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Oct 26, 2020

Middle-Market M&A Suffers Amidst the Coronavirus New Normal

The number of middle-market private equity deals took a hit in the second quarter of 2020, showing minimal improvement in July through September. The primary reason is clear: COVID-19 created an environment that has organizations skittish about investing too heavily right now. To explore the current outlook for mergers and acquisitions, we met with Anthony DeCandido, an audit partner and coleader of the CT financial services practice for RSM US LLP.

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By: Bill Hayes, Pennsylvania CPA Journal Managing Editor


Podcast Transcript

The number of middle-market, private-equity deals saw a steep decline in the months April-June 2020. There is certainly no question as to why: The environment created by the continuing pandemic has firms hesitant to invest too heavily toward the future. Today, we'll be talking to Anthony DeCandido of RSM US LLP about COVID's effect on mergers and acquisitions, the residual impact on fundraising, and so much more.

As we said in the intro, looking at middle market private equity deals in April-June 2020, there's certainly been a decline. Clearly, COVID-19 has been a big part of that. Can you walk us through why you think the decline has been steep, and is it status quo in times of economic stress for it to be like that?

[DeCandido] I think there's been tremendous uncertainty around this space. We've seen in the numbers, when you look at some of our datasets, private equity activity is on pace to hit something like a 10-year low in terms of count and about an eight-year low in terms of value. Through the most recent dataset, which is Q3 2020, we've noticed only 576 port go exits from private equity groups. This is roughly $218 billion of capital, and that's roughly, say, 30% of decline from the same time last year. This presents a pervasive issue, which is GPs increasingly are holding onto portfolio companies until the evaluations recover. I think, when we look at U.S. fundamentals, I would argue they are still quite weak. You see increased unemployment and sustained job losses. The issue of school reopenings, and even closures, is something that puts a bit of a strain on the U.S. economy.

We understand that there's still a lot to be begged for in the way of what becomes of a U.S. Presidential election, whether or not we have a Democrat in office, or not. People don't think about this one as often, but we've also had a pretty severe hurricane season so far, which puts added stress on the U.S. economy. Then last is the ongoing trade spat that we've had with China and the sense that we may be moving into a world of increasing nationalism, which I think we all would agree is poor for the U.S. economy.

So when we look specifically in all of those fundamentals, I'll focus a second just on employment. When we look at some of the past six weeks of data from the payroll sets, I'd say first-time claims, they're somewhere around 860,000, which points to a stalling out of improvement as claims remain at elevated levels. All this to me just points to the need for another round of fiscal aid to provide relief for the thousands of Americans that are still unemployed. All in all, I think it presents some challenges for all industries. Private equity is probably most insulated, but nonetheless are still quite challenged that way.

In the same time period that we're talking about here – April-June 2020 – fundraising activity was down as well. Are the reasons similar or are there additional considerations in that space?

[DeCandido] Fundraising totals are way down through our most recent reading in Q3. There was roughly 167 funds closed, representing $127 billion of assets. That's directionally in line with what we spoke about earlier with just capital deployment. That's roughly a 27% decline year over year.

It has to do with a few things. For starters, you have to consider the life-cycle stage of a planned private equity fund. If you're on the earlier side, you lack, at times, legacy, you may not have as heavy of an institutionalized base. It's much harder for those groups today, in my opinion, to get things going. Private equity groups today must possess some level of institutionalized infrastructure, whether it's in their back-office accounting or marketing or finance departments. That's really important. So when we look through the data, some of the more legacy and mature type funds, I think, have an advantage that way, because those relationships are much more established.

So when you look at the impact of COVID, clearly it's a detrimental impact to U.S. fundraising, but there is a little bit more to the story. For starters, we are coming off a period of time of all-time records with dry powder and commitments. We were even predicting a downturn in capital raising before the pandemic. People sometimes forget that, but that is relevant in this case.

The other part of the 2018 and 2019 timetables that was really relevant is it was this period of time where there was these tremendous mega funds that were closing. That's been down a bit. When you look through the data, sometimes those mega funds can distort what is in fact actually occurring. When we look through the data as it relates to our market firm, we're equally as interested to see what's going on in that real economy bucket, which are those companies that our private equity funds invest in that are the backbone of the U.S. They represent one-third of the U.S. workforce. They're 40% of U.S. overall GDP. What goes on in the markets on the upper end doesn't always mirror what goes on in a middle market.

Now, here we are, we're recording this podcast in October. It'll probably be released before the end of October. But we'd be remiss if we didn't talk about the third quarter. Have there been any indications at this point that the third quarter was any different? If it's not too early to tell, what are those numbers saying?

[DeCandido] It's not too early to tell. I think there was a slight pickup. It didn't bring the levels that we've seen prior to the pandemic. You can gauge it with two thoughts. One is a little bit better from the last period, but still nowhere near what it has been. I think we've got our eyes peeled to the fourth quarter for a few reasons. We understand that we've got an election looming. Depending upon the election outcome, you may have business owners seeking to sell and/or even capitalize on what's being presented as lower capital gains taxes when the Democrat President goes in. We've seen this before. When we look back in historical periods in the waning months of 2010 and 2012, a lot of the PE funds were closing and free of deals, as a lot of those families and PE firms sold their businesses. That was to maximize those after-tax proceeds that were anticipated before the tax rates go up. We'll follow that closely.

There's other things that are in play that dictate what level of deal flow we may have. The Biden campaign is proposing to raise taxes on things like carried interest and some wealth taxes on those top marginal earners. Depending on how you look at that, it could also spur some of those GPs with larger gains from historical periods to sell ahead of schedule. We'll follow that closely. I would not be surprised if we saw even a slight uptick in some Q4 activity before the end of the year.

