Corporate Restructuring Post Coronavirus: Carve-outs Represent Attractive Opportunity, but Execution Risk is High
The global COVID-19 pandemic has brought corporate deal making to a standstill. No one in a generation has seen anything like it, not even the 96-year-old Charlie Munger, vice chairman of Berkshire Hathaway.
Berkshire Hathaway provided a lifeline to several companies, including Goldman Sachs, in the last financial crisis in 2008-09. But this time around, “the phone is not ringing off the hook,” Munger recently told the Wall Street Journal.
“Everybody is just frozen,” he said. After a period of record merger and acquisition activity over the past decade, dealmakers now face unprecedented disruption
Companies in many industries, from hospitality to manufacturing, are seeing significant declines in revenues. Bankruptcy lawyers and advisers report that they have been receiving inquiries in recent weeks from cash-strapped companies drawing down loans. This public health crisis has left the global economy in shambles. Companies are in distress; millions of people have lost their jobs. Governments and the assistance they provide can surely help, on at least a short-term basis. However, capitalism and positive market forces will eventually need to weigh-in, and begin to do their part to pull us back to growth.
The M&A Supply
M&A can be one of those paths back up. Recent challenges provide good reason to believe the pool of acquisition targets should swell, with pieces of companies or entire organizations adding significantly to the M&A supply in coming months. What for a long while has been a seller’s market will switch to one favoring buyers, especially those in relatively strong capital positions.
Private equity firms, for one, have a record $2.5 trillion of committed but unallocated capital, according to estimates by data provider Preqin. Many American companies are also sitting on piles of cash, led by large tech companies such as Microsoft, Alphabet, Apple, Amazon and Oracle. These estimates of cash reserves were before the coronavirus pandemic hit, so not everyone is in the same position. Yet, the ability to buy – a key part of M&A demand – will be stronger than in past downturns, bolstered as well by low interest rates, and up to $4 trillion in Federal Reserve lending.
When what seems a likely surge in M&A activity will hit is anyone’s guess. At some point however, value-minded investors will urge businesses and PE firms to go bargain hunting for distressed assets, or pursue opportunities to carve out businesses that would otherwise have been too expensive.
Before the onset of COVID-19, competition for quality assets was driving up valuations. Data from S&P Global Market Intelligence shows that the year-to-date average through September 2019 of multiples paid for U.S. leveraged buyouts increased to 11.5x EBITDA, up from 10.6x over the same period in 2018. However these should now change direction.
Carve-Outs Don’t Live Up To Expectations
While the economics of carve-outs may be more attractive in the current environment, untangling a business from its parent company across multiple jurisdictions to create a fully independent entity loses none of its complexity. Our latest global research shows that up to one-third of cross-border carve-out deals don’t live up to expectations simply because of this complexity.
For our research, late last year we commissioned Mergermarket, one of the leading M&A market intelligence firms, to survey 200 C-suite executives at corporations and PE firms based in 29 countries with buy-side experience of a cross-border carve-out over the past three years. The aim of the survey was to analyze the source of value creation and value destruction in such transactions.
In this landscape now, where the impact of the outbreak is not yet fully understood, value creation in deal making is more important than ever. One of the keys to value creation is making robust financial assessments, which is a significant challenge under normal circumstances, the survey showed. The pandemic has led to decreased demand for products or services, supply chain disruption and idled facilities, among other negative business effects, which all impact financial performance and future earnings estimates.
Take the airline industry, for example. It faces global revenue losses of up to $113 billion, according to the International Air Transport Association. When stay-at-home orders lift, how close will demand return to pre-COVID levels? Myself and other frequent business travelers I know are finding that we are nearly as productive working from home during the pandemic, due in part to high-quality video applications and other digital collaboration tools.
Carve Outs And The Changing Competitive Landscape
While potential targets should be plentiful in the current environment, the competitive landscape for carve-outs and other M&A is changing. Buyers will have to make quicker decisions on risks, benefits, and valuation, because some sellers may be forced to raise cash quickly. They may also have limits on their due diligence because of travel restrictions and local mandates blocking access to assets.
Under normal circumstance, as we all know, buyers often overestimate the extent of synergies and cost efficiencies they will gain from the deal, while underestimating the time it will take to achieve them.
Now more than ever in cross-border deals, value creation includes having local knowledge of compliance, accounting and reporting regulations, labor laws, and any other country-specific requirements. And the right expertise and resources need to be brought on board as early as possible.
It should come as no surprise that acquirers with a limited or no presence in the target’s country are more likely to have disappointing M&A outcomes, according to the survey. Indeed, 38% of respondents who had limited or no presence in the carve-out’s jurisdiction say their most recent deal did not meet their strategic goals.
M&A Deal Value
A lack of preparation will lead to delays in closing a proposed deal. Time lost to various inefficiencies increase the cost of an acquisition and destroy value. Our survey found that more than 90% of PE acquirers, and 85% of corporates, said cost overruns added 10% or more to the original value of the deal.
One respondent, the head of M&A at an Indian company, described the delays as such: “We hadn’t expected it to be seamless, but we weren’t prepared for the effect on costs, and we had to make some hasty financial decisions to get the deal over the line.”
Succeeding through M&A in these uncertain economic times will require a whole new level of courage and discipline. Smart long-term investors love when the prices of favored financial assets fall, creating favorable buying opportunities. To quote Charlie Munger’s long-time partner, Warren Buffett, “Whether we’re talking about stocks or socks, I like buying quality merchandise when it is marked down.”
About The Author
Larry Harding is the Head of North America for TMF Group, a leading provider of international business administration support services.