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Kearney Guest Blog: Navigating uncertainty – mergers and acquisitions in uncharted waters

As the COVID-19 crisis transitions into a more long-term scenario, merger and acquisition (M&A) executives are considering how to navigate an industry affected in multiple ways by the global pandemic. The short-term trends pose distinct opportunities as well as a few pitfalls, while the long-term implications suggest that things may never go back to the way they were.

And although uncertainty remains the only constant, reflecting on and adapting to some disruptive M&A trends will better position all players in the industry. If anything, the pandemic may have accelerated some consumer and business disruptions that were already underway. But whether these sea changes are COVID-related or simply an evolution of the industry, the fact is they merit attention.

Based on our in-depth research, we’ve identified eight key disruptors to consider, with strategies to help businesses succeed in a post-pandemic world.

Short-term trends: the impact of the COVID-19 crisis and regionalism

1. Deal flow slows down, but valuations hold steady

The pandemic understandably hampered deal activity in the first few months of the crisis, with deal flow down by more than 50 percent in some markets. There were two major reasons for the slowdown. First, multiple would-be acquirers backed out of deals that were negotiated before the pandemic. Given the supply chain disruptions and continuity issues, revenue losses, and a new focus on health and safety, it makes sense that some companies paused to reconsider their M&A timing. The second trigger we’ve documented is the wait-and-see mode that acquirers have gone into—they may be hoping that weaker players fold under the current pressure.

Meanwhile, we’re not seeing many bargain-basement deals, as multiples have remained largely flat. However, in some cases sellers have discounted COVID-related declines as a one-off situation. At the same time, not only are strong assets holding their value, but some companies are commanding additional premiums, too—also COVID-related—to account for the proven resilience of their business models. The dry powder availability, which we’ll discuss shortly, also adds to the demand for quality assets.

We are, though, witnessing some regional differences in valuations. For example, valuations in Europe are trending down, even for companies that have survived and thrived through the crisis. It’s possible that valuations may settle at a lower level than before the pandemic. But at this point it’s too early to say, and close monitoring is the best approach.

The unusual circumstances do present an opportunity for firms to reassess their investment strategies and refresh their target lists. Those companies with strong balance sheets that are less dependent on leverage to pick deals may even find that now is the right time to take advantage of limited competition.

2. Scrutiny on deals increases and resilience will be a focus

COVID-19 has underlined the value of resilient business models and divided the field. There are companies that benefited from the disruption, rising to the occasion and deftly navigating the uncertainty. And there are companies that were not able to adjust to the sheer magnitude of the changes. The overall effect? Revised deal criteria that include tighter checks on business model resilience. This is especially true for larger, more complex deals.

We anticipate that the current uncertainty will persist, and the so-called new normal likely won’t emerge for some time, if ever. In such an unstable environment, resilient assets will probably continue to command a premium. Conversely, distressed assets may trade at a discount.

In all cases, acquirers need to create more robust commercial and operational due diligence processes, focusing on the target’s ability to operate in uncertainty and withstand supply chain shocks. Factoring this increased scrutiny into planning timelines is another smart move.

3. Consolidation is the name of the game

Industries and key sectors are affected differently by COVID-19. Some are thriving from a surge in demand; others saw their cash flow dry up as they tried to manage fixed costs or couldn’t get enough product to meet the rising consumer demand. Companies with global supply chains or labor-intensive production processes were especially vulnerable to the latter.

The circumstances create the perfect storm for driving consolidation. Companies suffering because of the recent disruptions are considering restructuring, which can often lead to aggressive divestitures. And others are exiting businesses with lower growth and profitability prospects while focusing on cost reductions to maintain profitability. The pandemic has become a sort of truth teller as companies that were successful in a hot economy—but lacked key differentiators—are now unable to weather the storm. Lastly, a significant dip in consumer spending and a shift toward omnichannel offerings is contributing additional pressure.

The disruption and resulting consolidation present a unique opportunity for companies to integrate, enhance, or even fully transform their current operations through M&A. Making moves such as capitalizing on the latest technologies or securing new supply chain capabilities today will lead to a stronger business tomorrow—and one more competitively positioned for an upswing in consumer spending. The current environment should also spur companies to review their brand portfolios in search of cost synergies (for example, joint wholesaler terms, back-office costs). Additionally, we predict that many organizations will reshape their portfolios as they refine and adapt their M&A strategies.

An uptick in consolidation will likely attract the attention of regulators around the world. And there’s no doubt that COVID-19 has changed their view of proposed transactions. In fact, the European Union’s competition chief signaled in a recent article in the Financial Times that “more [intra-Europe] cross-border deals [are] a way to stave off the growing threat of aggressive foreign powers looking to scoop European companies.” This is a 180-degree turn from the EU’s previous stance and may clear the way for increased consolidation on the Continent.

4. A shift toward regionalism builds walls instead of bridges

For decades, globalization has been a given, and spurred the growth of many countries’ economies. Supply chains have extended seamlessly around the world and global customers are now the norm. However, recent sociopolitical shifts have put this world order under scrutiny, with ever-increasing calls for national protection.

What started as political rhetoric is now having real business impact. In fact, Kearney’s annual Reshoring Index for 2019 showed a decisive shift away from low-cost countries in Asia, breaking a five-year streak. We expect this reshoring trend will continue to accelerate, driven in part by businesses rethinking their operations in the context of a new, more regionalized world order.

In this context, agile, diversified, and resilient supply chains primed to operate even amid uncertainty—such as changes to trade restrictions and global travel limitations—is a significant competitive differentiator. We anticipate that companies will continue to rely on M&A activity to build capabilities in this area.

