Private equity hunts for good news as M&A optimism vanishes

The mood for M&A in Europe this year was never particularly buoyant — and then came the pandemic. Now the outlook is grim, except for a few sectors where the quick gains could mean all the difference.

European dealmakers always expected 2020 to be a rough year for mergers and acquisitions, but the coronavirus crisis has all but crushed any remaining confidence.

But while the business world might have ground to a halt, the demand from investors for returns carries on — and for private equity that means making bolder plays now to try to make up for losses.

Global dealmakers: European M&A market update 2020
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The stark difference before and after Covid-19 can be seen on the pages of the most recent Baker Tilly International/Mergermarket report on M&A opportunity in Europe.

Back in January, the first version of the report was prepared, and it found ongoing political and economic uncertainty around Brexit, and generally poor economic growth, had dampened the confidence of dealmakers.

Since Q4 2019, deals in Europe had declined 36% in volume and 5% in value, the report found, and dealmakers were anticipating a recession.

Then came the crisis.

In April, Baker Tilly and Mergermarket went back to 60 of the surveyed dealmakers to get a fresh perspective as the world started to emerge from its coronavirus hibernation, finding the outlook has worsened from pessimistic to grim.

The Global dealmakers: European M&A market update 2020 now released by Mergermarket and Baker Tilly International shows 73% of dealmakers will reconsider or cancel M&A activity due to the Covid-19 pandemic, a sharp rise from the 32% who intended to pull back just three months ago.

Some 83% of respondents believe Covid-19 will have a negative impact on cross-border M&A through 2020 and possibly beyond.

The spectre of recession also looms in the minds of respondents, with 92% saying a recession in Europe will unfold in the next 12 months and unanimous agreement — all 60 respondents — believing a global recession is imminent.

These opinions compounded the downward trend that was already emerging in M&A activity in Europe, where deals in 2019 declined 5% in volume and 21% in value from the previous year.

Fortune really could favour the brave

But for all the doom and gloom — and there’s plenty of that to go around — there are some glimmers of opportunity.

Olivier Willems, Corporate Finance Partner at Baker Tilly Belgium, says many firms have been forced to reinvent themselves during the pandemic and that could bring about M&A opportunities in the short to mid-term.

“There are indeed companies that are doing quite well in several sectors, logistics for example, and it is true that if they are doing well, especially if they are already cash rich companies, they will continue to look for opportunities,” he says.

“What Covid also might have brought is that company owners who weren’t ready in the past, they might be ready for new partnerships now as they realize that they can be impacted quite heavily by an external factor, something like a pandemic.”

The private equity space will be an interesting one to watch in the coming months, believes Mr Willems. The poor results in recent months have left private capital exposed to downturns, particularly those invested in sectors worst hit by the global lockdown, such as hospitality, travel and retail.

“Private equity funds have huge amounts of cash that they have to deploy,” Mr Willems says.

“During the first weeks of Covid-19, private equities were focusing on operations and estimating the cash impact of the crisis, but they will now be looking at the impact over their investment horizon.

“They will have to look for ways to make up for the losses they are suffering this year. So, they have to be looking to bolder acquisitions to get their returns on the capital investments.”

Baker Tilly International Corporate Finance Lead Michael Sonego, from Australian member firm Pitcher Partners, expects the pressure on private equity firms to demonstrate returns will only grow.

“We’ve got record levels of dry powder in that private equity space. We’ve been talking about that for a couple of years now. Most private equity only have a 10-year investment horizon so that 10 years has now shrunk,” he says.

“If they had made investments, which you would expect most would have, they probably haven’t performed all that great recently, which is going to put additional pressure on them to make the remaining funds they have work and deliver great returns for their unit holders, so they can raise the next fund next time around.”

In considering where private equity might choose to invest, Mr Willems doesn’t see advantage lying in mopping up businesses that are struggling.

“Personally, I would go with consumer goods, food and the like, which have continued to trade throughout the crisis,” he says.

“I would go with healthcare, and I would go with subscription tech, so software-as-a-service businesses.

“I think those will also be the three sectors where multiples and valuations won’t be affected as much as in other sectors, because they’re typically the sectors that are still doing quite well.

“But I would also tend to be charmed by a niche supplier to the food sector, so go one step further in the value chain.”

Mr Sonego says there will also be sell-side opportunities but there was value in reading the market before rushing in.

 “I think it’s still too early for people to be racing to market, because there are issues around who’s got the cash, are they prepared to part with it, and how do they do an inspection?” Mr Sonego says.

“But I think there’s certainly a fair amount of preparedness for businesses who can see advantages of private equity looking for solid returns. For this group it is a matter of let’s get ready, knowing that we go live in the second half of the year and start talking to buyers at that stage.”

A dose of reality needed to get deals done

For businesses that had hoped 2020 would be a unicorn year, the impact of the virus has dashed hopes. But even mid-market businesses might need to readjust their expectations.

The M&A report found dealmakers expect the mid-market to pick up later in the year, as companies under strain from the pandemic become apparent, and to make up a bigger proportion of the market as mega-deals are shelved.

