As Q1 2021 comes to an end, the financial world is busy analyzing a full year of doing business under a global pandemic. The changes to the economy can be felt in how nearly everything about everyday life has needed to change and adapt. Learning what “business as usual” even means in times of social distancing and widespread remote work has been a process for everyone, everywhere.
In June of last year, the World Bank predicted that the global pandemic would lead to one of the worst recessions since World War II. Current data is already showing the steepest downgrades since 1990 and even if a more complete picture into 2021 bends the curve towards an upward trend, the incredible impact of the COVID crisis is clear.
With the end of lockdowns in many countries and international travel restrictions slowly being lifted, people and businesses are wondering what exactly they will be returning to face. For some, there is still a vague idea of continuing from where the world left off in 2019, but the harsh reality is that COVID has already impacted how deals are made and how negotiations are conducted.
About private equity and M&A, there has been an understandable decline in the number of closed deals. With everything around due diligence and determining the exact terms of a contract is more difficult, new outlooks and perspectives have needed to be adopted to find success.
→ Post-COVID deals will be marked by buyers and sellers with a strong will and an adaptable spirit.
While the long-term impact of the global pandemic has yet to fully be seen, it’s fair to say the overall slowdown felt around the world has generated a large amount of macroeconomic uncertainty. Specific industries and countries will differ in how the impact is felt, but in general, everyone needs to take on a more cautious mindset and attitude in the face of a more uncertain future.
As a firm example of how strongly economies have been impacted, the National Statistics Institute (INE) in Spain announced an 11% decrease in GDP as a result of complications from the COVID crisis.
The situation before COVID was already incredibly complex as well, with different countries and their domestic policies inherently having a strong effect on macroeconomic tendencies. If you look at nothing but the numbers, the GDP of the USA is about 40% higher than the EU-15 average. However, a lot is hiding behind those percentage points that are difficult to see without the proper perspective.
→ Understanding statistics and numbers in context help deal better adapt to everyone’s needs.
In the USA, people tend to work about 20% more than the average worker in Europe. Adding the overall higher unemployment rate in Europe makes the difference between the two regions even easier to understand.
Buyer and Seller Perspectives on Pricing
One of the more common issues between buyers and sellers comes down to a difference in perspectives on pricing. In the COVID era, the immense amount of macroeconomic uncertainty adds to that pressure, greatly affecting negotiations and how deals are made.
→ How the global pandemic is affecting a company needs to be carefully considered before talking about the specifics of a deal.
For M&A, this macroeconomic uncertainty is felt the strongest in disagreements between valuations between buyers and sellers. Sellers often want to use pre-COVID financial statements to evaluate the estimated value of their company. There is a reasonable reluctance to lower the price due to the uncontrollable impact of the pandemic.
Buyers are then just as worried about all the uncertainty surrounding these deals. On one hand, some opportunistic buyers simply see the current state as a chance for a much lower price. Many sellers are in a somewhat desperate position and they may not have any choice but to accept lower offers based on valuations they don’t necessarily agree with.
On the other hand, there are also many buyers looking to focus on longer-term growth, searching for healthy companies that show promise. These buyers still want to evaluate them based on their current COVID era performance and potential to reduce as much risk as possible.
From an honest buyer’s perspective, there’s an understandable degree of mistrust reluctance in using pre-COVID numbers and using projected forecasts. These numbers tend to raise the price seemingly artificially without any real proof in an era of unprecedented macroeconomic uncertainty.
→ The impasse between buyers and sellers is nothing new, but the broader context shifting so far from the pre-COVID climate has made the conversations more difficult than ever before.
Finding Common Ground in the Context of the Pandemic
One thing that hasn’t changed since the pandemic hit is the importance of being able to create deals where everyone feels satisfied. The win-win atmosphere that buyers and sellers should strive for may require different negotiation tactics and strategies as everyone shifts to video conferences and remote communication, but the goal remains the same.
→ All parties should be trying to find a way to make sure everyone involved is happy and satisfied with the final deal.
To make it a bit easier, private equity managers have a couple of tools that have proven to be
incredibly useful during the pandemic:
- EBITDAC. A new accounting measure was introduced to take into account the economic effect the global pandemic has on businesses. The expanded acronym, Earnings Before Interest, Taxes, Depreciation, Amortization, and Coronavirus, clearly shows how it is calculated with COVID in mind.
