As if the uncertainty of the upcoming US Presidential election and President Trump testing positive for the novel Coronavirus wasn’t enough, a new matrix of conditions impacting sell-or-buy business transactions has appeared just in time for Q4 2020. Here’s a look back at a few of the impacts that COVID-19 brought to the middle market in 2020, and a look ahead at some potential impacts to keep your eye on.
A Look Back
What a year 2020 has been thus far – unanticipated economic headwinds from shelter-in-place rules have affected supply and demand, with a ripple effect across many interconnected sectors. The resulting shifts in near-term business fundamentals and adjustments to capital markets increases risks for mergers and acquisition transactions, and has made valuations challenging.
A few of the impacts complicating middle market transactions included:
- Unexpected global externalities, such as supply-chain disruptions
- Volatility of product demand resulting in losses or surges in earnings
- Increased costs to business operations due to implementation of additional health & safety guidelines
- Restricted travel, with limited onsite visits for due-diligence, relationship-building & negotiations
- Information delays due to decentralized personnel & limited records access
- Sale-Purchase Agreements (SPAs) being delayed or with revised terms
Deals continue to progress and make it to the closing table. Businesses that are performing well in spite of COVID19 continue to be highly sought after targets from both strategic and financial acquirers. There was a clear industry prioritization as approximately 80% of the Q2 reported deal volume by GF Data were in four industries: manufacturing, business services, health services, and distribution.
However, buyers with cash and risk tolerance are increasingly seeking distressed deals as well. More business owners are considering an ownership transition, and could see interest from larger corporations considering complimentary products/technology as an attractive option as well. Consolidation in certain segments can drive additional market share in the case of a non-V recovery. In fact, some sectors continue to see enhanced valuations, primarily due to pent-up demand from institutional investors looking to deploy capital.
A Look Ahead
Acquirers of small and medium sized businesses need to think through the impact of US fiscal policies specifically in response to COVID-19. Some of this legislation has been enacted while other parts of it are a work in progress. Regardless, such legislation and government programs could potentially extend the scope and timeline for due diligence, as both parties of transaction examine compliance, adjusted accounting rules, tax changes and financial credits. Some key pieces of legislation and fiscal policy to keep in mind include:
- Paycheck Protection Program (PPP) –
Businesses receiving funds from PPP come with liability transfer rules varying for stock or asset sales. Additional disclosures are needed from the seller, and the buyer must evaluate if the loan was properly acquired and compliance was maintained. Ongoing compliance regarding employment-level commitments could restrict future operational changes.
- CARES Act –
Significant tax changes impact not just 2020, but returns filed for prior years. This act also allows deferred payroll taxes, net operating loss carryback refunds, interest expense limitation rules and employee retention credits. Any sales and purchase agreement (SPA) must detail whether the target or the acquirer will benefit from these credits. Additional Act modifications are likely and federal/state non-conformities still remain to be sorted.
- Net Operating Losses (NOL) –
NOL’s from 2018-2020 can be carried back for 5 years. There are additional considerations for amounts carried forward into 2019-2020. The SPA needs to address which party will be entitled to the refunds, which may create more attractive valuations for unprofitable corporations.
- Qualified Improvement Property (QIP) –
QIP altered 39-year properties into 15-year properties with accelerated cost recovery eligible for 100% depreciation, retroactive to 2018. This has significant impacts on net tax asset values to be negotiated in a transaction.
- Alternative Minimum Tax (AMT) –
Amended rules allow 100% capture of tax credits instead of multi-year allocations.
As a result, Sales and Purchase Agreements need to carefully consider the implications of these new rule changes, as well as related compliance requirements.
Impact of Uncertain US Presidential Election
Upcoming November elections add an additional layer of uncertainty. Unfortunately, this election cycle has developed like few before given extreme divisions, COVID responses, protests and lock-downs.
The impact of this uncertainty on middle market deals is significant. Take, for example, the timing of middle market M&A deals. Owners and acquirers may delay processes and shy away from transactions, as they seek more certainty regarding the economy’s direction and potential tax changes. Conversely, they may move more aggressively to complete transactions before any potential tax changes take effect.
The outcome of the election could have a significant impact on future M&A activity. Biden has proposed an increase to the Capital Gains tax rate, while Trump hasn’t announced a plan. Will there be more COVID related stimulus, and if so, how will those impact business and tax rules?
Even the process of the elections feels unstable. A smooth transition of power feels less assured than ever given concerns surrounding voting methods, election returns, expected legal challenges, and even comments made during the first 2020 US Presidential debate. If election results are unknown weeks or months later, even if protests don’t erupt, economic uncertainty is a very real possibility. Given the prior history of election-related litigation, it would seem that a volatile Q4 is one of the few things to be certain about.
Stay Calm and Plan Ahead
During times like these, we first need to remind ourselves of the old adage, “this too shall pass”. It’s best to avoid making hasty or uninformed decisions in the interim. There may be a new normal after the dust settles, but solid business practices and resulting value will prevail in the long-run.
A second practical step we recommend is securing professional guidance during this time. While DGP Capital always recommends assembling an experienced team of professionals for a transactional sale, this is exceptionally true in light of this unusual year. Economic volatility, political uncertainty, social unrest have created sales price uncertainty for sellers and capital deployment risks for buyers. Working with professionals who have their finger on the pulse of the M&A market can assist in determining the best valuations, monitoring evolving economic conditions and guiding the transactional process through these times.
Last updated: Oct 2, 2020