2020 is officially over, which is a big relief for many, given the personal tragedies and hardships endured by some during the global pandemic. Although the pandemic hasn't ended with the new calendar year, there is a renewed sense of optimism because the COVID-19 vaccines are being distributed in a rapid fashion, and it is the hope of many that the U.S. and other countries can soon begin to lift our super-restrictive policies and stop feeling so fragile.
As it pertains to M&A, 2020 was a strange year by any standard. U.S. lower-middle-market deal activity got off to a strong start in 2020, only to have Q2 and Q3 report dismal M&A trends for obvious reasons (COVID made its debut on the West Coast in March). Simply put, in March, April, and May, deals basically came to a stop as many active transactions were halted and new transactions ceased all together. Despite this, the M&A markets began to roar back in late Q3 and Q4, and deals were beginning to get started or re-started for a hopeful year-end 2020 or Q1 2021 completion.
As of today, there are mixed business results throughout our economy, which usually has a big impact on any outlook for M&A. Unemployment has escalated, some industries have been decimated by shutdowns or weakened consumer appetite, and there is a great deal of uncertainty in the U.S. with regard to when things are going to occur and how the political climate will change now that we have a newly elected president. When there are this many factors to consider (softness and uncertainty), it is usually not the most ideal time to think about selling a business. While I would generally agree with that premise, these aren’t normal times, and there are a number of overriding catalysts that lead us to possess a very bullish outlook for 2021 M&A.
1. Capital gains tax rates will likely rise under a Biden presidency. Those who were already thinking about selling in 2021, 2022, or even 2023 are probably going to start serious conversations and efforts now in order to take advantage of the lower tax rate environment. Biden’s tax plan calls for capital gains tax rates to nearly double from 20% to approximately 40% on investment profits over $1 million. Now that the Georgia run-offs are complete and the Democratic Party looks set to control of the Senate, tax rate increases are more imminent than once thought.
2. Business owners seem tired and are thinking about life differently. Leave it to the tragedy, trauma, and need to navigate through non-business-related issues in 2020 to make an owner question themselves and whether carrying on with running a business makes sense.
1. Private equity is still flush with capital. Dry powder to invest actually grew during the pandemic from $1.4MM to $1.6MM. This level is rivaling historic highs.
2. Specialty Purpose Acquisition Companies (“SPACs”) are seemingly back in vogue now, and they are getting transactions done. SPACs go public solely to raise funds to acquire or merge with private companies. 2020 saw three times as many SPACs complete IPOs, with the total capital raised being nearly five times higher. How long these will remain popular is anyone’s guess but, while they are here, they will continue to be very active consumers of transactions.
3. Lenders have held up reasonably well throughout the pandemic, but there is a slightly more conservative approach when lenders are reviewing transactions. Based on observations, lenders have pulled back on some of their appetite from a total leverage perspective, and there tends to be a lower pain threshold for 'storied' credits. In general, the usual banking process has slowed considerably, which is certainly adding to the lengthier deal timelines we are seeing.
4. Technology and efficiencies are now all the rage, as many have been forced to work remotely while keeping up the same output and pace. Because of this, there is a much increased enthusiasm for any transaction that can either provide efficiencies for the buyer or that can become a new product or service added to the buyer’s roster of products or services already offered
Our View on Valuations
We anticipate that valuations will hold steady or increase slightly in 2021. During the pandemic, valuations, or multiples paid relative to a Company’s earnings, showed some mild contraction relative to 2019 highs. The more noticeable changes stemmed from how the valuation was actually paid: the percentage allocated to cash, stock, seller note, or earn-outs. Throughout 2020, lower proportions of cash were being paid to sellers, signaling some ‘flight to safety’ by buyers, given that non-cash considerations are more contingent in nature. Company valuations have begun to increase from their pandemic lows, and we anticipate steady increases to start the year as order and our psychology is continually restored.
Despite some uncertainty, the M&A markets could and probably will have a very big year, barring some unforeseen new event such as what we saw in 2020. A pent-up supply from business owners who wanted to sell last year but held back, coupled with a very real risk of tax increases during the next four (4) years, and growing fatigue with having to navigate the pandemic and its side effects (new protocols, forced shutdowns, looting, rioting, etc.), all add up to what could be a very active year for M&A. Many business owners will use this as an opportune time to make their way to the negotiating table. Our M&A team has fielded an unusually high volume of messages from business owners who are worried by the unknowns, the state of the economy, and/or the risk of tax hikes. This last part is not incredibly scientific, but this uncharacteristically high number of inquiries is generally a very good indicator of future activity.
General Advice to Sellers
If a business owner has even remotely been thinking of selling, now is the opportune time to visit the situation and explore what a sale process would look like for them and their company. It is best to explore this situation with an investment banker, a very good M&A attorney, and a sophisticated wealth advisor that can simulate life after a sale (it takes all three professions to formulate a well informed decision). Assuming the Company is ready and marketable, valuations are still very good relative to historical norms. Most of the buyer panic (during the pandemic) has diminished, and the proceeds that are paid to a seller are presumably ‘on sale’ right now before new tax legislation is enacted and capital gains rates go up significantly. There is a huge difference in keeping 75-80 cents on the dollar as opposed to 60-65 cents on the dollar, all related to taxes. The only area of caution to sellers, assuming they push forward with a sell-side process, is that they will need to be patient. Deals are taking longer these days. It seems that the key players needed to get a deal done aren’t as efficient as they were prior to the pandemic.
As always, VonLehman’s M&A team is at the ready to assist you with all your buy or sell-side needs. Contact VonLehman’s M&A Director, Keith Carlson, at firstname.lastname@example.org or 800.887.0437.