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EPISODE 78: With the mergers and acquisitions market moving at a record pace, many business leaders want to better understand what factors are driving the activity and how best to prepare for opportunities. DHG's panel shared insights on the latest trends and challenges.
[0:00:09] JL: Welcome to today's edition of DHG's GrowthCast. I'm your host, John Locke. At DHG, our strength relies on our technical knowledge, our industry intelligence and our future focus. We understand business needs and are laser-focused on company goals. In this ever-changing world, DHG's GrowthCast provides insights and thought-provoking conversations on topics and trends that address growth opportunities and challenges in the current and future marketplace.
Thanks for joining us as we discuss tomorrow's needs today.
[0:00:42] ANNOUNCER: The views and concepts expressed by today's panelists are their own and not those of Dixon Hughes Goodman LLP. Always consult the advice of your legal and financial professional before taking any action.
[00:00:57] JL: On this episode of GrowthCast, we're highlighting some of the conversation around M&A activity from our recent executive briefing series. Let's listen to our DHG panel, Ben Redman, Jon Hottinger, Tom Yonchak, and Kate Leverone, as they discuss what they're seeing in M&A activity, and what organizations should be on the lookout for.
[00:01:19] BR: So, let's dive in. As we began researching topics and looking at items that were of interest to our clients and others attending the executive briefing series, M&A came up frequently. I think everybody on this panel recognize this. It's been quite a robust year. We've seen deal volumes that have been unprecedent, quite frankly. At times, if we look at the fiscal data for year today through three quarters of 2021, we've effectively, not effectively, we have exceeded the previous high in the past decade, from a deal volume perspective, in valuation perspective.
When you annualize three quarters for the full year, fiscal 21, or calendar 21, rather, you're looking at nearly a 40% growth number from a volume and evaluation perspective over the next highest year of the past 10 years. So, the third to 2019, which was the highest in the past decade, 2021 is going to far exceed what we've seen in those days. I know it's been challenging at times, it's been frantic at times. It's been, just again, unprecedented from what we've seen historically. And Jon, we'd love to kick off with you. How would you characterize the current M&A environment with regard to competitive dynamics, deal flow, and valuation multiple?
[00:02:36] JH: Glad that glad to jump in there, Ben. I'll echo what you said at a high level. It is, you read commentary from various participants in the market, and they'll call it a historic time. Leading into 2020, we had had several years of very strong M&A market. Lots of activity, strong valuations, very steady, consistently active market. Frankly, those of us in the profession, we're kind of asking, how long can this last? Well, obviously, none of us anticipated what happened in the beginning of 2020. And no surprise, there was a dramatic drop off in activity starting in the first quarter of 2021, excuse me, of 2020. That continued.
If you look at the data, steady decline, certainly in inactivity, but even more pronounced in value, aggregate value of transactions through the third quarter of 2020, as folks focused on their own businesses, shoring up their own businesses, understanding the impact of the pandemic, how to navigate it, and certainly if you were an investor, you were going to be very cautious about putting new money to work in new investments while we were all working to get our hands around the impacts of the pandemic.
Interestingly, though, then the switch basically, as if a switch was flipped, fourth quarter of 2020 was remarkably active. Activity bounced back and actually exceeded the year prior period. So, fourth quarter 2020 was more active from a deal quantity and deal value perspective then was the fourth quarter of 2019 and that has really continued. A little bit of a slowdown from that level in the first quarter of this year, and then very strong second and third quarters and 2021.
So, what's driving that? We kind of see it as three things. Both strategic corporate acquirers and then financial buyers, so private equity firms and alternative forms of institutional investors are both incredibly active. Corporate balance sheets have near record levels of cash available to do deals and make investments and likewise, private equity has been very successful and continuing to raise money and has a record near record levels of what they call dry powder, which is committed capital that investors have given those those firms and that they have to deploy. So, having both major categories of buyers very active drives a lot of activity in space.
Second, debt has been relatively inexpensive and readily available and actually defaults on debt are very low levels. And so, that's a favorable lending environment and the capital that's often used and needed to get these deals done is readily available.
I think the other thing that happened and we've all seen this company performance and overall economic health rebounded much more quickly than I think anybody expected if you go back to the second quarter of 2020. So, company performance, economic conditions strengthened quickly. That both gave buyers and investors confidence in putting money to work. But it also encouraged a lot of folks to go to market and bring their company for sale, because they knew they were selling off a strong performance at that point.
So, we consider those three to be the key drivers of what's going on in the market, Ben. The other we'd mentioned and we noticed, certainly among private business sellers was the anticipation of an increase in capital gains tax definitely drove some interest in seller's exploring or actually going through with trying to get a sale done in 2021 ahead of anticipated tax law changes. So, I would not say that's the largest driver, but that was certainly a factor, has been a factor in this calendar year on what's going on. Valuation is extremely high. One of the ways you know valuations across the board are high is private equity exits. So, private equity companies selling their portfolio businesses is at an all-time high and you're certainly they're in the business to earn returns. And so, they're seeing favorable exit valuations.