Just so people know, these questions come from a piece you did for our PICPA blog, CPA Now. One of the interesting parts that I saw in the article, according to numbers from the source PitchBook, it would seem that there were a number of deals possibly agreed upon, and then subsequently canceled. I guess my first question there, probably just out of interest for myself, is how can that be told by looking at the numbers? And then second, do deals like that traditionally get picked back up again when the economy is improved or are they scuttled permanently?

[DeCandido] I think it's a little bit of both. For starters, when you have, and to answer your question specifically, I think the best information we get that way is in some of the surveying we do as a firm, the surveys that we read from our competitors or others in the market. When you see that type of decline in Q1 fundraising and buyout activity to Q2, it begs the question. I think out of the gates, a lot of the groups were struggling to plan in-person meetings. We've learned again that those interrelationships are really key to develop the level of rapport and trust that would be needed for companies to want to transact with others. In the early innings of the pandemic, it was still unknown as to whether or not this crisis would be for a short period of time, one to three months, or much longer. I think everyone's natural reaction was just to kind of stall.

To answer the second part of your question about, is there this level of pent-up demand or not, I think it depends. Many of the industries that our private equity groups invest in are going through accelerated transformation processes. If you think of some of those most impacted industries, whether it's retail, real estate, oil and gas, the landscape of those businesses may be changed forever. Is there pent-up demand? Probably not. There's a possibility that those markets are sluggish for years and years after the COVID pandemic. Then to the other side of the house, which is that those industries are doing a little bit better. Say, for example, technology or even healthcare, the opposite may be true. There may be things that were in the works that were put on pause that are just sitting on the sidelines, waiting for the taking. I kind of look at it in the lens of “it depends.” It depends upon the industry that we're thinking about.

With deal-making limited, what sort of considerations do private equity firms have to keep in mind as they look to recover from this pandemic? What sort of steps should they be taking right now?

[DeCandido] I think if you're a private equity manager, you have to keep your eye on the ball. Private equity professionals are service organizations that deploy human capital. People will always remain their number one asset. They've had this rich tradition of always attracting some of the best minds in finance and in business. Whether they attract from the top MBA schools or investment banking firms or Wall Street or wherever, that won't change. But I think the methods for recruiting those individuals will. We see this even in our own business, virtual interviews are critically important, but evaluating things like professional aptitude and thinking and critical-thinking skills, learning agility, problem-solving, those are all things that are at times difficult to gauge. I know in the instance that we do have the opportunity to meet with people in person, that's always preferred. I'm also seeing a drive in interest for data and less on some of the traditional datasets, whether it's unemployment stats or consumer price stats, or what have you, but more so on alternative data.

So whether it's website scrapping or digital imagery, we can look at things like subway ridership for means of how people are getting back to work. There's all these alternate sources, I think, increasingly being utilized by private equity firms and even asset managers more broadly speaking. So, those firms' ability to get good information, whether they buy it from the outside or develop on the inside, I think is going to be critically important to evaluate these companies in light of them not always being able to be onsite.

Those firms are also considering their office blueprint, no different than our firm again. So what used to be a scenario where you needed to be in some of the top geographic talent areas like New York, Chicago, San Francisco, it may not be needed at least certainly in the near-term and maybe even in the long-term. A lot of these firms are looking to arbitrage some of their labor. If you look at some of those high-cost areas, maybe they're able to deploy human capital from different places. That could give employers and private equity groups a little bit of an edge that way.

Another thought that we have as a firm is this whole fluid workday schedule. It breeds different types of professionals in the work environment. For those companies that are able to create a manageable work schedule, it could bring other persons into an industry that traditionally have not been a part of it. For example, women. Women have not traditionally occupied VP-level or general-partner-level roles at private equity groups. If the firms are able to create amicable schedules that way, they may be able to capitalize on an element of the workforce that otherwise wasn't able to be done so previously. Those are just a few of the thoughts that are going through my mind, but it absolutely will be a changed landscape for private equities out of the gates of the pandemic.

Another interesting segment of the blog that you did, this time a particular line that just jumped out at me, it said, and I quote, "With so much uncertainty in the economy, it's difficult to draw the line between investing in the future and hunkering down to sustain existing business practices." Found that so interesting. What are the factors that lead firms to land on either side of that argument?

I think it's a lot of things. It's risk tolerance. It's available capital. It's talent. It's health and financial wherewithal of the existing investments. If you look at opposite ends of the spectrum, you've got portfolio companies that are doing relatively well. They're hanging on, they're maintaining market share. That affords more liberties at the private equity level because that portfolio company itself doesn't require as much support. If you compare that to the opposite side of the spectrum, maybe another portfolio company is essentially on life support and it needs bridge financing from a private equity group. They're doing change management. They may be furloughing or laying off staff. These are skeletons of an organization that they used to be so they may not be able to take the same liberties. When we think about private equity groups’ interest in either doubling down or just sustaining their business, we kind of see the jury split that way. I can point to plenty of examples on either side of the case just based on our own client deck.

But to me we look at the market in the following way: We think of it as the uncertainty of the industry. We think about the looming regulation changes or corporate policy changes that may come from an election. You've got companies with various different workforce dynamics and then also different liquidity needs. There's groups who are saying, "How can I access working capital to simply ensure that I have the cashflow in the declining revenue environment?" It's a pretty difficult question to answer straight, just given how different all the industries and for that matter, even every business is.

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Podcast transcripts are provided as a summary of the conversation and have been lightly edited for the written medium. The transcript is not a verbatim representation of the interview.
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