Financing M&A in a Pandemic

The year 2020 was anything other than ordinary and customary. Deal volume was down, like in most recessions. However, unlike other recessions, valuations held strong and even increased for COVID-proof organizations.

How are deals getting done in this economy? The capital stack has shifted to greater equity investment, partially by buyers’ choice.
Banks are willing to lend, but they have pulled back slightly. Traditionally, lower middle market deals have senior debt at an average of 3x EBITDA. Now that’s down to 2.5 or 2.75x, according to GF Data. In 2020, senior lending in M&A hit the lowest we’ve seen in five years.

To compensate, the capital stack is being filled in through increased buyer equity and increased rollover equity. Rollover equity is when the business owner or management team retain a stake in the enterprise.

Buyers like it when sellers keep some skin in the game. It shows the Seller has faith in the business and are committed to its ongoing success. For businesses valued between $10 million and $25 million, rollover equity accounted for 13.2% of deal funding through November 2020.
We saw an uptick in buyer equity in Q2 2020, likely stemming from buyers who were committed to getting deals done, even during the initial chaos after the pandemic hit. In the first nine months of 2020, equity share on platform deals averaged 54.5%. The quarterly splits, though, are notable: 1Q-53.2%; 2Q-61.6%; 3Q-51.4%.

Some buyers are pulling back on leverage in order to maintain some breathing room in case the pandemic gets worse before it gets better.
At the start of the pandemic, many industry experts were saying to expect an increase in earnouts in order to get deals done, but that hasn’t happened. Sellers typically don’t like earnouts (due to unknowns), and because the demand for COVID-proof businesses remained strong in 2020, sellers were generally able to avoid those deal terms.

As risk and uncertainty subside in the months ahead, we may see a return to more typical funding trends. Interest rates are at historic lows and cheap debt will help more buyers and sellers bridge their valuations gaps.

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