COVID-19, President-Elect Biden, Economic Recovery and More M&A on the Way
2020 has been a year like no other in recent history. In our previous post, we shared key trends shaping client needs in 2021 and how investment banks must evolve to better serve the lower middle market. Now, we will look at events shaping the current, near and mid-term future for our clients.
Having supported a range of clients; helped them mitigate challenges, seize opportunities, and improve their business and financial strategy over the past year, Auctus Capital Partners is familiar with the many issues facing corporate America and decision-makers across industries.
As we close out 2020 and wait for the ball to drop on 2021, it’s time for our Year in Review and Year Ahead Forecast. Check out our recap of the year that was and the core themes that will impact business, drive deals, and shape the 2021 landscape:
Coronavirus Changed the Game for All
The most obvious event in 2020 is the COVID-19 pandemic and the almost immediate recession it created. It is significantly different than previous recessions and societal disturbances and will have lasting impacts on people’s lives and the way they do business, even after the vaccine is widely distributed.
The scope and speed in which the virus spread forced all businesses to make significant changes to operations and focus on the financial impact to cashflow, assets, working capital, and more. The environment created an accelerated adoption of digital technologies, remote working models and forced companies to unearth new ways to drive customer stickiness.
Companies that leverage existing and invest in new technology during times of crisis emerge stronger, from increased efficiency and operations for business continuation to new products and services that disrupt the market.
Looking ahead, a resurgent pandemic is chief among concerns across the lower middle market, but uncertainty should ease with the availability of the vaccine. In the interim, business owners need to focus on strategic positioning and ways to allocate capital while generating appropriate returns.
Stimulus was a Lifejacket, Not a New Vessel
Global government stimulus packages aimed at offsetting the economic downturn topped US $10 trillion and supported recovery across financial markets. However, relief came too late for some businesses and navigating the process was far from easy. For many, however, stimulus successfully served as a bridge to offset a range of losses as management adjusted operations to maintain cashflow in our new normal. Well-performing businesses should continue to look at ways to use relief to avoid interruption and maintain growth trajectory.
Looking ahead, additional economic stimulus is expected, but the details may not be clear until the new congress convenes in January. Republicans may support a stimulus package of about $1 trillion, which is far lower than the $2.5 trillion passed by the House in October 2020. For many decision makers, in the interim, this means maintaining bare-bones budgets and agile operations for the first half of 2021.
Biden Brings New Tax Implications, Despite the Senate
The Tax Cuts and Jobs Act brought corporate tax down from 35% to 21% at the start of 2018 with reduced capital gains and provisions that created unique opportunities for M&A and growth overall.
President-elect Joe Biden’s tax plan suggests increasing the corporate tax rate to a baseline 28%, not only imposing increases in both ordinary income and capital gains tax rates on high earners, but also proposes the phase out of the qualified business income deduction, among other important changes. We outlined some of the specifics in our recent insights post here.
While the changes that are eventually made to the tax code will look different from the specific plans Biden campaigned on, the reality of US politics is setting in. One way the new administration can enact change is through regulation, even without a Senate majority. Rather than updating laws, Biden could use regulatory powers to change how the law is interpreted. He may push to allocate new resources to the IRS to enhance enforcement and litigation.
As such, the runoff races in January are crucial, but the 2022 midterm elections may be more significant. It is unlikely that congress will approve sweeping reform in the short term. The government’s priority is aimed at helping support the livelihoods of Americans impacted by COVID-19. As such, tax cuts for low- and middle-income households will be easier to enact, building on coronavirus stimulus measures. Raising corporate and high-income taxes will be difficult at a time when businesses are struggling.
The prospect of reform stirred late-year deal making and points to an uptick in M&A through 2021, as business owners look at divesting interests for a lower tax bill. This trend will accelerate among owners who were already thinking about a near to mid-term exit, and many who are undecided will look at selling a portion of their business likely before 2023.
Investors will also move quickly ahead of capital gains tax increases to capitalize on the lower price point of assets for sale, among other incentives the current tax laws provide.
Looking ahead, whether the business is on the buy- or sell-side, navigating tax realities will not be a simple endeavor, especially as the lower middle market continues to battle the impacts of the pandemic and lingering economic recovery.
Companies across all sectors should adjust their long-term risk appetite and focus on after-tax cash proceeds and strengthening their balance sheets in the New Year.
More M&A is On the Way
Mergers and Acquisitions create an important path to value — and the pandemic hasn’t changed that consideration. In fact, M&A will become a more crucial driver of economic recovery.
While overall deal volume plummeted in the spring and early summer of 2020 in the wake of COVID-19, it came back strong with transactions reaching more than US $1 trillion in Q3 alone. This recovery is expected to accelerate in 2021.
