After the now legendary “COVID bump” in valuations, have those gains leveled off now or not? And are they accounted for as the normal course of business?
King’s Servant: Valuations have come down some from 2021 levels. There’s nothing normal about the economic and societal challenges and transformations businesses have faced over the last few years and the uncertainties they continue to face. But when those valuations come down and stay down, there will be opportunities for greater returns to be discovered. The market and deal terms have adjusted to COVID-19 risks, and many companies have already dived and continue to divest non-core businesses. From a legal perspective, we have already seen the impact of the pandemic flow through the documents, such as in force majeure clauses, but it will be interesting to see how this continues to play out over time in the definitions of material adverse effect and in review by the courts.
this: In general, valuations seem to have leveled off or are coming down some from those that came out of the COVID recovery in 2021. With respect to the impact of COVID-19 on the operations and financial results of target companies, there are many factors to consider when evaluating normal course vs. temporary impacts due to pent up demand, federal stimulus, shutdowns, and furloughs, etc. Given the impact of COVID-19 varied greatly across industries, regions, and employee groups, it is necessary to evaluate each individual target and consider pro forma adjustments to normalize historical results on a case-by-case basis.
Flanagan: It appears that valuations certainly peaked in 2021. Many investors are reluctant to overspend given the macroeconomic issues we have discussed. These issues are coupled with sellers not being willing to come down on their price expectations. There seems to be a disconnect between what sellers and buyers feel a business is worth — which is another reason the deal pace has come down this year.
With a cool down in multiples, are we entering a buyer’s market? If yes, what should sellers keep in mind?
King’s Servant: It is true that M&A multiples did cool down, but if you look at the second quarter of 2022, they are nearly where they were for the first quarter of 2021. It may take some time before this is widely known or for the market to react . So it may be hasty to say that we are entering a buyer’s market. We are probably looking at a more balanced market, at least in the short term. With that in mind, it could be a mistake to approach transactions too conservatively. M&A investors still have significant capital to be deployed, and those advising them may want to revise their strategies to take advantage of these new opportunities and valuations.
this: As both borrowing costs and macroeconomic risks increase there will be less room for error from both buyers and lenders perspectives, which will reinforce the importance of sell-side diligence. It will be imperative to come into a process with clean numbers and avoid surprises to prevent re-trading and dead or stalled deals given there is going to be even greater scrutiny around the financials and less willingness to absorb multiple expansions that could result from findings in the buyer’s diligence process.
Flanagan: We don’t see that multiples have come down much. You might see that more in the public to private space where stocks might look cheap on a relative basis. It is certainly possible for some of the companies that merged with a SPAC to be taken private again as many of those stocks have been punished in the public markets. In this market, buyers see a lot more uncertainty, and most sellers still have not reduced their expectations on what their business is worth.
What are the best areas of opportunity for private equity investors right now? Are you seeing particular interest in certain sectors or industries?
King’s Servant: Private equity has been and continues to be an important player in the M&A market. Practitioners in the United States know that there is significant capital in the private equity market that can be deployed in the second half of 2022. Although it recently has shown a decrease in volume, the technology sector is still a significant driver when it comes to the percentage of market share, and we’ve seen some of that at our firm. Private equity investors may also begin to focus on areas such as renewable energy, life sciences/health care, or financial services, where there has been some growth in market share and which could continue to heat up.
this: While there is a greater level of unpredictability than in recent periods there may be opportunity for PE investors in the form of multiples coming back down to more attractive levels. While there is no single set of industries, we see PE investors focused on in aggregate, economic headwinds and increasing borrowing costs will make focused attention on the investment thesis important throughout the transaction cycle from careful diligence, to value creation through synergy capture and effective post – close integration. As a result, PE investors are likely to emphasize industries and sectors where they have existing expertise, platforms that are expanding through roll-up strategies, and where there is opportunity for synergy and supply chain integration across the portfolio.
Flanagan: Healthcare remains very resilient and attractive to many investors. The healthcare sector has proven to be a solid performer even in uncertain times. While we are not seeing as many “platform” investments as we did last year, we are seeing a healthy amount of “add-ons” in this environment as companies look to make strategic smaller acquisitions. While these might not be as sexy as new platforms, they certainly can be very accretive to earnings throughout the ownership of a given company.