We are entering into a serious recession due to the ongoing worldwide pandemic. The economy has taken a big hit, and it’s not over yet. But I see opportunity out there, especially in the M&A world.
Let’s put this in context first. Think back to the last recession – The Great Recession of 2008/2009.
There were lots of opportunities for businesses back then too, but there was no money. This time around, thanks to conditions prior to the downturn, there is plenty of dry powder available, not to mention very favorable lending terms.
Will there be opportunities to invest and acquire? We expect and hope, but we’ll see for sure soon enough.
Pace of Deals Now Versus What’s to Come
It’s true that currently the pace of deals has fallen off a cliff. Deals are not simply being delayed… but actually cancelled. That’s bad, of course, and it has people worried. But conditions are already shifting.
We’re moving from a Seller-friendly market to a Buyer-friendly market. Like everything else in the near term, prices will be coming down.
As a Seller, you may have had a potential deal in the works. But, due to recent events, the Buyer is reluctant to move forward. Understandable, given it’s a time of uncertainty. And, many Buyers are reevaluating and focusing on other priorities. On the upside, if the price comes down low enough, Sellers in a bind will have other suitors. It’s a Buyer-friendly market, after all.
Why PE Firms Are Sitting Pretty
In this environment, PE firms have the advantage. PE firms may have been more aggressive price-wise in the recent past, while Strategic Buyers were spending more freely. Now the tables have turned. Strategics will be less aggressive while looking at takeover targets because in the near term they’re trying to protect as much cash as possible.
This opens the door for PE firms and other financial Buyers to make lower offers and pick up those targets themselves (and then sell them later for a premium).
This is all set against a backdrop of declining valuations.
Some of these target companies have had recent valuations of seven to 10 times EBITDA. Just a short time ago, they were valued at 10 to 15 times EBITDA. A company with $10M EBITDA was being targeted at $100M to $150M. Now that the price tag has dropped below $100M, there are a lot more interested Buyers. That’s one of the reasons this looming recession is still a good environment for M&A. And, as I mentioned, it’s a Buyer-friendly market… especially for financial Buyers.
A Foundation for Continued M&A Activity
Despite this pause in our economy, let’s look at the underlying forces that support robust M&A activity:
There is a lot of dry powder among buyers, specifically financial buyers.
Sellers were demanding record high valuations – and getting what they wanted. Those valuations will be coming down because we are seeing fewer Buyers. This gives remaining Buyers more leverage.
Financing costs continue to be low.
The dynamic of aging owners and founders that want to exit.
Continued digital transformation and tech disruption in every industry. Companies have to upgrade their tech at some point with regards to IT security, cloud computing, and more. Those lifecycles and disruptions will continue.
These market conditions are out there, no matter what… despite COVID-19.
That’s why I think that once we have falling metrics regarding the spread and impact of the coronavirus and a stable stock market for three weeks, we’ll be right back in business, and M&A activity resuscitated. Spring has come.
Another factor to consider is that there are a lot of distressed businesses out there in industries like transportation, restaurants, hotels, retail, etc. There are a lot of capital raises out there now – funds set up to go after good – but currently distressed – acquisition targets.
How R&W Insurance Fits In
Under these current conditions, I see Representations and Warranty insurance as being a very favorable benefit because it factors into a few areas:
If a Buyer has more leverage in a deal, they will impose broader Reps and Warranties and other conditions. If a R&W policy is covering the deal, the Seller doesn’t really need to worry about more Buyer-favorable terms because it’ll be insured anyways. (A caveat: Underwriters are still conducting normal due diligence in these cases. They are not lowering the bar or loosening eligibility standards.)
Cash is still king. Getting R&W insurance means Sellers get more cash at closing and don’t have to worry about money being tied up in escrow for a year when they have to satisfy creditors or wish to invest elsewhere.
In distressed acquisitions, M&A Buyers need R&W coverage because often they don’t buy whole companies, just the assets. And the Seller may not have a choice. Having R&W is kind of like having protection for those assets if the Buyer has done diligence, but they are later compromised unexpectedly.
Without R&W coverage, the Buyer has no recourse to go after the Seller because they already took the funds to pay creditors. R&W insurance is the backup. Whatever dollar amount it cost for the policy… it’s more than worth it in those cases.
The longer a deal sits and doesn’t get closed, the greater the chance it will fall through completely. R&W insurance will accelerate negotiations all the way to closing.
Next Steps
It remains to be seen for sure, how this pandemic will impact the economy as a whole, and M&A activity in particular. But I feel confident that we’re shifting to a Buyer-friendly market and smart Buyers will take advantage of this opportunity.
In that case, it’s more important than ever to get Representations and Warranty insurance to cover deals for the protection of both Buyer and Seller.
If you’d like to discuss coverage, please contact me, Patrick Stroth, at pstroth@rubiconins.com.