After months of uncertainty, we are seeing a strong uptick in private markets, concurrent with public market moves. This positive momentum is enabling companies performing well to achieve valuations that are as high, if not higher than pre-COVID-19 levels.
Identifying the true best buyers and running even more targeted processes is critical for realizing successful transactions in the current environment. This targeted approach is well suited to our M&A processes at Cascadia, where we offer extensive experience within our respective industry verticals.
Ramping Back Up
Following a springtime transaction freeze and a general focus on PPP loans in the lending markets, things started to thaw in May, with investors looking to validate monthly financials for target companies by mid-summer. Investors are increasingly feeling more confident in the sustainability of strong company performance, and they are willing to pay premiums for investments in sectors where they have pre-existing assets and/or deep vertical experience.
Optimal valuations and transactions in this climate are dependent on:
- Laws of supply and demand: We have $1.5 trillion of un-invested equity capital (1) in private equity and hundreds of billions in family offices now making direct investments in private companies. When you combine this with many industries being largely un-investable because of material revenue declines in this COVID-19 period, we estimate the overall pool of growth companies in which to invest is down approximately 50% versus 2019. The laws of supply and demand are kicking in here, with over five times the un-invested capital chasing roughly half the companies that remain, resulting in material increases in interest and valuation for the right companies in this market.
- Targeted and creative processes: Getting a great valuation in the current environment requires advisors who know the seller’s industry well and thus can identify the best buyers efficiently without the distraction and confidentiality risks of a broad process, providing clients guidance on specific potential buyers and investors rather than entertaining dozens of bids.
Trends in the post-COVID deal-making climate include:
- Aggressive hybrid investors making preemptive bids
- Narrowing buyer universe to those with pre-existing subsector knowledge
- Lenders’ flight to quality
- Shifting dynamics of due diligence to accommodate COVID safety protocols
PE Firms Deploying Funds Through Platform Add-Ons and Preemptive Bids
Private equity-backed portfolio companies focused on strategic add-on acquisitions, sometimes known as “hybrids,” are rising to the top as some of the most aggressive bidders in the current environment.
While it is more difficult for PE firms to put forth an aggressive bid on a new platform given COVID’s impacts, they still have committed funds that must be put to use. They can use their existing platforms to execute deals in the same or adjacent spaces—especially with those portfolio companies showing clear evidence of stability through the pandemic—and they are becoming more comfortable with paying premium prices to win auction processes.
In our recent transactions, between two and four hybrids are typically a good fit for a given company from a counterparty perspective, and they are often submitting preemptive bids. These PE-backed strategic bidders usually track the targets in their space closely, and they are viewing this as an opportunity to be assertively acquisitive while public strategics are otherwise occupied with internal operations.
Because hybrid companies are backed by professional investors, they are also able to move quickly. Some are moving at lightning speed—getting to executed letters of intent within as few as 20 days and aiming to close within 45 days. Hybrids are increasingly making commitments not to re-trade, which sellers particularly enjoy in an uncertain economic climate.
Additional factors driving sellers to accept preemptive bids include:
- potential impact of the presidential election in November;
- certainty to close before year-end;
- and potential tax code changes in the coming year.
These factors may influence a company to take an offer that is close to the top but not necessarily the absolute highest dollar in order to complete the transaction in a shorter period. Acquirers that tend to move quickly on deals they like can often be the best buyers of those companies anyway—their speed is reflective of their comfort and experience in the space.
We are also seeing a dynamic in which sellers are seeking to be well-educated about which acquirer can pay the highest price on a preemptive basis and their motivations for doing so. As advisors with deep industry knowledge, we are better equipped to assess when a preemptive bid is likely where we would have ended up anyway in a process. With knowledge of the market, we’re able to help our clients decide what is a “market-clearing price” in the absence of a full process.
Sub-Vertical Knowledge Creates a Narrowing Buyer Universe
Dramatic changes in post-COVID demand curves are streamlining processes and narrowing the universe of buyers, with subsector knowledge becoming a key differentiator.
Cascadia is moving toward more niche projects as we shift to defined practice areas. Our clients have a certain level of sophistication; they often know who the top buyers are in their sub-verticals and are hesitant to look outside of that group. We know our industry sectors intimately, and we do not need to execute broad processes to find the right 5-20 interested investors that will be willing to pay the highest price, move quickly, and provide assurance to close.
Across the firm, we are seeing knowledge about subsectors as a critical diligence factor given COVID’s limitations on execution. Going into deals, buyers must already be well-informed about sub-vertical dynamics in order to feel comfortable enough to pay a top price and close quickly without extensive in-person diligence.
PE firms backing hybrids know the underlying industry elements and are already underwriting those themes. They know the demand curve and do not have to be educated—they simply want to know about our client’s performance and how that tracks to their existing understanding of market dynamics.
As Lenders Look up from PPP Loan Execution, Quality is Key
Coming out of a frothy period in 2019, companies may tend to have higher valuation expectations despite current market factors. Higher margins, technology, velocity, growth, and scale can push businesses into the higher quartiles, as all of these factors influence the ability to obtain the leverage required to support higher valuation expectations.
Lenders’ risk appetites for deals that take on five- or six-times leverage has not yet returned since the COVID-19 slowdown. Some banks and middle-market debt funds are returning to business as usual, but those with portfolios hit hard by the downturn are being more conservative with leverage levels.
There is a general flight to quality among lenders, who are looking to take on safe, low-risk ratings. Industry leaders are getting deals done at high valuations, and lenders naturally want to be involved with those.
Hybrids are also able to get favorable financing to increase speed and certainty of close because they already have banking relationships and borrowing capacity at the platform company level.
Long Overdue Diligence
Some processes that went on pause during the early COVID-19 period have come back, depending on the industry. Food, beverage, agribusiness, technology, robotics, industrial automation, and healthcare deals, for example, are accelerating. Those involving physical assets that investors want to visit in-person, however, have an elongated timeframe because of pandemic-related travel considerations.
More diligence is being performed remotely, but in-person meetings are still important for a buyer to finally close a deal. For the most part, this is not a gating issue, as investors are starting to travel again. Those meetings must now typically meet a high-bar, and they involve fewer people while observing COVID safety protocols.
We may not be shaking hands, but deals are now getting done.
We are seeing market-clearing valuations, even in this post-COVID environment. With the right advice, companies can achieve top valuations and timely, successful transactions. Please reach out to our team using the contact information below to discuss these or other factors impacting your clients and contacts.
Senior Vice President
(1) Wall Street Journal, Private Equity’s Trillion-Dollar Piggy Bank Holds Little for Struggling Companies, June 28, 2020.