DEALMAKERS: Distressed investments in the COVID-19 marketplace and beyond
COVID-19 has wreaked havoc worldwide on an unprecedented scale. The coronavirus threatens lives while the measures necessary to stop its spread threaten livelihoods. This combination has forced a vast number of businesses into financial distress and will continue to impact businesses for months and years to come.
As a result of the pandemic, there are three categories of companies available for transactions: companies that have benefited from the crisis (value likely to be up), those that were healthy pre-pandemic and are now stressed, distressed, or shut down (value likely to be down), and companies that were teetering or distressed pre-pandemic and are now even worse off (value even further down).
Because the COVID-19 crisis and the resulting distress are not geographically restricted, industry-specific, or size-specific, private equity investors of all stripes on both the buy and sell side of M&A transactions need to prepare for a high-risk, high-pressure period in an economy so unique that it’s all but impossible to predict accurately based on historical models or previous recessions. Even as the market has flipped from a seller’s market of high valuations and fierce competition for fewer deals to a buyer’s market of more deals at reduced valuations, many of the deals will be distressed. For dealmakers who are accustomed to healthy company transactions, distressed investing provides tremendous opportunity, but also tremendous challenge.
Distressed investing is to healthy company investing as sprinting is to marathoning. Though they are both running races, they have very distinct and non-transferrable characteristics and requirements to compete effectively. Just as a marathoner is not likely to do well in a sprint without significant preparation and support, a healthy company investor diving head-first into the distressed M&A market is likely to find themselves struggling to keep up and without adequate risk mitigation. But those who can adapt quickly to this new normal will have opportunities for significant returns.
Healthy vs. distressed M&A
The key difference between healthy and distressed M&A is the pace and the order involved in a transaction. Distressed company transactions typically take place under significant time pressure, often without good data on problems or solutions, all as cash runs low and stakeholder emotions run high.
Investors in healthy deals can proceed at a pace that works for them to get comfortable (or not) with data available from past consistent performance; distressed deals require investors who can handle difficult timeframes without historical information bearing any resemblance to present circumstances. Healthy deals often involve a growth thesis; distressed deals require a survival strategy. Healthy deals are often properly or under-levered, leaving room for leverage to make a positive difference; distressed deals are often over-levered with no room to maneuver, requiring alterative structures and solutions.
A particular challenge we expect to see in post-pandemic deals is that distressed deals usually lack both the information needed for good diligence and a comparative historical basis for comparison, planning, and, as a result, challenges regarding valuation. Consider:
- What is normal for demand/revenue?
- Is supply/COGS solid?
- How do you answer these questions for businesses that were healthy pre-pandemic and are now shut down? Was the demand disruption mandated and temporary? Was it mandated but likely to have permanent effects? And how do you model and value the go-forward opportunity?
Lastly, above all else, the hallmark of distressed deals is that liquidity challenges and lack of cash runway further complicate the ability to get from start to a closed transaction in the available timeframe, even if there are interested and capable parties.
Ways to maximize value and minimize risk with distressed opportunities
A useful tool for distressed transaction opportunities is the same framework we use when advising distressed companies: the 3C’s. The 3C’s help address the frantic activity that leads nowhere or the paralysis that strikes many executives facing distress by helping key players narrow their field of focus to three critical drivers: Cash, Communication, and Control.
1. Cash: How much is there, and how long will it last?
The single most important component to succeeding in a distressed transaction is understanding a company’s cash situation, either working within the existing parameters or being able to increase runway. The 13-week rolling cash flow model – ideally an integrated P&L, Cash Flow, Balance Sheet, and Borrowing Base – is the most common tool for this analysis (not a monthly projection). In truly dire cases, we have even used a daily cash flow model. The goal is to understand the timing between expected inflows (receipts) and expected outflows (disbursements) and to manage in such a way that the company does not run out of cash mid-diligence.
Usually, an unrelenting focus on cash means that you must move at lightning speed, be creative with how to improve liquidity, have a Plan A, B, and C, and be willing to contribute cash if you really want the deal. (The concept of propping up a company with pre-purchase cash is an anathema to many healthy company acquirers, but it is commonplace in the distressed M&A world, to get the company to a transaction close and give you the best chance for success post-sale.)
There are a number of potential ways to increase cash in today’s COVID-19 environment: stimulus aid, financing, incentives for faster collections, landlord and vendor management, monetization of non-core assets, operational improvements, and insurance or other claims. In a cash-constrained environment, cash, not profit, matters in the short term.
2. Communication: Talk frequently and transparently to all stakeholders
As the prospective buyer, the more you get to know the stakeholders and the more they come to see that you want to save their company, not ruin their recovery, the more you will gain goodwill points that go a long way toward a cooperative effort by everyone to produce realistic information quickly and drive toward a successful sale. Stakeholders can include owners, management, employees, lenders, landlords, trade vendors, customers, and regulators.
Additionally, if you think any of the existing management team could be part of the go-forward team post-sale, frequent interaction gives you a very good window into their contribution and skill level. In fact, in a distressed transaction, it is not uncommon for the management team and prospective buyer to form a unit even before the sale as a result of a collaborative, in-the-trenches approach to getting the company from here to there. This is quite different from the more arms-length approach often seen in healthy company acquisitions.
3. Control: Assessing EBITDAC and bridging to future performance
Control takes many different forms, but generally focuses on understanding what makes the business tick, projecting how it will tick going forward, and knowing and tightly monitoring key performance indicators (KPIs) to ensure that the bridge from past performance to future plan is on track and achieved.
