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| In a 2020 COVID-19 crisis, will corporate mergers and acquisitions be on hold for much of the year? |
With an energetic push from investment bankers, when corporate entities at some point decide to meet business goals they must either
(a) buy and invest in other companies,
(b) arrange mergers of equals with peers,
(c) sell off significant-sized assets or subsidiaries,
(d) divest in selected business operations or divisions, or
(e) allow themselves to be purchased by rivals.
Into the picture march the Goldmans and Morgans to spark ideas about how to accomplish these tasks and, of course, how to value prospective transactions: How much should Company A pay for Company B? How should it arrange funding the transaction (cash reserves, debt, equity stock, debt and equity)?
Investment banks and their cohorts at the client companies spend much time analyzing the company's own "market value" before the transaction, the "intrinsic value" of the target company, and the "market value" after the transaction of the merged companies. They develop strategy and make decisions about a merger, acquisition or divestiture. Do the merger. Ignore the merger. Find another way of structuring the combination. Of course, they will have considered countless scenarios (funding options, interest rates, capital structures, economic trends, legal risks, political risks, timing).
M&A decisions are difficult; the analysis is complex and often imprecise, ever-changing. Ultimately all analysis should lead to CEOs and boards of directors into making the right decisions.
Companies contemplating M&A start with several approaches. There is no one common, correct way. Often the approach revolves around overall business strategy (at least the strategy at that point in time). They may take an "inside-out" approach, investigating internal operations and deciding what they need to complement current operations. Or they may take an "outside-in" approach, exploring beyond current operations to decide ways to expand and grow (also known as "scope" approach). They may start from scratch: What transaction can we do to boost shareholder or market value of the company?
Bankers, from the bulge-brackets to the boutiques, stand behind top corporate managers to assist in these new strategies.
Unfortunately there exist long lists of M&A transactions that have failed and should have never happened in the first place. Some skeptic observers of a frenzy of mergers enjoy counting off the failed deals. They typically blame an over-estimation of synergies in most failures.
Remember long ago when General Electric decided to leap into financial services first by purchasing the reputable investment bank Kidder Peabody? The TimeWarner-AOL deal is one for the financial history books. In some industries, all it takes is one headline merger to spark a spree of mergers among others in the same industry. Airlines merge. Pharmaceuticals merge. Food companies merge. Financial institutions merge (Morgan Stanley agreed to acquire E*TRADE a few weeks ago.)
There are lists just as long that explain why M&A deals don't work they way bankers and boards intended for them (unexpected costs, unrealistic synergies, delays in approval or rejections in regulatory approvals, flight of talent, hidden risks, unexpected market downturns, cultural clashes, etc.).
Yet year after year M&A activity persists.
Before the current COVID-19 crisis, industry analysts summarized 2019 activity and attempted to project transactions for 2020 and beyond. But that was before today's volatile, uncertain scenario. Consulting firm Bain & Co. reported there were $4 trillion in deals in 2019 (flat from 2018, slightly down from a peak in 2015). The biggest deals included mergers involving pharmaceuticals (Bristol-Meyers and Celgene, e.g.) and energy (Occidental and Anadarko, e.g.).
In 2019, Goldman Sachs reported its involvement in $1.4 trillion in transactions, a 16% increase from the previous year. (It closed $1.3 trillion in deals.) It has generated at least $3 billion in related fees in each of the past three years. Bank of America reported $1.3 billion in fees, a 10% increase.
JPMorgan Chase boasted of its leadership role in U.S. and global deals. Morgan Stanley, Citi, and Evercore follow closely behind. Other big players in M&A, based on 2019 performance, include Barclays, Evercore, RBC, Centerview, Lazard and Moelis.
Just as in other financial-industry segments, the M&A industry expected there could be a recession on the horizon, but something for which the industry could prepare and brace.
By March, 2020, the world changed.
And that means merger strategies were altered abruptly. The backlog of anticipated transactions for the next 18 months will change, too. The nature and even tone of early-2020 discussions about possible combinations were upended.
Companies contemplating acquisitions and expansion must now consider restructurings and divesting of assets to raise cash to prepare for a prolonged downturn. Bankers advising in proposed deals must return to models to revise values of companies and purchase prices. In fact, some have proposed a rethinking of the concepts "shareholder value," "intrinsic value," and "market value."
