The year was looking to be another possible record-setter for deal activity, and then Covid hit. The impact in Lehigh Valley was similar to Pennsylvania and the country as a whole. Deals suddenly were put on hold or cancelled. According to GF Data®, lower middle-market deal flow in Q2 2020 was 76% below the prior five-quarter average. Surveys of deal professionals from the AMAA and M&A Sources both came up with similar conclusions where approximately 50% of transactions in process were put on hold or outright cancelled, and in most cases, it was the buyers making the call. Buyers and lenders were rightly apprehensive as businesses were shut down, and demand dropped.
But something happened by the end of May, as parts of the economy started to open up, demand increased, and the general mood improved. This was reported here in Pennsylvania and elsewhere. Many deals that were on hold moved towards completion in Q3. This happened because as bad as Covid shutdowns have been for certain sectors, particularly hospitality, other sectors had surprising resilience and even strength. Business and industrial services, along with manufacturing, saw some declines but a strong rebound, and we also saw the same in home improvement related businesses as business demand rebounded to levels above prior years. Although hospitals have taken a large hit, other healthcare sectors, including home care – medical and non-medical, have seen lesser impacts.
At the same time, buyers came back into the market in a strong way in May and have continued to be very active right thru September, creating a competitive situation for sellers of quality businesses. The current market is good primarily for quality companies with few or minor imperfections. Buyers may be active but are also more cautious and have less of an appetite for companies with significant issues beyond demand. This is a cautionary note for owners thinking about selling soon – if you want to get a good price – prepare your business as Covid has brought an additional level of scrutiny. Even for the deals that are being completed, we have seen an increase in the use of earn-outs to help bridge some of the near term uncertainty. The sizes of earn-outs have been relatively modest, which seems to reflect the buyer’s concern about the near term but continued optimism for the long run.
Commercial lending for business acquisitions continues to be mixed. While base interest rates have decreased, premium levels have increased due to bank’s perceptions of uncertainty. SBA backed lending continues strong for deals under $5 million, although we have seen additional due diligence as lenders attempt to assess the longer-term impact on companies’ performance. For larger deals, some lenders have pulled back on their lending or decreased their risk tolerance. GF Data® reported for Q2 2020 that debt to EBITDA levels declined about 15%, forcing private equity buyers to increase their equity injections. The lending environment bears watching over the next six months.
All of this means, for quality companies that are weathering Covid with minimal impact, pricing valuations have not declined. There does seem to be some pullback on the very highest valuations, but very few companies saw these even in the best of times. For the rest of the market, valuations remain in an expected range based on size and quality. Deal structures are seeing an increase in risk sharing as noted above with modest earn outs, but so far, we have not seen any noticeable increase in requests for seller financing.
The future is uncharted waters for all of us, and Covid-19 is not going away anytime soon, leading to continued hardship for many individuals and businesses. For business owners thinking about an exit, some will have a receptive market, particularly quality companies in the economically favored industries. Many corporate buyers have strong balance sheets and a desire to continue growth while private equity also has significant funds available and are deploying that capital for platform and add-on companies. Even high net worth individuals are actively pursuing deals, so at the present, the outlook is favorable if not quite settled.