For nearly 30 years, Harris Williams has forged strong and deep relationships with the world's leading private equity groups (PEGs). In today's virtual environment, our senior bankers continue to stay closely connected with their private equity colleagues, offering advice and soliciting input on current market conditions.
"Much has changed since the summer," says Bob Baltimore, managing director and co-head of M&A at Harris Williams. "Deal volume has increased significantly since Labor Day. PEGs are finding a new balance between virtual and in-person interactions as they pursue new platform investments. At the same time, the bifurcation between A and B assets has widened."
Here, we share the key takeaways from our most recent conversations with leading PEGs.
A Fall Upward
"One PEG noted that their deal flow in April was down 80% year-over-year, but their September deal flow was at an all-time high, up by more than 25% over its previous peak," says John Neuner, managing director and co-head of M&A at Harris Williams. Neuner says other PEGs experienced record-high deal flow between August and October.
However, while deal flow has been high, it has not been evenly distributed across industry sectors, says Bruce Kelleher, a managing director at Harris Williams. Kelleher, who works across all of the firm's industry groups to deepen relationships within the private equity community, says PEGs reported particularly vigorous activity in business services, especially essential, contracted, or tech-enabled services (e.g., digital marketing); in healthcare, healthcare services, and healthcare IT; and in building products, home improvement products and services, and outdoor living.
While many PEGs say sellers are targeting smaller groups of buyers, most also report that they lack the capacity to review more deals. "To address this challenge," says Baltimore, "many PEGs are focusing earlier on identifying unique angles and on picking the right spots to dedicate time and firm resources."
"When they cannot find an angle," he adds, "many PEGs are deciding to pass earlier than they did pre-COVID-19.
"PEGs also have told us that with so many high-quality assets in the market, it is increasingly challenging to be competitive if they haven't been tracking the company before it comes to market," adds Trey Packard, a director focused on strengthening key PEG relationships.
Likewise, several PEGs have reported an increasing number of situations with a small group of buyers who are already well-positioned on day one. "PEGs say there are no more 'casual indications of interest (IOIs)," says Packard. "One group mentioned their management presentation count is almost twice its typical level, and letters of intent (LOIs) are up almost five times, but closing deals remains challenging."
As a result, he says, many PEGs are relying on key relationships to understand the competitive landscape and craft strategies to prevail, especially when there is a tight timeline.
Early Birds Zooming In
Many of the PEGs with which Harris Williams works also have noted a meaningful increase in virtual early look meetings, as well as greater access to management earlier in their pursuit of new platform investments. This access helps them accelerate their efforts with greater conviction, says Baltimore.
Obviously, technology has played an essential role in supporting all stages of the COVID-19-era sales process. However, Baltimore says that while some PEGs have closed on new platforms in 2020 without meeting management teams in person, that is not ideal and is unlikely to persist post-COVID-19: "Early virtual interactions are beneficial, but in a post-COVID-19 world, they will not be a substitute for building rapport face to face."
There are varying perspectives on the effectiveness of virtual management presentations (MPs). Many groups have indicated they are shorter, higher-level, and generally less effective than in-person sessions. That has driven some PEGs to work with bankers to gain in-person or virtual access to management teams before or immediately following submission of an IOI to build rapport and create angles that allow them to move more quickly post-IOI.
From a diligence perspective, adds Neuner, several process innovations have been useful during COVID-19 but may not necessarily be the preferred option in the future. "The classic example is tech-enabled facility tours, including by video drone or via GoPros mounted on a Segway. Most groups still indicated a need to walk the floor of a critical manufacturing facility, operations center, or distribution center before closing on a transaction."
Indeed, PEGs say they are most willing to travel in the latter stages of a transaction. "Travel is typically limited to meetings with management and critical on-site due diligence," explains Baltimore. The future state will likely lie somewhere between pre-COVID-19 and today: Less frequent travel than before complemented throughout the year with virtual meetings.
What about conferences, panels, and other events? Many groups are minimizing participation in generalist conferences. "For many PEGs, the perception is that they can do direct outreach and one-on-one video calls on their own," says Kelleher. However, several groups say they have found greater success with smaller, sector-focused conferences. Benefits include deeper conversations, closer alignment with specific investment interests, and better connectivity with sector-focused colleagues.
Minding the Gap
Many PEGs are seeing a widening gap in deal quality, with a clear differentiation between A and B assets. In an environment where PEG capacity is constrained and sales processes are faster and more competitive, buyers may downgrade B assets to a valuation discount from pre-COVID-19 levels. Buyers may also simply pass on them.
Many groups, including some with a history of investing in operational improvement opportunities, have indicated that they are more focused on A assets now than ever before. Several PEGs noted high-quality assets trading at a 10%-30% multiple premium versus pre-COVID-19 levels, with buyers bidding off elevated or forward earnings.
However, PEGs also say there is limited willingness by buyers or lenders to accept extensive COVID-19 adjustments. Some groups have noted that there haven't been as many proposed adjustments in recent deals as they would have expected. In many cases, the adjustments have been relatively minor, and buyers have been able to get comfortable with them.
"Almost uniformly, PEGs are saying that aggressive addbacks result in a quick pass on the deal, often without much review," says Neuner. "Most are unwilling to see through inflated COVID-19 valuations and inherent questions around long-term earnings sustainability. Quality of earnings (Q of E) teams are running harder than ever and are often taking a 'belt and suspenders' approach to supporting adjustments."
As with so many aspects of the sales process, buyers are discussing adjustments with sellers far earlier than they have historically. PEGs have consistently indicated the need to agree on accepted and rejected adjustments earlier in processes and well before their own investment committee presentations.
Similarly, some groups have alluded to lenders driving the adjustment discussion more than ever before: "If buyers agree with adjustments, they need to reach out to lenders and get them on board early," says Baltimore. “Regardless of the degree of adjustments, a business needs to be well on its way to recovery on an unadjusted basis to be attractive to most PEGs."
While lenders are generally unwilling to underwrite extensive adjustments, the majority of PEGs have indicated that financing is in no way limiting their ability to close new platforms, as it was in the summer. "Like equity investors, lenders are making firm and early 'go/no-go' decisions," says Kelleher. "Debt levels are generally in line with pre-COVID-19 levels, with several examples of 6.5x, covenant-light debt packages on the highest-quality deals."
Packard adds that lenders are seeking to distribute risk, making syndicated and clubbed deals far more common. At the same time, he says, pricing tends to be generally in line with or marginally more expensive than pre-COVID-19. And where the debt appetite from lenders may be underwhelming, some PEGs say that LPs are increasingly willing to step in.
The lender outreach approach has also changed for some equity investors. More groups are having early, targeted discussions with their best lender relationships. Only if there is no interest from that group will they branch out to a broader set of lenders.
Overall, notes Neuner, buyers have found success creating a narrative around the business model, COVID-19 impact, and go-forward growth strategy, and communicating that investment thesis early to their close lender relationships.
After a relatively inactive deal market in the spring and early summer, the fall of 2020 has given PEGs and other M&A participants an opportunity to make up for lost time. It's challenging to squeeze two quarters into one—especially amid a global pandemic—but PEGs are certainly trying. Virtual meetings, a belt and suspenders approach to adjustments, and a sharp focus on quickly finding the best opportunities have made it an intensely active fall for M&A. Only time will tell when and to what extent we will return to pre-COVID-19 approaches to getting deals done.
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