How has COVID-19 impacted Buyer / Seller Valuation?

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Having made it through the initial shock of COVID, the questions now are where, as a deal-making community, do we go from here, what factors will get us back to where we were at the beginning of 2020, and how long will a recovery take? These are the questions Sean O’Reilly, CFGI, Jonathan Chou Eureka Equity Partners, and Patrick Dolan, Delancey Street Partners helped to address in the May 14^th presentation “What’s Happening Now: How has COVID-19 Impacted Buyer & Seller Valuations"   

Recent Perspectives from the Buy & Sell Side

There has been a general shift in focus from sourcing external opportunities to ensuring existing portfolio investments are best able to weather the COVID crisis.

• Are operations as efficient as possible with adequate safety precautions in place where appropriate?

• Every company is different but there is a need to manage near-term cash flow while gaining an understanding of what the business will look like in the medium to long term (3 to 6 months) when things do start to open up.
• While they have been rare and typically have other factors involved, some opportunities do still come up and investors do have an interest.
  • Prior to COVID, investors were reviewing 15 to 20 books per week; in the current environment, this has fallen to 1 to 2 books per week.
  • In recent weeks, there has been a pick-up in activity, but only in certain pockets of the market.
• How can you expect to underwrite a deal without being able to meet the management team / see operations in person?
  • There is a need to adapt! Technology can help, but that personal connection between a potential buyer and management, essential to the success of any collaboration, is hard to obtain through video conferencing.

Diligence Surrounding Projected Performance

Historically reserved for more distressed businesses, there has been a renewed focus on near-term budgets (i.e. 13-week cash flow forecasts) while also illustrating recent cost initiatives implemented and how operating margins will look going forward.

• The benchmarks for evaluating a deal will not be all that different from the pre-COVID period. There will continue to be heavy weight on EBITDA multiples (the EBITDA may contain COVID-19 adjustments as part of a typical list of adjustments) and future cash flow projections – of course, the adjusted EBITDA and financial projections may look drastically different now than pre-COVID, but the way one approaches how to value shouldn’t really change.
• Significantly more rigor has been applied to developing projections – viewed on a more granular level with multiple scenarios incorporating management’s insight into the probability of each scenario’s occurrence.

Anticipated COVID related Normalizing Adjustments

While not fully established yet, initial indications are that COVID-related adjustments to operating performance will exhibit a large range.

• Do these adjustments reflect credible COVID-related addbacks or will these adjustments just represent a new way to mask underlying unrelated problems in the business? Evidence of operating performance over a period of stability will be necessary to validate any sort of COVID-related adjustment.
• From the buy side: How much of the actions taken to address COVID are really going to last for the long term when / if COVID is behind us?
• Lenders have been cooperative with covenant compliance with a “We’re all in this together” attitude, but there is a limit.
• Once COVID-related adjustments are determined, what sort of multiple makes the most sense? Trailing? Forward? Multiple on 2021 operating performance?

Lending Community

The appetite from lenders is pretty low for any new deals with primary attention being given to their existing portfolio. As such, buyers may need to be open to alternative financing arrangements.

• As an example, some buyers have come to the negotiating table with no letters of support from lenders, assuming they will be able to secure financing later.
• Just like during the Great Recession, close relationships with a lender group who understands the business and the market is most important.

Deal Structure

In this environment, broad auctions will be difficult, and buyers need to be open-minded if there is an opportunity they do not want to miss. It is likely a buyer will need to possibly over-equitize an acquisition up front and seek out a recapitalization at a later date when the lending market improves. Additionally, the lack of debt financing can be used by buyers as a rationale for a less aggressive purchase price multiple when dialoging with sellers.

• Alternative transaction structures will likely gain popularity in this environment, including an increased acceptance of seller notes and earn-out structures to bridge any sort of current valuation gap.
  • For earn-outs in place prior to COVID-19, it is doubtful there will be any accommodation for sellers. Ultimately, if any existing earn-outs are well defined, sellers really will not have any basis to ask for COVID relief. Disputes may arise regarding the definition of the earn-out and if the related threshold has vague language such as “add-backs for non-recurring events”, however these would be very rare.
• Sellers are aware of the environment and the need for risk-sharing. This can be advantageous for buyers who give some thought to deal structure and provide a rational offer.
• Buyers still want to deploy their capital and this period can be a good opportunity to pick up quality assets at attractive valuations.

Which industries have been holding up well?

While there has been a general decline in valuations, some industries have fared better than others.

• Software / Services – Success depends on end markets.
• Tech is holding up well - Any business model which allows folks to work remotely.
• Food / Packaging – Ex. of an opportunity: How do you package certain types of food in this environment?
• On the Manufacturing Side, some companies have been reevaluating their Supply Chain Strategy. Do the benefits of having a global supply chain outweigh the risks?

For those businesses struggling during this time, goodwill and long-lived impairment testing has become more prevalent and is anticipated to increase during the second quarter and at the end of the year.

When will exits return to normal?

While investors are sitting on a lot of cash, this period of uncertainty has created much apprehension. There is a general expectation of a gradual recovery through the end of 2020, but it will be much longer to get back to where we were pre-COVID. The health risks associated with the virus need to be under control before both buyers and sellers truly feel comfortable enough to get back to pre-COVID valuations. Those first to rebound will be the few which have thrived during this COVID era.

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