Cracking the Coronavirus Code: Valuing Post-Pandemic Deals

A lot of companies hit the pause button on deals when COVID-19 hit in March 2020. Due diligence was more difficult due to the virus, and traditional valuation methods didn’t always capture the effects of the pandemic. After all, valuations are forward-looking. How can you value companies in a crisis environment that is, by definition, outside the norm and with sales often plummeting?

Business valuations adapted, much as businesses themselves did, helping to fuel a recovery in deal-making, rather than the extended market correction some anticipated. Deals are back to getting done, and they are getting done at a record pace. As buyers and sellers work through the uncertainty of valuing businesses emerging from the pandemic, structuring deal terms to address the uncertainty has been a key part of cracking the Coronavirus code.

Getting deals done

At the beginning of the pandemic, deal-making initially ground to a halt but resumed gradually as 2020 progressed, albeit at a slower pace year-over-year. Overall, U.S. private equity investment slipped to $708.4 billion and 5,309 deals in 2020, down 7.3 percent in dollars and 3.4 percent in volume from 2019, according to Pitchbook. It was the first time since 2009 that both numbers dropped. Bad news? Not entirely. Annual numbers only tell part of the story. By 2021, deal volume and dollars rose as the economy began to recover and reopen. Private equity transactions reached a whopping $250.6 billion during the first quarter, up 116 percent from a year ago, according to PE Hub. Buyers and sellers were once again able to value companies and close deals, sometimes with the help of structuring. What went right to help get the deals done?

Pent up demand

There is investible capital out there, fueled by public markets, private equity dry powder, low interest rates and cash reserves, even through the difficulty. Mega-deal volume and dollars rose from 251 valued at $57.6 billion in 2019, to 336 valued at $76.6 billion in 2020. There were 167 mega-deals deals valued at $41.7 billion as of March 31 so far in 2021, according to PitchBook. They attribute this in part to “high levels of VC dry powder” and strong public markets. Pent-up demand is also fueling deals. Dry powder is being deployed to purchase robust companies – and for opportunistic buys. SPACs, or special purpose acquisition companies, are fueling demand, sometimes creating new competitors in industry niches.

Interest in software deals soared, as they accounted for 15.6 percent of overall value in 2020, up from 13.1 percent in 2019 and 5.3 in 2009, according to PitchBook. Term Sheet tracked software transactions, like Welsh, Carson, Anderson & Stowe’s agreement to acquire Canada-based Absorb Software, a cloud-based learning and performance management software firm, in a deal valued at $500 million. GI Partners invested an undisclosed amount in Massachusetts-based Aras, which makes product development software. As society turned more to software during the pandemic, investor interest followed. Deal flow has picked up beyond one industry, however. Buyers and sellers have been able to navigate the pandemic to reach numbers that work for both.

“C” for COVID-19

EBITDA is key in valuing companies, particularly in the middle-market, but it couldn’t account for the pandemic. “EBITDAC,” or Earnings Before Interest, Taxes, Depreciation, Amortization and Coronavirus, arrived, allowing for the necessary adjustments.

Some were skeptical of the efficacy of EBITDAC to account for the pandemic, but the skepticism underscored the desire to quantify that impact. No matter where you stand on EBITDAC, there’s no arguing that measuring the impact of the pandemic provides additional data, and more data can help the valuation process. Middlemarketgrowth.org pointed to the “COVID-19 Alpha,” essentially building in some risk to better manage uncertainty and “get a clearer picture of company value.”

The COVID Bump

The pandemic actually boosted profits for some businesses, providing a COVID bump and keeping valuations high. Zoom, for example, and many distributors as well as e-commerce companies such as Amazon, saw sales skyrocket. Companies with software-as–a-service business models let the good times roll. Some consumer products and companies catering to those stuck at home also did well. Other companies shifted on the fly, using their resources to make PPE, hand sanitizer and other high-demand supplies during the shutdown. Still, some companies saw the bottom of their businesses drop out as factories shut down temporarily. Retail, restaurants and travel took hits, although food delivery companies saw revenues rise and the reopening boosted restaurants. Small companies with $3 million-$10 million EBITDA sometimes searched for deals “because they lacked a sufficient financial cushion to handle the downturn,” according to Pitchbook. The desire to get a deal done – by companies seeking to cash in on strong performance and those under pressure – fueled transactions, helping buyer and seller agree on an enterprise value during the pandemic.

Lending an Ear

Lenders needed to understand the COVID impact, which often meant how to handle COVID addbacks incorporated in presentations. Many lenders took a conservative approach to COVID addbacks, which were often difficult to quantify. They wanted, and often were willing, to wait and see. EBITDAC adjustments were also attributed to other reasons. Vaccination and the reopening of the economy may lead to a return to business as usual, even a new normal, with the biggest pandemic impact likely in the past. As time passes, the impact may decline or disappear altogether, making it easier to value companies using traditional metrics – and without the need to point to the pandemic. In many cases, rather than making EBITDA adjustments, companies may see sales normalize as we move farther away from the pandemic.

Earnouts Are In

While determining adjusted EBITDA or EBITDAC is key, structuring deals has been crucial in getting to the finish line. It’s not just what a company is worth; it’s whether you can link a price to the future. The pandemic created massive uncertainty. Sharing the uncertainty between the buyer and seller through earnouts helped some deals get done. Restructuring through earnouts became more common amid the pandemic, reassuring buyers facing future sales uncertainty and allowing room for compromise.

Earnouts defer some payments into the future, sharing and spreading risk. Taking some uncertainty out of the equation makes a deal more attractive for buyers by shifting some of the risk to the seller. Structuring deal terms can be the bridge that allows buyer and seller to cross over to each other and get the deal done.

The Rearview Mirror

Now that we are 15 months out from the onset of the pandemic, companies are more distant from the initial disruption. Some business owners may want to wait a little longer before seeking or doing deals until March-April 2020 truly are history. Others may see benefits of doing deals now while valuations are high during this sellers’ market and before the Biden Administration’s proposed tax reform or some other legislation including tax hikes becomes law.

The next big question is what the new normal will look like. M&A has weathered the pandemic. How did it change deal-making and will those changes last? The technology-propelled environment that gave rise to virtual road shows may continue – though there’s no true substitute for being live and in-person. EBITDA will certainly remain a key measure of earnings as the pandemic’s impact gradually fades. In some cases, the question will be whether the COVID bump is sustainable. For now, the deal market remains hot. As valuations adapt, earnouts sometimes help get deals done.