As M&A professionals consider what deal-making activity will look like in 2021, Steven Frank, a partner in DHG’s Transaction Advisory group, and Scott Linch, a managing partner in DHG’s Private Equity group, discuss what they are expecting to see in 2021 and where they think deal-makers will be placing their bets.
Q. Tell us about recent M&A trends and where you see the market heading in 2021.
In late Q3 2020 and into Q4, we saw significant deal flow return. The increase in deal flow was driven by the re-emergence of paused deals, pent-up demand from private equity due to significant amounts of dry powder, an urgency for some sellers to close a deal prior to year-end to preempt an expected rise in capital gains taxes, as well as some distressed opportunities arising as a result of the pandemic.
In 2021, I expect there may be a short-term pullback followed by various surges of deal flow beginning in Q1 for companies that performed exceptionally well during the pandemic, and then we may eventually get back to some level of normalcy mid-year. However, I do anticipate sustained volatility for some time. The most common obstacles to deal flow next year are economic and political uncertainty, the availability of quality acquisition targets, buyer competition and valuations. The presidential election may result in some short-term volatility, but I suspect it may not be that impactful.
Q. Which industries have experienced the most investment interest during the last year and what do you expect in 2021?
Technology and business services have remained relatively strong. The software, technology, digital and telecommunications space likely continue to lead the charge as they are generally more resistant to short-term disruptions, and their valuations have performed well in 2020. We see plenty of opportunistic deals in growth segments such as internet and streaming services, cloud computing services, remote working technologies, cybersecurity and fintech. On the telecom side, we are seeing significant growth in managed services as companies move away from on-premise solutions and high capex investment models to a recurring managed services model. This shift marks the growing adoption of cloud-hosted solutions. The overall growth in technology and telecom is driven by broader economic and consumer demand, but also the appeal to investors of the recurring revenue model.
Partner, DHG Transaction Advisory
Private equity groups are showing a high level of interest in the business services industries, particularly for companies with recurring revenue and scalable margin, often in industries in a fragmented market that is ripe for roll-up strategies. As such, there has been a significant amount of consolidation and add-on investment opportunities. We have seen increasing activity in tech-enabled business services and commercial and residential services, such as HVAC servicing and repair, pool services and maintenance, and repair or renovation services. Buyers are seeking smaller add-on deals in the lower middle market at lower multiples of EBITDA and with synergistic opportunities to drive value.
Q. Which due diligence considerations will be key in 2021?
One of the biggest challenges is assessing the impact of COVID-19 on operating results. In all transactions, we continue to see varying degrees of acceptance on normalizing for COVID- 19 results in valuation discussions. Consideration should also be given to the impact of COVID-19 on working capital as we continue to see challenges with buyers and sellers agreeing on the appropriate level of target working capital at closing. Other key considerations are PPP loans and changes in accounting policies, especially revenue recognition and the new lease accounting standard.
Emerging Strong in 2021
Q. In times of uncertainty and disruption, companies often focus on optimizing cash flow and working capital. What did you see from the middle market in 2020?
When COVID-19 came to the U.S., private equity was very focused on updating forecasts, cash flow modeling and profitability roadmaps with all their portfolio companies, and now most groups are maintaining and updating those models.
Managing Partner, DHG Private Equity
As for the Paycheck Protection Program, many portfolio companies did not receive a loan; however, many of the businesses not backed by private equity did, and they eventually need to consider the right number of employees and other cash expenses once their PPP loan has been used. During the pandemic, some businesses retained more employees than possibly needed due to the stipulations of the PPP loan, and we later saw profitability was not as high in those months.
In terms of working capital, there was greater focus on cash flow considerations related to timing of payments, extended terms and recurring business, particularly for software and services companies. We also saw delayed purchases and renewals on certain government and municipal agreements. Throughout the year, we knew to distinguish between situations that were delays rather than a lost customer base.
Some examples of industries most adversely impacted in 2020 were fitness studios, restaurants, retail businesses and other brick-and-mortar companies.
Q. Which value drivers received the most attention from private equity in 2020 and what do you expect to see in terms of performance improvement in 2021?
Monitoring business performance is crucial for all businesses, but private equity seemed most focused on performance improvement in 2020. We saw many investors interested in optimizing the effectiveness of their sales force, including efficiency and compensation. In the specific event of add-ons, there were typically situations in which the sales force was compensated very differently, and the goal was to find a solution involving consistent compensation. This can be particularly true for software businesses and other subscription-based businesses with a large and widespread sales force.
Going into 2021, we expect to see more activity related to financial management. Financial management becomes a focus on Day One for many portfolio companies since it can take months to implement. Likewise, good forecasting requires a proper finance team in place to measure growth and performance. Often, this may involve adding an industry CFO, implementing an ERP system or establishing new reporting. Many founder-owned businesses do not have the sophistication required of private equity when it comes to KPIs and monthly reporting.
Q. How are you seeing the recent market uncertainty affect valuations?
In the middle of 2020, many private equity groups had to mark down their portfolios, some adjusting nearly 20%. Despite the portfolio markdowns, acquisition multiples and valuations are still very high and future-focused. Run-rate revenue and future EBITDA often have increased importance rather than the previous last 12 months of EBITDA. The pent-up demand for deals along with the surplus of dry powder continues to drive deal activity and valuations.
Q. What types of deal issues do you envision playing a large role in 2021 M&A regardless of the industry?
The biggest issue for transactions in 2021 is COVID-19. How companies adjust, whether positive or negative, continues to play a large role as companies attempt to determine the new normal. Businesses also need to reconsider their go-to-market strategies, particularly customer acquisitions and business operations in a virtual environment. Another top issue is e-commerce platforms and digital visibility and reach. This may result in increased technology investments to enhance touchpoints and communication with customers.