In January, companies and bankers outlined deals on the horizon, suggesting another prominent year in M&A for banks. Several weeks later, some of the same companies are looking for ways to postpone deals or get out of them all together. Boeing, the aircraft company that has faced a multitude of issues the past few years for well-chronicled reasons, was still an ongoing operation by late 2019. It pursued to Brazil's Embraer, a commercial jets business.
By mid-April, Boeing pursued ways to cancel the $4.2 billion planned acquisition. Boeing decided it was better to keep the $4.2 billion in cash than to invest in another enterprise and spend years in regret. Boeing canceled this deal, mostly because airlines have canceled their business orders with Boeing. Not to mention a recalculation of the value of Embraer would not justify the target being worth anywhere near $4.2 billion. Boeing's bankers, Evercore and Lazard (in restructuring roles), may have been the voices to urge Boeing to balk and helped it find the legal loopholes to withdraw from a proposal.
New Concepts of Shareholder Value?
In a recent issue of the Economist, a former governor of the Bank of England recommended now might be the best time for analysts and investors (and traders) to redefine shareholder value in the wake of COVID-19 and "the new normal."
Business school books for decades defined shareholder value based primarily on a projection of future operating cash flows, cash available annually for shareholders. In recent years, finance professors and other business leaders have proposed adding community contributions, environmental and social impact and governance ("ESG") to the components of shareholder value. The Economist observer proposed assessing "value" based on whether companies are prepared for crises now and in the future and on how companies responded to employees and their communities during this crisis. Hence, companies that behaved responsibly during this crisis and are prepared for future worst cases should earn a premium in value no matter what cash-flow projections suggest.
For the second half of 2020, M&A departments at major investment banks won't die or disappear. They are known to be creative in how to approach CEOs with ideas for combinations and spin-offs (all while they are hyper-motivated by the lure of million-dollar fees). Corporate leaders will still encounter issues and opportunities where the best option might be an acquisition or a marriage with a peer. More often than not, in a downturn, they will contemplate spin-offs, restructurings, and asset sales. They reframe business strategy and elect to withdraw from certain business lines or look more closely for operating efficiencies.
Private-equity funds will be on the prowl to find under-valued assets and will look to bankers for guidance. Some of the same are still waiting to see if the bottom has been reached and continue to survey lists of survivors, thrivers, and corporate wreckage. Some will decide which companies should thrive, but are impeded by bad management, bad luck or fragile balance sheets.
PEs, EVs in 2020
M&A analysts focus on price-earnings-related estimates and metrics. How much is a target worth? How much should a company be sold? How much will potential acquirers be willing to pay for an operating subsidiary?
M&A analysts also value companies based on concepts of "enterprise value." EV encompasses value of the enterprise to both equity shareholders and long-term debt investors. The enterprise generates operating cash flow that will be available for discretion, rewards or reinvestment for both debt and equity investors. They attempt to compute or assess "enterprise value." They use a convenient metric (a multiple) to assess the value operating cash flows: The EV/Ebitda multiple, closely watched from period to period and from industry to industry.
EV/Ebitda for deals done in 2019 (from Bain & Co. and Mergermarket reports) ranged between 9-15 across multiple industries and averaged about 12.5 (down from 15.0 in 2015). The 15-year average computes to 12.0.
Acquiring companies or private-equity funds were willing to pay about 12.5-times cash flows for target companies last year. The higher the prospects for growth, the more they are willing to pay for targets. The more certain the cash flows will be generated, the more they are willing to pay. Thus, growth and certainty contribute to value.
Expectations for high growth in technology industries explain EV/Ebitda multiples averaging 15.0 in deals from 2015-2019. Expectations of low growth and uncertainty explain the average of 11.0 in consumer and retail industries over the same period.
Now enters COVID-19. Forbes reports M&A in the U.S. activity in 2020's first quarter fell 50%. Before March, Xerox had coveted HP and expressed its intentions broadly and publicly. Since March, Xerox has backed off and focused on more pressing matters.
