fully understand the impact to our businesses for several more months. A Quality of Earning (QoE) report from a reputable firm, which had become relatively common-place in middle market M&A, will be even more important as investors and buyers try to understand what impact from COVID 19 was anomalous and what is indicative of the “new normal”.
With capital becoming tighter in the face of unprecedented times, a lot of private equity groups (PEGs) and PEG-backed businesses immediately drew on their available credit facilities over the last couple months. The cost of capital significantly impacts the rate of returns for PEGs and is one of the factors considered when determining their purchase price in an acquisition. Some of the capital was drawn as a way of shoring up balance sheets and ensuring sufficient cash on hand to survive leaner times. But some of that capital may be used for strategic acquisitions if the right opportunity presents itself, particularly if the business is performing during the current crisis.
Across the board, PEGs are telling us they remain eager to see new opportunities and have capital that they want to put to work (remember, their job is to invest money, not sit on a pile of cash). We continue to hear they are being aggressive in the current environment and flexible with respect to deal structure, but we are not convinced yet that will translate into actual deals at sensible valuations and suspect some PEGs see this as a time to buy good businesses at discounted prices.
These PEGs will also be a seller one day in the future as they need to create liquidity to return to their investors. As a result, there is a view that businesses which can demonstrate an insulation from the current financial tumult could be highly attractive acquisition targets. These buyers can use counter-cyclical businesses as a way of diversifying their current holdings and sell a consolidated business that, on a pro-forma basis, appears to have performed well during volatile periods. We don’t see this as an impetus for going into the M&A or capital markets today, unless necessary, as this strategy will still be viable later this year when the macro-environment is more stable and businesses have the benefit of time to ensure their financial and operational reporting is complete.
Public & strategics buyers
Many strategic buyers (i.e. operating companies) have been building cash on their balance sheets in advance of today. Those with liquidity will likely view the current market similarly to the private equity groups – opportunistically and with the expectation of discounted valuations. These buyers, however, don’t look at acquisitions through quite the same lens as PEGs as they don’t typically have to sell their investments in order to return capital to investors. This, coupled with the potential for them to realize some level of synergy from the acquisition, allows this buyer group to take a longer-term perspective and potentially pay at the higher end of the value range for attractive businesses.
Public buyers traditionally have the added benefit of being able to use their traded stock as a currency to make acquisitions. With stock markets down significantly from their highs, these companies have seen that currency devalued and are under shareholder scrutiny to protect their employees while surviving the pandemic. Again, the fact pattern doesn’t elude to these buyers extending themselves on opportunistic acquisitions at high prices.
Today’s M&A and capital markets are rapidly changing, and the near-term future is uncertain. Each business is facing its own unique set of circumstances and dynamics. It’s a stressful time for management teams and employees alike. Times like these are exactly when management and owners need to look outside their organizations for advisors that can be a resource as they think about the potential strategic alternatives for their business. Prudent executives should be proactively thinking through all the various contingencies in order to be best prepared to update and adapt strategies as the business environment changes.