For the first time in 16 years, mid-April saw a week where no merger or acquisition worth more than $1bn was announced anywhere in the world, according to Refinitiv, while early suggestions are that the value of deals has fallen 25 per cent in the first quarter.

Mr Sonego says the coming months will include a potentially painful rebalancing of expectations and an examination of the risks they are prepared to take to make a transaction happen.

“One way in which sellers try and achieve a greater outcome is they build earn-outs in,” he says, pointing to provisions that deliver sellers additional payments based on the future performance of the business.

“If you had an earn out in a sale agreement over recent times, you’re in all sorts of trouble. There’s trade-offs in everything you do in business, so there’s a trade-off about the return or it’s a trade-off about how much you sell your business for.

“I can sell your business for $20 million today but if you want $25m, there’s going to be an earn-out arrangement in there, so it’s at risk. And so that vendor will probably find themselves walking away with $15 million with a big portion that relies on future performance, rather than a guaranteed $20m.

 “The past few months have been a reality check that something can come from left field. It doesn’t matter how well prepared you are and how well you know your known risks, all it takes is one unknown of this magnitude, and it disrupts everything.”

Mr Willems believes the next six to 12 months will be particularly difficult as parties adjust to the new normal.

“Sellers will still tend to want sell at yesterday’s multiples,” he says.

“But buyers, they look at the future and they’ll be more conservative, and they will account for additional risk and then will tend to buy at tomorrow’s multiples and there might be a discrepancy when you bring those expectations together.”

With revised valuations comes the problem of finance.

“One of the main challenges in the future of transactions in the coming year will be that banks will be far more cautious and leverage will go down,” Mr Willems says.

“On the bright side, that might have an impact on valuations which might bring opportunities again as well for stable companies.”

Friends in the right places to get deals done

One unusual aspect of this crisis over past economic downturns has been the impact of restricted movement and travel.

Border closures and lockdowns have emerged as some of the biggest hurdles to doing business across nations, Mr Sonego says, and doing cross-border deals without people on the ground is problematic.

It’s where having a global network of experts becomes more important but it will also mean a greater demand for buyers to draw on local knowledge.

“One of the hardest challenges is going to be that global M&A and cross-border M&A will be challenged unless you already have a footprint in that country,” he says.

“If you’re trying to run a process at the moment, it’s very hard for someone who doesn’t already have it a team on the ground to do the deal because of travel restrictions.

“We’re going to see a reduction in appetite purely because people can’t see the business they want to buy. We can do Zoom calls and the like, but they’re only good to a certain point.

“At some stage you want to touch and feel before you actually hand over the money. And if you don’t have a management team on the ground in that country to do that touching and feeling for you, then that will be a challenge.

“Until we open up the borders and have more free flow of travel, we are going to have limits on what investors believe they want to buy.”

Focus shifts to business as unusual

As dealmakers come to terms with the new normal, the focus is shifting to where markets might recover faster or see rapid growth.

While only 18% of dealmakers think there are better opportunities in Europe’s mid-market than in other regions, some areas perform better than others.

Mr Sonego expects to see a shift in the mindset of business, as they look for certainty in an uncertain world.

“I have a feeling that it’s a three to four-year window where we’ll see more conservative balance sheets, lower multiples, more sensible decision making,” he says.

“And then at about three three to four-year mark, when all of a sudden it’s far enough forgotten, — no different to the GFC —  there will be a change in sentiment by investors who decide all they want is to get the highest return on investment and that will change their behaviour.

“There will be deals done, but it will take time to find the new norm.”

Deal drivers case study: Tech is top priority

Procuring new technology will be the strongest motivator for investment in Europe, according to dealmakers, so it’s no surprise technology, media and telecommunications sits comfortably as the most attractive sector for M&A in the months ahead.

The forced digital transformation of businesses has highlighted the need for better tech investment, and European tech firms are well placed to benefit, according to the Global dealmakers: European M&A market update.

“We are seeking better and advanced innovations, for which European markets are known to provide,” says one respondent.

“European [tech] assets are strong in terms of value generation.”

Even among the depressed M&A activity in the wake of COVID-19, dealmakers are looking closely at the technology sector, as the team at Baker Tilly Spain has seen first-hand.

The business has secured multiple buyer-side mandates in recent weeks, building on its strong record of deals in 2019.

Among those deals in 2019 was the acquisition of the Madrid-based software firm IMAWEB by Providence Strategic Growth.

Baker Tilly Spain’s corporate finance team, led by Diego Gutierrez, advised IMAWEB and closed a deal that will finance its growth strategy.

IMAWEB has created a web-based operations system designed specifically for car dealerships and is one of Spain’s largest developers of digital solutions for the automotive industry.

The technology, which serves both dealers and some of the best-known car brands in the world, helps improve in sales, profitability and customer loyalty.

Mr Gutierrez says the technology can be quickly deployed cover a dealer network and gives manufacturers an instant return on investments, not only by improving sales but by “an enhanced quality image and by the most powerful reporting system in the market.”

This technology and IMAWEB’s growth potential proved attractive to PSG, an arm of the Providence private equity firm, which has about $40bn of assets under management.