Without a doubt because of widespread uncertainty, acquirers will not be willing to pay 12-15-times Ebitda for targets. For potential acquirers (especially for private-equity funds), even if there are "good buys" in the market at 9.0-10.0 multiples, too much uncertainty and risk may keep them on the sideline for several months.
Bankers and acquirers, like just about most investors, may continue to observe and wait until uncertainty dissipates. Uncertainty won't reduce the urge or the need to do transactions. Uncertainty may slow the steps to decide when to do a deal. Yet in the midst of such uncertainty, don't forget the motivation of bankers to generate fees.
For years (or decades?), star bankers have been blamed for pushing companies to do mergers that shouldn't have been done, weren't properly rationalized, and ultimately failed. Investment banks have earnings incentives to get deals done and risk pushing for undesirable corporate match-ups to earn millions in fees, even if they have doubts about the success of a merger.
Scale vs. Scope vs. Private-Equity
Merger data in recent years show 85% of global mergers involve corporations acquiring other businesses for the purpose of scale (to expand, grow, gain market share, or get bigger) or for scope (to evolve, diversify, or revise business strategies). And most involve public companies (as buyers or sellers). At 15% of the total, private-equity funds continue to be significant players.
History suggests "scale" deals tend to involve more successful integration than "scope" deals. But scale deals have additional hurdles: Regulators must evaluate and approve for anti-trust implications. And often regulators take their time to decide, especially in technology and telecommunications industries.
In the periods to come, corporates will focus on existing operating priorities ("return to work," employee force, reviving cash flow, improving balance sheets, ensuring ongoing funding, raising equity, issuing term debt). They may seek merger partners only after everything else has gone wrong. Under this scenario, they seek partners to reduce costs, improve operating efficiencies, or raise cash.
Private-equity players, especially those undeployed cash and related commitments, will explore and hunt for bargains, looking for businesses slowed temporarily because of the crisis, but showing signs they can rebound rapidly once the worst of COVID-19 is behind us.
Banks see themselves as advisers, but also idea-generators or list-drawers with rosters of potential targets. If deal flow slows in mid-2020, they will huddle and hustle more aggressively than usual to prepare pitchbooks of candidates and valuations. No matter the good deals done or the mounting number of prior failures, M&A activity doesn't go away forever; it reappears when banks show up to present ways to solve corporate problems via corporate pairings.
Irrational vs. Rational Mergers
The Bain 2020 report blamed bad or failed mergers on (a) bad due diligence by bankers and acquirers, (b) acquirers not understanding the business model of the target or leaping into businesses they hardly understand, (c) loss of management talent after the merger, and (d) unexpected departure of senior managers of the target. In a COVID-19 environment, merger partners will not likely want to take the risks of possible bad mergers. The costs and impact will be too much to bear. In good times, a top technology company can risk millions making a bad decision to acquire an unproven start-up. In bad times, the same firm might pass.
Bain highlighted the best deals are a result of
(a) better due diligence and scrutiny of operations,
(b) well-executed integration (because of planning),
(c) stronger awareness of strategy and planning on both sides and
(d) retention of talent on both sides.
Before the onset of COVID-19 and the near shutdown of global economies, M&A analysts had begun to note some trends over the past few years. The market valuations of companies (public companies, for sure; private unicorns, in other cases) have soared the past decade.
If two large companies merge, then valuations, market shares, and their combined impact on markets will be enormous--overwhelming enough such that regulators will examine prospective deals closely for anti-competition implications. Large-value deals attract close scrutiny and lead to longer timetables to approval. Cross-border transactions extend the timetable, because of the layers of overseas approvals and related issues.
Sometimes deals are done because of regulator orders. The regulatory authority may mandate the company sell a business operation (because of anti-trust implications). Or a company may agree to acquire a target, but approval is granted based on the acquiring company selling off certain divisions or assets. The same requirements still generate business activity for investment banks, who get to preside over the reorganizations.
Outlook for 2020-21
Analysts have noted the continuing rise of public-to-private deals. Large public companies, trends show, are electing to run their operations without the scrutiny and threat of activist public shareholders, without the pressures of having to manage the business to particular earnings-per-share from quarter to quarter. They enjoy not having to rationalize recent results and project boundless optimism in quarterly calls. (Years ago Dell, the computer company, prominently decided to quit the public arena and go public for similar reasons.)