This bridge from past to present to future is such a challenge in today’s environment that a new tool for investment analysis has been rapidly deployed – EBITDAC, or “earnings before interest, taxes, depreciation, amortization and COVID-19.”
To understand the viability of a distressed company in a post-COVID-19 world, you will need to be able to assess the company’s past performance and likely future performance by understanding:
- Was the business already stressed or distressed pre-COVID-19?
- If pre-COVID-19 fundamentals were strong, can the company survive through restart and beyond?
- Does the existing business model fit with (or is it easily adapted to) expected post-pandemic consumer behaviors?
- Was the demand disruption from COVID-19 likely to be temporary or permanent? If permanent, what percentage of previous demand will be the expected new normal post-restart?
- If demand is holding (or expected to return), is supply available and reliable?
- Can the business make money going forward, and if changes are required to answer “yes,” are the changes likely? This is especially important for distressed companies, as they tend to be inefficient, not well-automated, and not properly focused on value drivers, i.e., what is making money and what is not.
- Where are the skeletons? For distressed companies, it’s important to understand at the outset the extent of contingent or unrecorded liabilities as well as risks created from lack of liquidity, angry stakeholders, etc.
Asking the right questions is the first critical step to generating a positive post-transaction ROI. Good analysis of the information provided is next.
To calculate EBITDAC in a distressed environment, financial disclosures must be complete, accurate, and fast, and those who review them need to act quickly to focus on key value drivers. It’s important to analyze at least 2-3 full years and perform a thorough trailing 12-month analysis, as well as a forward look by month for the next 9-12 months. You might also consider data analytics tools that dig deeper into sales transactions at the customer and product levels to better understand the company’s sales performance and customer buying patterns.
This analysis needs to sort out the “real businesses” from the “one-hit wonders” that may be succeeding among the conditions of COVID-19 but have been masking red flags in business performance even before COVID-19 disrupted the economy. Potential red flags in top-line performance include:
- A decline in average selling prices or increased promotions that may be contributing to higher sales, but ultimately will result in lower profitability.
- Increased selling prices that lead to overall higher revenues, but may hide the fact that customers are actually buying lower volumes.
- Inventory channel stuffing due to customer over-buying and not having insights into true demand levels on the shelf
Slicing and dicing revenues by doing a price/volume analysis as part of the financial due diligence is critical to uncovering these key trends.
Can the business adapt quickly enough to survive?
Distress creates the opportunity for an investor to “get it right” as the business emerges from its immediate crisis. Once you’ve developed a deep understanding of how the business got to its current condition, you’re in position to identify what can be changed to improve performance going forward. The immediate to-do list should include an analysis of the company’s structure, customer base, pricing, days sales outstanding (DSO), workforce, capital structure, historical liabilities, vendor contracts, days payable outstanding (DPO), and shedding of non-core/non-money-making assets, units, and locations. While predictions are difficult today, business fundamentals remain. More money has to come in than goes out; it is typical that 20% of the revenue results in 80% of the profit; and bet on good management every time.
When it comes to analyzing the ability of a distressed business to survive and eventually thrive in the long term, investors typically look backward by challenging every line on the balance sheet and the income statement, and look forward based on economic and consumer-trend forecasts. COVID-19 has injected a new level of uncertainty because no one has a clear picture of how consumers will behave once mandates are lifted and a reliable forecast is available. The long-term viability assessment now needs to challenge every assumption about consumer behaviors in the same way that the historic analysis has always challenged every line item in the financials. Will customers return to stores and restaurants, or will the COVID-19-driven migration to online sales permanently change the retail landscape? Will people return to airplanes, hotels, and face-to-face interactions, or have they become so accustomed to virtual interactions that those sectors will never return to pre-2020 levels?
And demand isn’t the only uncertainty: Assumptions around supply must be questioned as well, as you’re dealing not with just one faltering business, but with entire industries that are faltering. Look at the entire supply chain, from parts to facilities to distribution, and factor in where supplies are coming from – are they being produced somewhere overseas, where production could be shut down even as the U.S. opens again?
Investors and business managers who get the answers to questions like these right will be the ones who are positioned to succeed in the years ahead.
A last thought on urgency…
While we’ve focused this article on distressed transactions, it’s worth noting that every transaction in the time ahead will have a higher level of stress than normal. If you’ve previously worked on healthy transactions, the impact of COVID-19 is going to inject new stress that wasn’t there before; a lot of companies are going to have some form of distress. And if you’ve thrived in the distressed sales market until now, COVID-19 will be increasing its intensity.
Dealmakers need to be prepared to act even more quickly than in the past, as the timetables and deadlines that companies are facing in this historic downturn are unlike any seen before. Your transaction team needs to include advisors who understand the nature of distressed transactions, who can act quickly and decisively to collect and analyze relevant information, and who can adjust nimbly to circumstances that change from hour to hour. While a healthy deal may take months, with gradual provision of complete, tidy financials and negotiation, a distressed one may include incomplete, incorrect, or otherwise imperfect information, laid out quickly as cash runs out, as the business tries to remain operating while managing creditors, lenders, staff, and publicity.
The pandemic has shifted what had been a frothy seller’s market into a higher-risk landscape of businesses desperately in need of capital. Those dealmakers who possess the market intelligence and technical know-how to navigate through and beyond today’s marketplace will be in the best position to navigate the years ahead.
Coronavirus Resource Center