Mike Hughes, corporate finance director at Grant Thornton, assesses the M&A market and its prospects of recovery.
Immediately prior to lockdown, how would you describe the state of deal making in the region?
Mike Hughes The first six months of 2019 started with optimism and saw good levels of activity across the board, with corporates and private equity Houses keen to undertake transactions. As 2019 progressed, uncertainty grew off the back of Brexit, the change in Prime Minister and then the call for a general election. We saw a clear slowdown in M&A activity and progress on transactions around October and November as the general election approached.
Following the election result, there was a good pick-up in activity, driven by both the benefit of further clarity around Brexit but also deals were accelerated as concerns and uncertainty grew around the potential changes that might come to EntrepreneursRelief. This provided some strong optimism entering 2020 and some strong deal flow in quarter 1, but then Covid-19 hit.”
What was the immediate effect of coronavirus and the lockdown on deal making?
MH The crisis has produced everything you’d expect – we saw some deals accelerated to completion but the majority stalled or were simply put on hold. It slowed very quickly in the early days of lockdown as businesses focused on understanding the impact on their markets and operations, battled with the uncertainty of how long the challenging environment would last and tried to navigate through how to leverage the various options of support offered by the government.
The impact has also differed significantly by sector with different sectors being affected at different times, in some cases very negatively, such as hospitality and leisure and in much less cases positively, for example, certain parts of healthcare and logistics.
Two months into the crisis, the statistics suggest that globally 90% of all M&A transactions have stalled and the impact on market activity has been profound. That said, although M&A activity remains at significantly lower levels, many businesses we speak to feel that they can see light at the end of the tunnel from a trading perspective and that they are “through the worst”.
What will be the impact on deal making in the post-lockdown period?
MH Our view is post-lockdown deal activity will initially be very sector dependent. We expect private equity houses will look to grow their portfolio companies with bolt on acquisitions in sectors that have demonstrated resilience or where strategic purchases are possible.
We also expect to see even more competitive pressure in some sectors that have demonstrated their ability to manage and continue to trade in the lockdown environment, for example, software-as-a-service tech businesses.
Other sub-sectors of healthcare, testing and diagnostics, logistics, and businesses relating to working from home have also proven to be robust and should remain attractive.
In other sectors it’s much more about pockets of activity. Food manufacturers that predominately supply restaurants and high street outlets have been hit hard. But some have been able to adapt their model and the sector as a whole is certainly busy in some areas.
Hospitality, leisure, tourism, pubs, clubs, and gyms are all examples of businesses where, for the next six months, the sustainability of the business model has big question marks.”
Corporates will acquire where strategically important assets become available and we anticipate they will also reflect on their business activities and consider disposing of non-core operations.
The challenges of the last few months may well create an opportunity for private equity as shareholders seek to broaden the skill set around the board table and de-risk the value built up in their business, leading to more partial exits.
What impact will Covid-19 and lockdown have on financing and pricing?
MH Price is always sensitive and clearly there’s an impact when something fundamental happens to a business, a sector or an economy but this can be both positive as well as negative.
We expect overall to see pricing changes which are sector led with increases for those assets in areas least affected by Covid-19 due to both their resilience and their scarcity features as private equity houses get back to deploying cash.
We also expect to see some short-term downward pressure on businesses which have been affected more greatly as buyers ponder over the impact of a possible second or later wave of the pandemic.
There will likely be structural changes too. For the foreseeable future we will see more deals with earn outs and deferred elements used as a bridge between historical vendor expectations and the current market norm. Even private equity houses are likely to adopt this change in the short term as we all try to find a way of completing deals on a balanced basis.
On a more positive note, it is more likely that there will be buyers looking to be opportunistic and to take on more risk through acquisitions to access greater reward at lower prices. When we think back to the last recession, that’s exactly what happened. Those that were able to buy early and opportunistically enhanced the momentum in their own business and drove further value.
What do you think will be the main issues that will determine the shape of deal making in the medium and long term?
MH Valuations. Businesses valued on earnings multiples will inevitably have to work out what the true underlying / sustainable earnings of the business are post-Covid. This will lead to earnings adjusted for Covid, which in some cases will be adding back value but in others will need to adjust out enhanced earnings items that are above sustainable trading.
This will make performing diligence more difficult than before the crisis and lead to more subjective views having to be taken. The likely impact of this is valuation gaps between buyer and seller, most likely bridged by structures including more earn-out / deferred consideration mechanisms.
What other major issues do you think we need to consider as regards deal making?
Managing international sales processes will likely require a different approach. For those overseas buyers without a current UK presence further support and access may well be needed to get them engaged and deliverable on the transaction.
Adapting sale processes which incorporate international businesses will be key to opening up this part of the market again.
Mike Hughes is corporate finance director at Grant Thornton. email: mike.hughes@uk.gt.com