In the COVID-19 scenario, there might be companies encouraged to "hide out" from public scrutiny during tough times and consider becoming private--if they can do so, if they can find buyers who see long-term prospects.
Divestitures to Raise Cash
Now more than ever, a prominent corporate theme in 2020 into 2021 will be corporates ensuring they have piles of cash reserves to offset the risks of near-zero or negative operating cash flow. Cash reserves help companies in a downturn to offset operating expenses.
After companies have exhausted all ways to raise funds from revolving credits and new debt issues, companies will consider raising cash from selling assets of divisions and operations they declare to be non-strategic (or too much to tolerate). They hire bankers to help them find buyers among competing firms or companies looking to expand into other businesses. The assets under sale, remember, will likely be assets that had not been performing well or will likely suffer substantially in a downturn. The value they achieve from the sale will likely be less than value they could have generated just a few months ago. But cash generated is king.
They achieve the objective of raising cash, building reserves, and strengthen a balance sheet that must weather tough periods.
Deal Postponements and Cancelations
Like the Boeing deal above, other companies will, too, look for ways to back off on doing transactions that made sense in late 2019. They are nonsensical in May, 2020, or they certainly aren't worth the values acquisition models derived a few months ago.
The ability to postpone or cancel deals will depend on the legal documentation in place before March, 2020. Is the COVID-19 crisis a material-adverse event? Is it a force majeur? Can present conditions be interpreted or construed as "Acts of God" that permit a cancelation or a right to renege on a promise to buy or sell?
After March, 2020, it will, of course, be all but certain that merger-related documentation will include defining statements to address responsibilities of buyer and seller in a COVID-19 environment. Lawyers on all sides will define such an environment with detailed measurements and define the timeline of the COVID-19 period.
Mergers Involving Failing Businesses
Struggling companies reach a point where they are willing to take on partners. Neiman Marcus has reached that point. That's not a surprise, given its place in the retail industry where cash flows are based on customers avoiding the convenience online shopping and appearing on site at a mall. Companies like Neiman Marcus, JC Penney, Nordstrom and Macy's have suffered for years. The same group may pursue marriages if they prefer to stay solvency and out of bankruptcy courts.
Beyond the retail industry, other failing businesses might be struggling temporarily or have had sluggish performance blamed on bad strategy or incompetent management. Those businesses could find buyers who might be confident a mere tweaking (after the worst of COVID-19) could turn them into stable cash cows.
Restructured Organizations
Some of the best known investment banks in periods of decline change their caps and transform from merger bankers to restructuring experts. Companies that once tapped Lazard for ideas to expand into Europe or Asia will seek out Lazard for advice on how to reorganize to manage a downturn and squeeze out cash to service debt. Lazard, the firm, has run a restructuring unit that thrived in the Financial Crisis, 2008-10, and is well-staffed to help companies in 2020.
Restructuring will involve a sale of assets, but could imply ways to raise funding in creative ways. It also might mean coaching companies wrestling with decisions to file for bankruptcy or in how to manage through bankruptcy. Banks like Lazard, of course, provide these services for a fee.
Impact on the Process
To say the least, COVID-19 will have impact on the process of getting deals done. A successful M&A transaction results from dozens of people contributing to a months-long process that requires perhaps a hundred steps. Companies must be valued. Fees, pricing, and valuations must be negotiated. Information must be verified and substantiated. Lawyers prepare and interpret language (especially anything that implies "commitment" or "guarantee" or "promise"). Documents must be prepared, reviewed and submitted. Regulators must review and approve. Investors must be informed. Buyers must arrange funding. Boards of directors must convene. Shareholders must be informed. And amidst rampart market volatility, valuations must be updated daily.
The spread of the coronavirus slows the process down and extends timetables indefinitely. Fewer deals will be consummated over a similar timeframe.
The hundreds of steps toward consummation will be modified significantly if only because
(a) bankers, regulators, accountants and all other parties and stakeholders involved cannot meet in person,
(b) some parties involved (regulators, sellers, etc.) may have other more pressing priorities,
(c) uncertainty prevails everywhere (the ability to arrange funding, the reluctance of bankers and buyers to commit or guarantee performance, the inability to value companies as precisely as bankers would prefer)
(d) new forms of legal documentation must be prepared
Due Diligence will mean much more going forward. For experienced bankers (and the analysts and associates who perform much of this work), due diligence was a rote process, a necessary step to ensure the buyer understands and knows what it targets.
