M&A Valuations in the Age of the Pandemic
The COVID-19 pandemic has weighed down large swaths of economic activity across the country, and mergers and acquisitions in engineering and construction has not been spared. Buyers and sellers have moved to wait-and-see mode, staying on the sidelines until construction projects pick up, until demand comes back, and restrictions by state governments begin to loosen. Deals with signed letters of intent are waiting out the uncertainty, with a handful of exceptions.
Two types of E&C transactions are still generally moving forward now: 1) strategic buyers that are typically large entities seeking synergies, or fulfilling a targeted need for their organization, or, 2) distressed asset deals.
But how should E&C acquisition targets be valued for companies once the outlook begins to improve? What adjustments, if any, should be made for the COVID-19 impact? Construction and engineering deals are frequently valued on a multiple basis of EBITDA, or a discount on future cash flows. But as EBITDA and cashflows take a major hit now, dealmakers need to determine whether to treat the drop as an anomaly, or to incorporate the dip into the valuation as part of the longer-term story.
Any valuations for new deals should first and foremost factor in expectations around the downturn’s duration. Bankers representing E&C sellers are hopeful for a more optimistic position on duration. While few are talking about a V-like snap-back, many do speak of a gradual upturn to the E&C economy. States are beginning to loosen restrictions on many fronts, including construction activity, while interest rates remain low. “Looking at publicly funded construction, such as infrastructure improvements, there is pent-up demand for ‘shovel ready’ projects that could begin as soon as the funding is secured. The possibility of a Federal infrastructure package could provide significant tailwinds to certain segments of the E&C space, such as Construction Materials,” says Robert Mineo, VP, FMI Capital Advisors. In addition, widespread adoption of safer protocols at job sites could also buttress the case for at least the beginning of an upturn in construction and engineering work before Q4.
If any of these scenarios prove out, the case for treating the current dip in earnings as a short-term anomaly could make sense. Under these assumptions, if a deal were to kick off today and take a typical 4-6 months to complete, we’d be crawling out of the trough by the time the paperwork was signed. Hence, crediting the seller for the losses occurring during this period makes the most sense, says John D. Wagner, Managing Director at 1st West Mergers & Acquisitions, LLC. Wagner thinks people should ignore the delta in the growth rate. “If we can make an assumption around a non-recurring, defined period of time – maybe it ends up twelve weeks or so -- then we should credit those losses in the valuation; they are, after all, undeniably an anomaly” he says.
In fact, strategic deals of greater than $50 million that are currently in-process are, in fact, ignoring the COVID-19 effect. These deals appear to be taking a longer view of their investment, and have not incorporated the negative impacts to EBITDA over the most recent two months into the deals’ valuations.
But some buyers may otherwise take a different view. There is the more pessimistic, but not unlikely scenario of a second wave of the virus, where a Federal infrastructure package gets pushed off indefinitely as more funds are needed to keep people afloat. The recession could soften overall demand for many more months, leading to cancelled projects and a weaker pipeline, particularly on the private market side. For E&C businesses with public customers, municipalities could see a hit from the drop in gas tax revenue normally be used to fund highway projects.
Another factor is the longer-term impact on the balance sheet. Debt costs may rise to pay employees and other operating expenses. Asset values will drop, particularly for cash and accounts receivables. Changes to the capital structure could thus make interest rates more expensive for the company.
As such, buyers may not be willing to give full credit on any coronavirus-related losses experienced this year. It may take businesses more time to recover than just a few months, and a drop in revenue, and/or increase in debt load could be an indication of longer-term fragility. That may impact the multiple.
Alternatively, buyers and sellers could adjust other agreement terms like earnouts, which enable buyers to address downside risk while allowing sellers to still get full value if the target business meets expectations. Financial milestones on earnouts could be adjusted over a more flexible time period to allow the target business to regain its footing after the near-term impacts of COVID-19 pass. At the same time, sellers would want some assurances on how the entity would be managed to ensure it’s appropriately positioned to achieve the agreed milestones. These issues will be especially critical in a period of layoffs and cost cutting.
So what should a company do that needs the cash now?
Small to mid-sized contractors with owners looking to retire, or running low on cash, may feel pressure to sell in the current market. In a sale process, it is important to accurately portray a company’s operations in a “normal” setting, in order to avoid negotiating from a weak position, says Mineo. If a business can show its ability to survive this period, it will have a better case to frame its financials over a longer-term trajectory and receive a better valuation.
For now, bankers are getting deals prepped until things come back later in the year.
Hopefully.
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