Like many of us whose businesses are tied to the vagaries of the M&A transaction market, we are keenly interested in how transaction professionals are currently viewing it. While holed up in my home office over the last couple of months, I’ve had the opportunity to better connect with many of them (Zoom has been a useful tool to those unconverted to it) and frankly, the most interesting conversations have been with Private Equity folks. As the most significant acquirers of lower middle market businesses, it is always enlightening to hear what they have to say.
My takeaway is that PEGs have been focusing on trying to answer two questions:
- What should the impact of the pandemic be to valuations?
- How will lenders react to all of this?
PEGs in particular are monitoring their portfolio investments and generally see these falling into what one called a 20-60-20 distribution. 20% are doing fine or even better. 60% are having issues and will recover post pandemic. The remaining 20% are being severely impacted with no clear understanding of what their future will be. With this happening, PEGs are asking the same questions about their portfolio companies as they would of any other new acquisition. We know what we paid for them but what are they worth now? As they think through the process what I’ve been hearing them say is that the firms still doing well should get a pre-pandemic valuation and maybe even a premium to that, but the rest shouldn’t. The idea of a Covid-19 earnings add back adjustment seems to be going by the wayside and any company other than the top 20% will have to earn out a pre-covid valuation.
What about lending? PEGs have begun to see a retrenchment among senior lenders. They are financing transactions with debt to equity ratios of 3 to 4 times versus 4 to 5 times in the pre-pandemic environment. Increasingly, lenders are also passing on deals they would have financed at the drop of a hat earlier in the year. More expensive mezzanine capital or other alternative sources will have to make up this shortfall. The long and short of it, costs of capital are increasing which will impact returns and negatively affect valuations.
What does this all mean? The general consensus is that valuations will suffer for all but the best performing firms. The future is still too cloudy, and the costs of capital are increasing. Not great answers but this could change. If the economy rebounds more quickly than anticipated then views could change. In the meantime, though, I suspect fewer deals will get done because of this valuation gap.