Looking forward: the changing M&A landscape

5. Private equity firms are primed for significant activity

Private equity markets continue to represent an ever-growing source of financing; as of June, PE firms were sitting on $1.5 trillion in dry powder, according to Preqin. In addition, the firms are growing increasingly open to a wider variety of deals. All of this adds up to more buyers and sellers that are ready and able to move.

Mega funds in particular have been preparing to use hard-earned learnings from the 2008 financial crisis and take advantage of an economic downturn. For example, after the Great Recession, many PE firms were slow to pursue new deals and missed out on significant opportunities to acquire quality assets at a discount. In some cases, we are seeing firms already emerging from the first wave of the pandemic with newly raised funds. We’re seeing PE firms seeking out deals adjacent to their original mandates in order to capitalize on new opportunities, and divestitures by companies that have struggled during the crisis. They’re also leaning on value creation teams—this helped drive performance in the aftermath of the last recession. All this is bolstered by competitive bidding and an eagerness by PE firms to deploy their static capital.

6. Smaller, more focused deals may win the day (or year)

There is a shift toward smaller, capabilities-focused growth deals over scale-based megadeals. Certainly, megadeals will always have a role in the broader M&A market. However, targeted scope deals allow buyers to build strategic capabilities, acquire the latest technologies, and gain instant access to new markets or suppliers. Indeed, we are seeing an increase in corporate venture capital, which is key to smaller-scope investments.

The evolution of a global private investment market that allows investors to conduct deals in previously distant geographies is helping drive interest in smaller deals. Another contributor is the increasingly well-funded venture capital community, which is supporting the development of emerging technologies all the way through to mature solutions before scaling commercialization.

Smaller capabilities-focused deals will require an agile approach at the beginning, from better target screening to due diligence. An earlier level of engagement will also likely inform which deals will be the most successful. Given that these deals might be outside an investor’s current experience and immediate industry or functional boundaries, it will take time to understand a target’s capabilities and complete the additional (but required) due diligence.

Given the relatively limited impact these deals typically have on overall market dynamics, they stand to face less anti-trust scrutiny. This, coupled with the tuck-in nature of these transactions—meaning potentially less complex systems integrations or separations compared to a megadeal—should result in faster integrations.

This is especially true considering that capabilities-focused deals are targeted toward value creation rather than functional integration. And because the true value of a scope deal lies in its growth and revenue potential, integration strategies should prioritize top-line value creation rather than bottom-line cost synergies.

7. Alternative deal structures become commonplace

M&A players are becoming increasingly sophisticated, with both buyers and sellers looking for alternative deal structures to generate value. Deals are no longer driven exclusively by scope or scale. Rather, we see a transition toward deals taking place for targeted reasons, whether motivated by the market, tax implications, digital transformation objectives, or in other nontraditional ways. This shift appears to be more permanent, with emerging deal structures rising as alternatives to the traditional full-scope acquisition.

The new structures allow investors to bet on a wider range of investments in their portfolios and explore deals that are not necessarily related to their investment mandates. To be sure, this will come with its own set of complications, including managing a larger number of investments, less control, and a departure from the investor’s core objectives. For buyers, developing the capabilities required to navigate increasingly complex approaches to investing is becoming crucial. Alternatively, buyers have added flexibility and can tailor their investments to their available capital and risk profile.

Further, we are seeing an increased interest in the use of earn outs. This is, in part, to bridge potential valuation gaps, especially for those deals that are more “scope over scale” and likely to involve entrepreneurs/owner operators. Earn-out programs can also have an impact on the potential to integrate if the assets are managed separately for longer.

8. Remote work and virtual integrations are the new norm

Long before COVID-19 forced the issue, virtual integrations and divestitures had been gaining in popularity. The pandemic put M&A systems to the test and proved that deals can successfully move forward virtually.

The longer the pandemic keeps businesses from returning to their old ways of operating, the more likely that remote work will become a standard part of operations. As such, we expect that integration and separation programs will adopt a similar level of virtual activity.

Although M&A execution is a delicate and critical activity traditionally handled in person, travel restrictions and crisis-related work-from-home requirements spurred acquirers and sellers to make large portions of the effort remote. Looking forward, technology will play an ever more important role in deal management, accelerating decision-making processes, lowering costs, and helping teams become increasingly agile.

The big takeaways

Economic uncertainty will continue to be part of investors’ work and lives. However, even so, it’s important to draft near-term M&A plans that are based on the impact of COVID-19 along with long-term M&A strategies that are rooted in the broader, larger-scale shifts. With these observations and insights in mind, we recommend that investors do the following:

  • Reassess investment strategies and refresh target lists so you’re positioned to jump on opportunities before valuations resume their climb.
  • Ensure that resilience has a place in your new deal criteria and evaluate targets with an eye toward how they’ve navigated these recently choppy waters.
  • Review and refocus supply chains to create an agile operation that can adapt to the ramifications of growing regionalism, from trade restrictions to travel limitations.
  • If you’re exploring smaller-scope, capabilities-focused deals, engage as early as possible, expand your due diligence process, and keep the focus on top-line value creation.
  • Invest in technologies that enable and empower remote work so that you can maintain momentum on deals with no personal contact.

M&A activity has historically been cyclical, and our rapidly evolving environment means companies need to take this time to reflect and reassess. Those that come out as the most successful will leverage the situation at hand to improve their resilience and create strategic M&A plans that capitalize on once-in-a-generation opportunities.

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