COVID-19 and Middle-Market M&A: Where do we go from here?

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September 21, 2020
Provided by: Steven DeMatteo, Senior Vice President - Wealth Management at UBS Financial Services
Several months ago, UBS Private Market’s investment banking experts (“UBS”) held a cautiously optimistic outlook for 2020 middle-market M&A activity. 
UBS’s view was bolstered by a number of factors, including: (i) overall stable macroeconomic backdrop, (ii) positive business and consumer sentiment, (iii) C-suite focus on growth with capital to invest, (iv) significant dry powder from private equity, (v) high valuation levels, and (vi) strong credit markets with available financing for buyers. However, the recent global COVID-19 outbreak has materially changed the near-term outlook for middle-market M&A and instead paved the way for increased market volatility and weakening economic forecasts. Still, there are steps that business owners can take to prepare for a future liquidity event once the market regains stable footing.
How have recent events impacted the M&A process?
M&A activity has been slowed and will likely remain low until volatility subsides and there is more visibility into the impact of the pandemic on businesses and near-term economic outlook. Most current deal activity is around counter-cyclical businesses or where flexible financing may be had.
According to UBS, business owners contemplating a near-term M&A process may consider the following:
  1. Impact on diligence: Buyer diligence and management meetings have slowed or halted in many cases, as these functions often require face-to-face interactions. Many companies and investors have mandated that all meetings take place electronically.  
  2. Stress-testing downside cases: Buyers will look to stress-test management forward projections and understand how COVID-19 will continue to impact earnings over the next several quarters. 
  3. Availability of credit to buyers: Access to credit for many new issuers may be difficult until the market regains stable footing. High cost of capital or lack of available credit will result in buyers not bidding for assets or lower purchase multiples from buyers.      
  4. Decline in valuations: Overall risk appetite has contracted. Reference valuations for comparable public companies have declined, albeit public markets have rebounded from their March 2020 lows. Investors are also likely to re-evaluate business forecast assumptions and place more weight on downside scenarios. 
How should business owners navigate current market conditions?
Business owners should continue to focus on execution and planning. The first priority should be to successfully operate the business over the next several months. Business owners should take care to implement business continuity plans to safeguard employees, customers, suppliers and other stakeholders, and work to ensure there is limited operational disruption. Now is a good time to reforecast the business’s short-term budget and long-term financial plan. Business owners should work to understand any liquidity constraints the business may have and take measures to shore up financing and insulate the business in the event of a drawn-out potential economic downturn.
Importantly, in times of crisis, cash is king. According to UBS, the below steps may be taken to stabilize cash flow and ensure the business is on sound footing.
  1. Conduct robust short-term cash flow forecasts to understand funding requirements
  2. Access available sources of capital today and strengthen balance sheet
  3. Implement tighter controls over cash to reduce leakage and adapt to shifting lender requirements
  4. Create short-term liquidity strategies
  5. Maintain open lines of communication with stakeholders including lenders, suppliers and landlords
  6. Explore alternative financing solutions 
Once the business is stable and management capacity is available, it may be appropriate to work with an investment banking professional to begin pre-M&A planning work. Going forward, UBS expects that investors will have renewed focus on due diligence efforts evaluating business resilience, supply chain risks, and other operational aspects of the business. Further, for years to come, potential investors will be evaluating both the operational and financial performance of businesses during this period in order to measure the cyclicality and overall resilience / risk profile of a business. The "right" course of action for each business is unique, but the company’s management team will likely be measured on how they navigate this environment.
To the extent possible, it’s important to track any COVID-19-related impacts on the business and expect that at some point the management team may need to explain in detail how and why the business performed the way it did during this period of disruption. UBS recommends tracking "exceptional" events such as contract delays, customer order cancellations, overtime costs, sick leave, supply disruptions, and elevated transportation costs, among others.
Looking forward and positioning for the future
It is unclear how long the market volatility will last. Some estimate an additional 3-6 months, while others estimate a longer path to recovery for some sectors[1]. Key factors for recovery include the rate of decline in COVID-19 cases, an easing of government mobility restrictions and the overall rebound of the global economy. 
M&A activity typically lags a recovery in the public equity and credit markets. With the recent rebound in the public markets, UBS has gained a renewed sense of confidence that M&A activity will similarly rebound as credit markets continue to open up for buyers. Still, that optimism is tempered with the overall political and civil climate that has continued to create a volatile atmosphere as businesses begin their initial phases of reopening. 
For business owners planning to sell their company in the near-term, beginning the preparation process now will increase optionality and allow for optimal positioning to enter the market as volatility subsides and the M&A window reopens. There continues to be liquidity in the system and "dry powder" (funds raised by investors, such as private equity funds, but not yet invested) on the sidelines. When investor risk appetite returns, there may be an imbalance between demand and available supply. High-quality companies that are primed and ready to capitalize on a reopening of a market window may be able to benefit from the potential market outlook. 
Business owners should take a balanced view when looking at the current middle-market M&A landscape. With markets recovering, encouraging signals are pointing in the right direction to an M&A window reopening, yet the current overhang of uncertainty due to the pandemic and broader political environment remains. Business owners should be able to reach their strategic and monetization goals, but it will be business owners that remain cautious and engaged will be best positioned for success. 
Steven DeMatteo is Senior Vice President - Wealth Management, Torrey Pines Wealth Management, a UBS Signature team. Together with his team, Steven draws on broad experience in the wealth management industry to help clients exit their companies, develop retirement plans, and preserve wealth for future generations. He has earned the Wealth Advisor and Certified Exit Planning Advisor (CEPA) designations, is a member of the esteemed UBS President's Council and was a 2018 recipient of the UBS Aspire Award for collaboration, leadership and service.  Steve is also a retired Marine Corps helicopter pilot where he was decorated for performance in peacetime, humanitarian and combat operations. 
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[1]UBS surveyed 500 business owners with at least $250k in annual revenue and at least one employee other than themselves, in the month of June. Read the report here.
Steven DeMatteo, Senior Vice President, (858) 947-7094