In fact, the pent-up demand of Private Equity (PE) and the desire of sellers to come to market has been building since the early days of COVID-19 in the spring. Like many sectors, the March-May timeframe saw coming-to-market PE deals slowing down. The result? The industry’s agenda throughout summer and early fall was dominated by valuations that needed revisiting as well as cash-draining situations at many companies that needed to be addressed.
But as private equity firms began adjusting to new work-from-home (WFH) realities of COVID-19, some other interesting parallel developments also began happening in the deal market:
- A renewed focus on the basics. PE firms began spending more time with portfolio companies on core issues such as improving their finance excellence and key reporting functions.
- Business continuity was uninterrupted. C-suite transitions continued as planned, as Zoom-only interviewing of a CEO or CFO became a reality and key transformational hires were brought on board.
- Remote due diligence is now a reality. This included more creative use of technology, less on-site travel, and more peer-to-peer conversations between senior-level PE funds.
- Bottom line: PE deals are getting done.
Valuation, Exits and Aggregate Deal Level
PE’s current state can be told in three ways: valuation, exits and the aggregate deal level. A quick glance at all three and it may look and sound like the pandemic never took place.
Valuations have always been an art and science to begin with, and through the early stages of the recession a new term emerged: EBITDA(C). No, that’s not a misprint. Nor does it mean “copyright.” You guessed right: The (C) stands for the impact of COVID’s business disruption on your adjusted EBITDA calculation.
The numbers started being recast in several deals beginning in April and May as they neared closings, impacting working capital adjustments and deal-term assets.
There’s now a place in deal vernacular to take a one-time adjustment/event (Q2-Q3 2020) and to assess its overall impact on companies’ valuation and operation companies moving forward.
Analyzing historic and future data sets has always been critical to valuation. The issue today is whether the industry has the vision to quantify Q2-2020 as truly a one-time event to earnings—or a longer-term trend that will transform the business.
While private equity would have expected decreases in hot valuations prior to COVID-19, it wasn’t for long. Valuations are still high as measured by enterprise value/EBITDA multiples.
Overall to date, annual deal activity is trending down, which is no big surprise. However, while Q2 was a bust, deal trends are up again in Q4. Additionally, reduced market exits are a clear sign that PE firms are using the time to strengthen the enterprise and ride the higher valuations trend to time a more opportune exit.
Indeed, by calendar’s end, there’s even a possibility that 2020 could end up being a net positive year for PE deals.
Three Major Lessons from the Pandemic (So Far)
- Watch the scoreboard. There are winners and losers on the industry side. Among the winners: owners of companies in healthcare, B2B enterprise productivity software and technology-enabling business models will weather the downturn and become hot industries that can demonstrate growth with agile business transformation. Those not so lucky include most B2C and food services as well as hospitality and travel companies, which will likely take large hits as their models transform slowly.
- Build it and they will come. PE firms that have adapted technology to the deal lifecycles are finding deals are getting done and new platforms are onboarding. Diligence, recruiting, executive mentoring and transformation done with technology can create value and growth in the emerging blended workplaces of the future, combining on-premises with WFH. Technology and a new way of looking at deal thesis and timelines to measure value and growth are now important trends in PE operations and they’ll likely stick moving forward. Early digitization and cloud migration adopters will be rewarded for their foresight.
- Drive value. Value creation and growth is a three-legged stool of top-line growth, finance excellence and superior tech/operations. Companies with all three will come out ahead. Doing the right deal and having a platform company that has scalable processes will aid in speeding the growth. Smart integration of add-ons and finding assets that need remediation and which can be dropped into a platform will continue to drive rapid value.
Trends to Watch in 2021
With 2021 now around the corner, be prepared to watch some emerging trends impacting the upcoming year:
- Top-line organic growth will be challenging throughout most of 2021, and buying revenue, markets or product development initiatives will be a popular route. The current upswing in middle market deal multiples from Q2 onward in 2020 proves that this trend is real.
- M&A activity will increase in 2021. Several factors could be in play. Perhaps it’s due to pent-up supply from 2020. Perhaps more carveouts are possible. Or it could be because of potential tax changes. It might even be a combination of all three, but this much is certain: deal supply will be up—especially in the middle market.
- Watch valuations and debt support levels closely. There may come a point where private debt (while abundant) will not support weaker assets at transaction. Will this slow the market or will excess debt create a middle market company bubble to be held by private equity? Remains to be seen.
Finally, as mentioned earlier, Q4 2020 may indeed be like year-end closes in years past. But with 2020 being unlike any year in recent memory, Q4’s possible stellar performance could end up being the quarter that saves a year that few thought would end well. Stay tuned, PE’s 2020 story is still being written.