In the last financial crisis, private equity firms that quickly put money to work in struggling companies generated the best returns when the economy recovered. That’s not lost on the current crop of private equity buyers in the current Covid-19 crisis — but what’s happening on the ground reveals a deal-making process that is long and drawn out.
Eva Davis, managing partner of the Los Angeles office and co-chair of the private equity practice at law firm Winston & Strawn, said one of her clients, a buyer, finally closed on a $100 million deal in June that was originally agreed on at the end of February. The deal required the buyers to update due diligence multiple times, as the underlying business was changing significantly in terms of both demand and supply over the negotiation period.
As an example of the complexity in the new environment, Davis pointed to a negotiation around an earnout, or an earnings target that a seller must meet to collect full payment. The earnout, which was originally only a couple of sentences in a renegotiated letter of intent in late March, turned into three pages of ten-point type, stipulating a long list of targets and assumptions that would go into any increased earnings payouts.
“The buyer said, ‘I will support higher costs, for example, if I get higher revenue.’ It was the most complicated earnout I’ve done in 30 years, but it was the only way to bridge the valuation gap,” she said.
Davis said the deal was also jeopardized by trust and fatigue issues. Terms had already been renegotiated again around late April, but then the buyer wanted more changes as it became clear that the shutdown would be prolonged.
“It didn’t change the purchase price in the last round of negotiations, but it did change how some things were calculated, including deferring 10 percent of the purchase price to 2022,” she said. “The seller was losing trust, but the buyer, who specializes in this sector, was learning more about the underlying business than even the seller knew.”
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On the distressed side, some sellers just want out.
“Some founders are exhausted. Covid is like nothing they’ve ever seen, and they’re tired,” Davis said. “While the business was worth more last year — and conceivably could still improve — if there is some sort of distress in the business, they’re thinking next year could [be even worse], so it may just be better to sell now.”
Although she hasn’t seen a pickup in activity yet, Davis also expects more selling from large companies that will start shedding non-core assets fairly soon.
Valuations have clearly declined since March, but it’s not a total buyer’s market yet, said Davis.
“Seller certainly can’t demand the terms they got before, and they aren’t quite willing to recognize buyers’ leverage. But they’re not necessarily desperate,” she said. Davis added that sellers that don’t need to sell are just waiting it out.
An executive at a middle-market PE firm said both buyers and sellers are completely unrealistic at this point. He's waiting until over-eager buyers start withdrawing from the market. “I don't feel the urgency to do deals right now,” he said.
Nick Tsafos, partner in charge of New York at accounting firm EisnerAmper, said he believes buyers and sellers are deliberately slowing things down.
“Slowing down the deal — it’s a tactic,” he said. Buyers are doing it because the power is slowly shifting in their direction. Sellers, on the other hand, think the economy may improve faster than people initially thought.
“Look at the stock market this morning. It really took off,” Tsafos said on Friday. “Certain industries will be hit dramatically, and others will grow and flourish because of this.”
There are bargains around, not only because of the state of the economy, but because banks and other lenders aren’t extending the same amount of financing as before the crisis. But private equity can’t leave sellers empty handed.
“It doesn’t do anybody good when a private equity firm does such a shrewd deal and got every penny,” said Tsafos. “They want to keep people happy and balance the demands of investors and the needs of [a company’s] management to stay intact, run it profitably and manage it through the crisis.”