In 2020, that process must include addressing many questions for which today there is no helpful answer: What impact will COVID-19 have on operating expenses, markets, legal responsibilities, products, and political risks? What impact will working from home have on productivity for business operations? What roles will information technology groups play as more business activity is conducted online and when most employees are working from home?
Negotiations, for which in a routine M&A deal are numerous and continual, will be cumbersome and often haphazard. U.S. regulators (the Department of Justice, the Federal Trade Commission) will be slower and more deliberate in approvals.
Lawyers for all parties will redraft standard documentation to encompass the new environment: How can buyers be assured sellers are meeting conditions for closing and are representing accurately business activity, expenses, efficiencies and productivity? How strong will legal documentation be if it is negotiated and executed online?
Financing
Buyers must finance an acquisition, as mentioned above. They fund acquisitions from cash, new debt, new equity or combinations of the three. Before 2020, investment-grade companies, advised by the models from their respective banks, could comfortably choose how they preferred to raise funds. Often the financing decision was based on the advantages of debt, interest rates, debt-equity ratios after the merger, cash reserves on the balance sheet, and the degree to which earnings-per-share after the merger would be reduced (diluted). Logistics, process, and the time to receive funding were also factors.
After 2020, acquisitions funded by new debt and new equity may slow down because of market uncertainty, market volatility, lack of interest in equity markets and a dwindling risk appetite from debt investors and banks.
Banks and debt markets will be more careful about providing acquisition financing. The "highly confident" letters and "financing commitments" some major banks happily provided for big-name mergers may disappear because of the difficulty to predict how markets will behave:
(a) Highly leveraged combinations will not be treated as favorably as before,
(b) "Bridge funding" from banks could dwindle if bankers aren't sure debt markets will be open and liquid in months to come, and
(c) Bank risk managers understand well how quickly investment-grade companies in certain industries (in a COVID-19 setting) can transform into struggling, risky borrowers in a few weeks.
Post-Covid Planning
Although there is little way to project when this crisis will be pronounced "over," many companies behave as if this will come and go. They prepare for an upswing in the economy and a "the new normal."
Potential acquirers may look for company bargains in anticipation of a post-Covid scenario. Companies that can do this look for targets where market values have nearly plummeted, purchase them, and spend the crisis integrating them. Companies surviving well and thriving nowadays (because they have positive operating cash flow and ample cash reserves) set their eyes toward strategic moves. That list might include Walmart, Amazon, Facebook, Alphabet, and big pharmaceuticals. According to one market analyst, some potential targets might include restaurant chains, Target, and Under Armour.
Public-to-Private
Public-to-Private deals occur when a private group (a fund, a private company, a majority owner, a management group, etc.) decides to take a public company private because the parties decide there is an advantage to being a private company vs. public company. There are joys and advantages in being a public company, most notably because of the ability to raise capital broadly and realize market values (especially on an upswing) daily. There are troublesome factors, too: shareholder expectations, the thorns and probes of activist shareholders, the requirements to distribute operating details to a broad universe each quarter, the agony of being valued everyday, etc. Then there are joys and advantages in becoming private again.
Private-equity buy-out funds will likely look for bargains where sluggish operations and performance could turn to promising profit margins post-Covid. Some companies may entertain bids from private companies or management groups just to escape the scrutiny they encounter as public companies, something they may welcome if there are 12-18 months of economic nightmares and uncertain operating earnings. The veil of being a private company may give those companies a chance to hide out of view and revamp strategies or change the scope of the business model without being subject to constant input from market investors.
Public to private, however, doesn't happen unless there is some underlying value and there are potential buyers, most of whom often require ample debt funding.
In sum, M&A in the U.S. and around the globe will pause or dip and will slow down. It will be deliberate and purposeful and even better-rationalized. The billions that big banks generate in related fees will tumble after late-2010s highs. But M&A won't disappear.
Tracy Williams
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