Buyers seek growth by acquiring market share, expanding reach, or investing in capabilities, technology, talent and new assets. Seller rationale can be tied to wealth maximization or a need to monetize business, or the desire to sell off ancillary divisions to focus on core business units. The intention is unique to every organization, but it is based on the idea of creating more value and synergy — which has become a commonplace strategy today.
Auctus Capital Partners supported a range of clients during the height of the pandemic and successfully closed several transactions that earned the attention of industry leaders and deal networks, including the presentation of a COVID-19 Closed Deal Badge from Axial. The recognition praises successful advisory roles and completed transactions since the Declaration of National Emergency in March 2020. Since then, from Q2 to Q3, deal volume increased 33% and deal value grew 140% (according to Mergermarket).
Looking ahead, corporate and private investors have access to capital and will pursue deals to build scale and expand scope. According to PwC’s Pulse Survey, more than half (53%) of US executives said their companies plan to increase M&A investment in 2021, with more than 60% saying their companies will pursue an acquisition by October. Targets will come from a growing pool of sellers, including companies that have fallen into distress during the pandemic, select private owners looking to monetize an investment, and many businesses looking to offload non-core segments with higher valuations that are likely to hold up.
For many sectors, multiples are almost the same as the heights reached before the pandemic, and the average sale price among companies considered essential increased 20% in Q3 compared to 2019 (according to BizBuySell). This trend will continue from buyers favoring smaller targets that are easier to integrate within an existing operation, without taking on added risk. Structuring considerations, such as growth capital and equity investments promote collaborations that leverage capabilities and increase growth opportunities.
Finally, industry convergence and sector consolidation may have the greatest impact on strategy, targeting, and deal activity in the year ahead. The trend will show greater blurring of lines between companies willing to move outside of the space in which they traditionally operate. Companies will look to complementary sectors or capabilities that were previously lacking; with the emphasis on strengthening customer stickiness, operational and supply chain resilience and other offsets that were identified during the height of the pandemic heights, as well as digitalization tools to streamline the new normal among workforces.
Cautious Lenders Tee Up Private Capital with PE in The Buyer’s Seat
The Federal Reserve worked quickly as the pandemic began to show its true colors, supporting the flow of credit to businesses with rates set to zero, aggressive purchases of bonds, and grants to troubled businesses. However, many lenders remain cautious in underwriting new deals, especially with businesses that were severely impacted by COVID-19.
While the cost of capital for banks remains low, lenders will likely seek to limit exposure through conservative leverage and restrictive terms. At the same time, lower middle market executives are not satisfied with bankers churning out loans with no added value. The interest expense and principal amortization associated with debt financing can create a heavy burden on the cash flow of a growing organization. This will be supplanted by equity investors who can provide invaluable board level perspective and insights to help successfully manage growth and pursue expansions, which can be as valuable as the capital itself.
Looking ahead, the lower middle market will turn to flourishing private capital and access financing through leveraged credit loans — such as mezzanine or unitranche financing — which are already driving deals. Growth equity will remain an effective tool for owners that want to remain investors but also realize a portion of their investment. In addition, it can be an effective vehicle for providing liquidity to certain shareholders, while allowing other equity owners to remain invested in the company.
On the buy side, as the pool of desirable sellers grows, more than US $1.7 trillion of PE dry powder will go to work. While this unprecedented amount of capital available for M&A has prepared PE firms for deployment opportunities over the past several years, it is their common established competencies to weather economic downturns that enable investors to remain active. PE will take advantage of sectors with falling valuations, companies trading at discounts and smaller, mid-sized businesses with less liquidity.
Diligence, Deal Structure and Go-To Market Timing Has Evolved
Despite a turbulent environment, the essential ingredients of deal making haven’t changed. Deal timelines were initially extended at the onset of COVID-19, as additional diligence was requested around heightened scrutiny on near-term financials, and the matter of social distancing delaying meetings. The rapid increase in video conferences, virtual due diligence, and adoptions of deal software and data rooms provided accurate analytical and insights that actually have decreased timelines.
Looking ahead, with today’s work environment being more virtual than ever, M&A teams will continue to adapt to working efficiently and effectively outside of the traditional norms. Auctus Capital Partners’ Managing Partner, Muhammad Azfar, addressed these trends and the evolving process driving deals in May 2020 on popular industry podcast M&A Science.
Investment banks need to have a process and strategy for the entire process— from due diligence and valuation, to documentation, meetings, negotiation terms, and closing paperwork, to capturing value after the transaction.
All-in-all, 2020 was another notable year for successful deals with the trends that will continue into 2021. However, beyond COVID-19 implications, we are in the midst of a revolution; moving towards true value-added financial advisory, serving both the CEO and CFO, speaking directly to everyone working within the organization, and advising on what to do to transform business — not just the transaction.
As investment bankers, strategic advisors and business counselors, our role has never been more important.
For more information contact the Auctus Capital Partners.