The distortion caused by supply chains and entire countries being locked down makes the use of this new metric understandable, especially when faced with the need to ensure credit lines and prospects. However, it can be seen as hiding details when entering into M&A negotiations, which is detrimental to the building of trust between buyers and
sellers. - Earn-outs. This optional pricing structure is not new, but it has proven to be extremely useful as a way to comfort both negotiating parties as they face uncertain macroeconomic trends. With buyers tending to undervalue companies and sellers tending to overvalue them, earn-outs offer a way to bridge the gap between the two price points. Sellers can “earn” some of the buyer’s price and pay it after the deal is made. The amount a company needs to pay overtime is calculated using their current performance and potential, removing much of the risk associated with COVID era deals.
Earn-outs in particular are rising in popularity in the early recovery era. Buyers are drawn to this win-win option, proving it to be a solid way to move M&A deals forward while keeping risks to a minimum. Sellers are not always as enthusiastic about earn-outs though. The situation often boils down to not wanting to lose future earnings to a current deal, especially when the offer is determined by COVID era numbers.
→ In most negotiations, there is a mutual understanding of the need to reduce the risk that helps M&A deals move forward.
Buyers and sellers have learned to adapt, finding the right tools to bridge the gap between their different perspectives. The post-COVID era will be marked by that attitude of accepting and working with a new reality rather than against it.
How Itaca Capital Partners Invests in the COVID-19
ITACA CAPITAL PARTNERS has noticed a significant uptick in the use of earn-outs in several M&A deals from both its direct-investing and search funds portfolio during the global pandemic, especially when compared to the pre-COVID decade in which abundance of liquidity has increased pressure on private equity managers to pay high multiples and accept relatively loose terms. private equity in general.
With over 70 years of combined M&A and private equity experience, the partners at ITACA entered the search fund space before the pandemic attracted by a 30-year industry track record of 30% IRRs. When the pandemic hit, a reasonable concern came about whether the benchmark finds a ratio of 75% over the 2-year search period would maintain. Just 8 months into the process, already 2-thirds of the initial searchers had found a target company to buy and are still in advanced stages of due diligence.
For ITACA, two main points reasons are underlying this early that led to finding success in the era of macroeconomic uncertainty:
The search funds’ win-win focuses on sellers with legacy concerns beyond price. Search funds approach retiring owners who care about their legacy: company culture continuity, employment preservation, and client reputation. After all, these companies are generally a 30-to-50 year masterpiece of hard-working founders who have had little time to think about succession and their main goal is for their life product to continue to run forever when they step down. If a company owner is only concerned about a specific price point and early cash-collection about a specific price point, they are less likely to care about selling the company to the best candidate for long-term sustainable post-acquisition.
Use earn-outs to bridge the gap between pricing perspectives. There will always be disagreements around the exact value for a company when negotiating M&A deals and these gaps are larger in times of the pandemic. The natural process of finding terms, conditions, and a price that everyone can agree to involves going through the steps of due diligence and risk assessment to find objective metrics so everyone is at least speaking the same language. Getting everyone on the same page is all the more important in the era of a global pandemic. Earn-outs are proving to be the favorite pricing structure for all parties as, they do allow for smoother and more transparent negotiations, giving M&A deals a clearer perspective with the firmer ground to stand on and often result in a higher total pay-off to the seller.
Increased focus on Trust and Transparency is here to stay
The global pandemic and economic downturn have greatly affected businesses everywhere. Macroeconomics in the post-COVID is marked by low-interest rates and high volatility of equity markets. As a result, investors shift interest to private equity and all its sub-classes from good old mid and large-cap LBOs and growth plays to emerging asset classes such as venture capital, SPACs, and search funds.
In all subclasses we expect increased efforts to operate more transparently, both when it comes to deal terms but also as to how the whole private equity industry works when it comes to returns benchmarking, fees calculation, and co-investment opportunities.
→ The flow of capital towards private equity in the turbulent times of COVID should result from increased transparency of the private equity industry and a cultural change as to how deals are done when it comes to negotiation and value-creation strategies.
Transparency is the core value of ITACA and we see it as the only way to operate in this market. Private equity is a risky and complex space. The only way to operate is to stay humble, work to reduce the unknown, and be aware of the fact that reality always tends to differ from expectations. We are not alone in this approach; all the contrary, we think it will become the norm.