At a recent event for our UK Entrepreneur Network, two corporate financiers described a buoyant M&A market and how buyers are focusing on a business’s underlying strengths.
Ever since the late summer of 2020, just a few months after the UK opened up following its first lockdown, there has been a wave of merger and acquisition activity as entrepreneurs have put their businesses up for sale. Six months on, deal-making levels are still high and look likely to remain so for the foreseeable future.
Those entrepreneurs fortunate enough to be in resilient sectors where growth has accelerated, such as information and communication technology (ICT), are cashing in. At the same time, private equity buyers flush with surplus capital have crowded into the sectors not frozen by the pandemic, pushing prices higher.
Yet these are not normal times, so the art of the deal must adapt. While many of the factors that buyers zero in on are the same, they are working harder at judging the underlying quality of earnings. Entrepreneurs can easily get distracted by the unusually high level of interest in potential acquisitions, but concentrating on the basics of how a business is presented to buyers matters more than ever.
There is a danger of rushing sales processes, especially with pressure to complete transactions before the possible introduction of higher capital gains tax rates in a spring Budget or autumn statement. But haste can result in a disappointing price, or even a sale falling through. Generally, it is better to concentrate on working with advisers to prepare meticulously for a transaction, even if that takes more time.
“A lot of those that rush to market will be up against it and probably sell for a lower than premium price because there’s a hard deadline to do a deal for a tax change that may or may not happen, which is a bit of an issue,” notes Marcus Archer, Managing Partner at Clearwater International, a global corporate finance house. “If deals haven’t happened, it often boils down to going too quickly and not preparing properly.”
What’s looked for in a deal
Just as in normal times, an investor’s first interest is the business’s market opportunity. What’s its position in the market and potential for growth? Today, though, that often means estimating to what extent that market has been affected by the pandemic, and what the opportunity will be once normal life returns.
Turning to the business specifically, the management team and its flexibility are key, explains Archer. Investors are looking for management that has adapted quickly to changing circumstances and helped clients through what might have been a difficult journey. These points are in addition to the usual desire for management to have an investment in the business, or ‘skin in the game’ to borrow a private equity industry phrase.
Buyers may also seek to understand how management has looked after the health and wellbeing of staff. They want to gauge how management has helped to set up home offices and kept staff engaged. More generally, they may probe the culture of the business.
These ‘soft’ issues have a bearing on the ‘hardest’ factor of all – the financial metrics. A business is still valued on EBITDA (earnings before interest, taxes, depreciation and amortisation), which is a proxy for cash profits. Buyers are trying to understand a business’s underlying level of profitability. They are investigating exceptional increases or decreases in revenues; changes in margins, perhaps resulting from temporary deals with customers; shifts in the cost base that might revert to normality once the pandemic retreats.
“What matters is recurring revenue and quality of earnings,” says James Chapman-Andrews, UK Head of Technology at Alantra, the global mid-market investment bank. “Buyers and investors want to understand how solid the business is, how robust revenues are, how strong gross margins and operating margins are and so forth as you go down the P&L.”
Additionally, a business’s environmental or social credentials increasingly add to its value. “You can’t put it in a spreadsheet but there is a premium because there are more impact funds focused on investing in businesses with a special purpose,” says Archer.
No time for old economy businesses?
It’s true to say that there is a ‘flight to resilience’. Reflecting this, ICT businesses are selling on EBITDA multiples between one and two times higher than they were 10 months ago, according to Chapman-Andrews. But both he and Archer agree that there is still a market for many old economy businesses from sectors such as industrials and medical devices, outside the worst-hit areas such as hotel and leisure.
“There is even investment going into the prime retail sites that have been vacated by some of the old guard high street chains because the reality is that in the new post-Covid, post-vaccine world, those will still be prime retail sites,” explains Chapman-Andrews.
The important thing is to be a hidden gem; play hard to get.
Be a hidden gem
For those entrepreneurs with businesses that remain saleable, this is a time when there are plentiful buyers. Yet with private equity buyers actively seeking out investment opportunities, it’s easy for entrepreneurs to become distracted from running their businesses by networking with many possible buyers in their desire to achieve the best terms.
Submitting to invitations to engage are often counterproductive. Some private equity buyers become disinterested if they are one purchaser among many, concluding that they have little chance of success. For that reason, it’s best to leave the networking and sale process in the hands of a trusted M&A adviser.
“Engaging 25 to 30 investors in a conversation is just too many,” concludes Archer. “Your business becomes a lot more special if just a few investors get the chance to meet the founder. The important thing is to be a hidden gem; play hard to get.”
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