M&A in the first half of 2020: What does it look like?

At the start of 2020, the outlook was very positive for U.S. accounts receivable management (ARM) companies. The economy was strong. Public stocks were performing very well. Consumer confidence was high. Companies and governments were outsourcing. Regulations were being clarified. Mergers and acquisition (M&A) markets were attractive for buyers and sellers alike. But what does M&A in the first half of 2020 look like?

How is M&A in the first half of 2020 faring?

The rate at which M&A transactions closed, compared to previous years, plummeted in the first half of 2020. We attribute this reduction directly to the emergence of the Coronavirus (Covid-19) pandemic in the U.S. Many owners who were positioning to sell their company earlier this year put their process on hold, starting mid-March, to focus on moving employees home to work. Financial performance was also in question as some clients and state governments ceased collection activities into specific regions, and for certain types of accounts, such as student loans. Deal activity slowed immensely as buyers were forced to reassess budgets and forecasts to account for the impact of the virus. Representations and Warrantees provisions were scrutinized so buyers were not left “holding the bag” if sellers underperformed. Due diligence processes also slowed to a crawl as travel came to a virtual halt. 

What can we expect for the second half of 2020?

We do not expect a pickup in the amount of M&A activity in the U.S. ARM industry this summer as many states are reporting significant increases in the number of COVID-19 cases in their regions. Fear of a second round of closings is looming large, preventing some buyers from getting comfortable that the terms of their transactions will account for potential downturns. Starting in September, business buyers and sellers alike will focus on the November elections as outcomes will impact M&A transactions. A new crop of business buyers is also emerging, sending letters to owners and calling brokers to express their interest in acquiring underperforming companies at bargain-basement prices. While some companies will be forced to sell during the pandemic, most owners will wait until the market stabilizes.

Some buyers are adjusting their acquisition criteria.

Some acquisitive ARM companies are changing their buying parameters to adjust to the effects of the pandemic. As recent as three months ago, some experienced buyers were targeting specific market segments for expansion. Now they are seeking to purchase companies that will diversify their companies into new asset classes less impacted by the virus. For example, some top performers in the Federal Government sector are looking into new markets for growth as the U.S. Department of Education ceased collection activities until September. Other new “vulture” buyers are emerging, looking for distressed companies they could purchase for little or no cash. 

Other buyers are concerned about their own depleted resources during the pandemic.

Most leadership teams are fixated on their own business performance and cannot afford to be distracted by making acquisitions in the immediate future. Some companies put a stop to business travel since March. Remote due diligence efforts require a level of sophistication that most companies simply do not possess internally. The cost and availability of external resources is another limiting factor. As existing resources are stretched very thin, most due diligence processes are being extended by months to account for these shortfalls.

Pricing gaps have widened between some sellers and buyers. 

How transactions are priced is always a concern among buyers and sellers alike in any market. In today’s volatile market, some sellers are holding onto 2019 valuations, citing concerns that performance downtowns are only temporary and their revenues and profits will rebound so they should not be penalized with a lower purchase price if they were to sell their company during the pandemic. Most buyers of ARM companies will continue to look closely at historical financial performance, but they tend to value the selling business based upon current performance indicators. This creates the potential for a huge gap in pricing between buyer and seller. Some buyers are looking to bridge that gap with creative deal terms and longer term earnouts so they can share the risk with the seller, whereas most sellers still want cash-heavy transactions if they were to part with their company. 

Is EBITDA being replaced with EBITDAC?

Most buyers price selling businesses based upon their calculation of normalized or adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Allowances are made for certain non-recurring or excess operating expenses to establish a baseline EBITDA level for pricing calculations. Over the past three months, some buyers started adding back the impact of COVID-19 (“EBITDAC”), trying to adjust for the cost of moving staff home or temporary client losses. While this addition will be short term, it will have meaningful impact on transactions that close in 2020.

Buying and selling companies is a challenge in any market. During this current pandemic, it is even more challenging to complete M&A transactions. If you have any questions, please contact us at hq@kaulkin.com.