Back in April, I wrote a commentary titled “Nobody Knows Anything” that described the immediate challenges facing the M&A industry in the wake of a global health crisis that rendered inoperative most methods of business valuation.
Since then, we’ve all tracked the successive waves of normalization – first the companies that could be valued and traded irrespective of coronavirus, then the businesses enhanced by or at least able to power through the pandemic, and finally the ones regaining their footing and able to forecast beyond these unusual conditions.
GF Data’s just-released August report provides some hard numbers to place alongside the anecdotal experience. The report captures completed transactions in the $10 million to $250 million total enterprise value (TEV) range reported by 227 private equity funds and other deal sponsors as of June 30, 2020.
Total debt averaged 3.9x in Q1, in line with overall averages going back to 2017 but in Q2 total debt fell to 3.3x.
While COVID-related strictures began to take effect in March, first-quarter deal activity tends to be weighted toward the beginning of the period. So, the quarterly splits give us a fairly sharp view of what got done before and after the onset of the virus.
Here’s what we know:
- Volume fell off the table. GF Data contributors reported completed deal activity in Q2 at about 40% of the volume level in Q1 and in the year-ago second quarter.
- Valuations stayed aloft. Pricing on this markedly smaller cohort averaged 7.4x TTM Adjusted EBITDA in the second quarter – the same as in the first quarter, and within the trading range that has prevailed for the past several years. There was remarkable consistency within deal size brackets. The Q2 marks by TEV range were:
- $10 million to $25 million – 6.1x; $25 million to $50 million – 6.9x; $50 million to
- $100 million 8.4x; and $100 million to $250 million – 9.7x. None of these multiples varies by more than .2x from the corresponding figure for Q1.
- Deferred consideration mechanisms helped — on smaller deals. One question widely asked in the last few months: has there been increased use of seller financing or earnouts to bridge valuation gaps? The use of these structuring devices rose from 35 percent in Q1 to 39 percent in Q2 but deals in the $10 million to $50 million TEV bracket accounted for all of the pick-ups. At $50 million to $250 million, the incidence was essentially unchanged.
- Favored sub-sectors remained active. Completed deals are publicly reported, so GF Data has no proprietary window on deal composition by industry. However, our data does show with precision the extent to which sub-sectors, rather than the broader publicly reported categories, are finding favor. NAICS categories 5416 (IT consulting) and 4234 (healthcare-related distribution) are two examples.
- Debt retrenched immediately. Total debt averaged 3.9x in Q1 – in line with overall averages going back to 2017. In Q2, total debt fell to 3.3x.
- Average equity share spiked. Static deal pricing with reduced debt meant more equity was required to get deals done. Average equity contribution jumped eight percentage points, from 48.7 percent in the first quarter to 56.5 percent in the second quarter.
- Deal mix tilted to add-ons. Not surprising given these dynamics — sponsors found it easier to complete additions to existing portfolio companies rather than to capitalize and close on new platforms. In the period 2017 to 2019, platform acquisitions accounted for a consistent 75 percent of our reported deal volume. In the first quarter, this percentage dropped to 63 percent and in the second quarter the figure was 45 percent.
- Bank and non-bank lenders both receded. One trend noted in GF Data’s first-quarter report was the convergence of commercial bank lenders straining to compete with non-banks, and non-bank lenders providing more conservative capital structures to acquirers preparing for a conventionally recessionary environment. That apparent trend was obliterated in Q2. Average debt in uni-tranche deals continued to decline, from 3.6x to 3.0x. Average debt provided by commercial banks, however, plummeted from 4.0x to 2.6x.
- Mezzanine financing stepped in. We have remarked before on the counter-cyclical resilience of this class of capital providers. The only “up” leverage metric from Q1 to Q2 was on average debt involving mezzanine/junior capital providers, where there was a jump from 3.7x to 4.6x.
- Deals that closed commanded favorable key deal terms. The general cap on indemnification against breaches of reps continued a multi-year trend of decline, averaging 8.6 percent of TEV in Q1 and then dropping further to 6.7 percent in Q2. While there was little movement in valuation across quarters, this may well be a comment on the robustness and risk profile of the select group of deals that found the finish line this spring.
We see no reason to expect radically different conditions for the balance of this year, and possibly the first quarter of 2021. (Sellers a few months away from close are already interested in avoiding potential federal tax changes, which will pull some volume back into this year.)
Looking forward, a groundswell of new products is being prepared for launch post-election. Also, private equity funds and lending sources that are not focused in favored sub-sectors are now content to keep their powder dry in anticipation of a more settled political and public health environment in a few months.
By then, we may know a lot.