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How to approach M&A under the new normal

Matthew Woodgate Matthew Woodgate

Recent world events have seen the way every sector does business change dramatically in a short period of time. Matthew Woodgate looks at how you need to change your approach to M&A transactions under the new normal.

Recent world events have seen the way every sector does business change dramatically in a short period of time. Matthew Woodgate looks at how you need to change your approach to M&A transactions under the new normal.

All industries have been affected by recent events in one way or another. Some have experienced a greater impact - such as travel, hospitality, bricks and mortar retail, and businesses relying on consumer-discretionary spend - while others, such as online businesses, companies offering ‘mission critical’ services and those that have been able to flex their business models, have weathered the storm far better.

Not surprisingly, the macro-economic challenges have impacted M&A. UK deal volumes in H1 2020 fell by 36% compared with H1 2019, and it was the lowest first half figure since 2011 (source: Experian,2020). Most transactions that have been adversely impacted by the economic headwinds have been put on hold, and those transactions that are completing are in certain sector pockets, including technology and healthcare where market prospects have remained sound.

Business sector impact and outlook

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Green shoots emerging?

However, it’s not all doom and gloom. Companies that have emerged from the crisis weaker are considering their strategic options; corporates are looking to divest non-core businesses and ensure their business models are ‘future-fit’; and some opportunistic acquisitions are taking place.

Private equity still has funds to use and is looking for strategic, value-based bolt-ons where value arbitrage is achievable.

This positive sentiment of M&A recovery is confirmed by the responses to a recent poll we undertook during our “Evolving your approach to M&A as we emerge from COVID-19” webinar series. 72% of the respondents indicated that they are either currently undertaking a transaction or plan to commence one before the end of 2020.

Evolving your approach to M&A

So, how does M&A need to change as we emerge from lockdown, and what have we learned since March 2020?

Revisiting the business model for M&A

Whether you are acquiring or divesting, there are a number of key considerations in preparing for a transaction.

In terms of commercial points, understanding how the market has been impacted is key, including changes in customer needs and demand, and in the competitor landscape, and the short-, medium- and long-term prospects for the business.

The appropriateness of the business model should be revisited and validated, along with the underlying business plan assumptions, which may look materially different compared with the pre-coronavirus environment.

The traditional assessment of historical trading and adjusting for one-off or exceptional items to arrive at underlying EBITDA is no longer a good indicator of future profitability.

A business may have experienced profound changes to demand and had to make cost mitigations and strategic and operational changes simply to stay afloat.

Due diligence needs to go beyond the numbers

Financial due diligence needs to consider the specifics of the sector, the adequacy of management’s restore and protect strategies, and ultimately, how well positioned the business is to recover when demand returns and we arrive at a ‘new normal.’

Furthermore, due diligence needs to consider the impact of the full array of government measures in the given jurisdiction.

For example, in the UK, the deferral of VAT and PAYE payments and furlough schemes. These measures may not only have considerably altered the business cashflow, but could impact the future tax position of the business.

Other considerations include tax residency and the utilisation of tax treaties between countries, because the mobility of management has been so severely impacted.

Operating in the new normal

Learnings from operating during lockdown should challenge some of the key elements of a business’ old operating model, and may present opportunities and risks for both buyers and sellers.

The key question is how viable the operating model is in the new normal. For example, how appropriate is the organisation's design and skills mix, and what is the optimum property strategy now that working from home has become the norm for many employees?

Property in particular has become a key negotiation item, given the potential cost impacts for both buyers and sellers. Finally, resilience of supply chains and operations should be assessed, including diversity of the supplier base, how near shore the supply chains are, and how future disruptions can be mitigated in case further lockdowns occur.

Valuations are more subjective than ever

Macro- and micro-economic uncertainties and market volatility have added more subjectivity to the valuation process and resulted in wider valuation ranges. Based on our recent webinar polls, companies consider valuing businesses to be one of the key challenges when transacting at the moment.

The traditional valuation methods continue to be applicable, however, greater care and consideration is required when using them. For example, the use of benchmarks to derive deal multiples based on publicly traded company forecasts has become more difficult. Many companies have stopped publishing forecasts, or forecasts that are published may be highly subjective.

Pre-coronavirus transaction multiples should also be taken with a large grain of salt because they will often reflect very different market conditions. Comparability is therefore a lot more difficult.

To address these challenges, consider using cash flow forecast scenarios to identify base, upside and downside cases and work out a range, taking into account all considerations, but ensuring risks are not double counted in both cash flow projections and discount rates used for discounted cash flow (DCF) valuations.

Dotting the Is and crossing the Ts

Sales and purchase agreements (SPAs) and completion mechanics have taken on a new level of importance in the current deal climate, but can mitigate the key uncertainties (ie, earnings and cash flows, balance sheet, and underlying business uncertainty) that are currently faced by deal makers.

The use of deferred consideration structures, which were widely used before lockdown, has been offset by the increased popularity of earn-out structures to address these uncertainties, enabling some transactions to complete. The earn-out duration is key, and caution is also needed in relation to defining the earn-out in the accounts including adjusting items.

Also defining working capital targets that form part of pricing mechanisms is proving more challenging in the current environment, because working capital and cashflows are not at their normal levels, making it more difficult to define a normalised level.

In addition, similar to the last financial crisis, the use of completion accounts instead of locked box mechanisms is growing in popularity in order to provide increased comfort around the balance sheet of the business.

As a result of lockdown, we have witnessed a rise in the number of claims and disputes, so appropriately defining the SPA in terms of language and ensuring that the figures are watertight has become more important than ever to protect deal value for buyers and sellers.

The effects of the coronavirus lockdown will continue to unfold over the next 12 to 18 months. We are, however, seeing a resurgence in M&A appetite in some sectors, and a predominately buyer-focused market currently. We expect deal activity will continue to increase during 2021 with cross-border deals hopefully returning.

Whether you are acquiring or divesting, you need to have your eyes wide open more than ever before to assess both transaction risks and opportunities, and to give you the best chance of achieving your deal goals.

For support in navigating M&A during lockdown, get in touch with Matthew Woodgate.

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