[00:07:07] BR: Significant consolidations taking place across various industries, that goes without saying. What industries have you seen across our corporate finance team here at DHG that have been most active and or gaining momentum, if you will, over the past 12 to 18 months?
[00:07:23] JH: Yeah, Ben, you put an important caveat there. Obviously, this answer will skew towards what we've been involved in because there are a lot of industries that are experiencing this. But let me speak to a couple different kinds of large sectors and then subsectors within those. Inside healthcare, lots of consolidation of practice and provider groups. And that's really across, medical, think of everything from physician practices to outsource outpatient surgery centers. On the dental and orthodontic and other dental specialties, periodontics, endodontics, lots of consolidation there moving to another segment of the healthcare market that's hot that has typically been regional and where you're seeing, some financial sponsors, as well as some pure strategic try and consolidate and roll up the market. Mental and behavioral health has gotten a lot of attention as an industry, but it's also one that's ripe for consolidation with lots of small local and kind of regional players that do very similar things, but in different areas. That's ripe, obviously, for consolidation. Home health care is similar as well and lots of interest there in the healthcare sector.
If you want to switch gears to kind of industrial and commercial sectors, one of the things all of us I think are hearing from serial acquirers both in the industries but then also private equity is anything service related, really. So, let's talk industrial and commercial services. Tons of interest in HVAC, tons of interest in logistics and transportation. Again, businesses that have kind of recurring revenue often serve are regional or super regional in nature and can be extended nationwide. Everything services related is getting a lot of attention from serial acquirers. And then on the consumer or individual services side of things, everything from – in the home, everything from pool service, businesses and landscaping and residential HVAC and final mile delivery into the home is a huge deal. Ecommerce delivery into your living room of a peloton or whatever is coming to you, all of those industries that are coming, services that are coming into the home, we're seeing a lot of consolidation.
[00:09:53] BR: Shifting gears a bit, let's talk about some of the biggest deal issues and risks, rather, that exist today they weren't here in prior cycles. Tom, from a tax perspective, what are you seeing that's evolved and/or surfaced over the past, we'll call it 18 months, give or take compared to periods before that?
[00:10:16] TY: Yeah, I think just the constant state of pending tax legislation or past tax legislation. I would even maybe push that out to the last four years. If your call right after the election for when Trump was elected, we had this huge tax reform under TCJA, the Tax Cuts and Jobs Act and how that impacted deals and buyers and sellers and just getting some guidance on the new rules under that.
Fast forward a year later, you've got the huge Supreme Court sales tax decision under Wayfair that up ended all sales tax procedures that needed to be done in a deal environment. Then COVID hit, of course, and we had COVID relief provisions, the PPP loans, and ERC's, things like that, did impact deals. But also, a pullback to some of the TCJA provisions, some relief on those changes. And then now we've got the proposed Bill Back Better coming in, that keeps changing every day, of course, and yet to pass.
So, I think just trying to get your arms around the ever-growing list of tax changes and have targets and funds, accounted for them properly and valued them properly, and really, just how that impacts the deal.
[00:11:42] BR: Those are great points, Tom. Kate, not to dive too deeply into it. I want to give you the first word here ahead of Jon, from the banking perspective. Not to dive too deeply into quality of earnings, but let's talk issues and risks that you're seeing today. I feel like, and I don't put words in your mouth, a lot of reports I see often, I don't use the term aggressive, but maybe taking a stronger position on certain issues, be it pro forma, be it synergies and otherwise, to kind of maybe stick out a bit. But what have you seen from an issues and risk perspective, as you're executing on all these transactions?
[00:12:12] KL: Yeah, I think the biggest risk is trying to identify everything that's happened in the last 18 months. What is temporary? What's going to continue? What would it look like if the shutdowns hadn't happened? And there's a lot of different approaches that you can take. I mean, looking at potentially lost revenue, or maybe you're paying your employees when there's no revenue coming in the door. So, it's trying to get your arms around all of what has happened, and what's still happening with the business and what's going to be a permanent change versus what's a temporary change that is really kind of one time and non-recurring.
[00:12:54] BR: What about, talk to us about some findings you've seen, just from a PPP perspective. We've had a lot of government assistance across the board, that's kind of impacted operations. I mean, quality of earning is intended to find and identify normalized earnings. I mean, how have you seen kind of both sides of that, Kate, just on a quality of earnings perspective?
[00:13:16] KL: Yeah, you know, obviously, that the PPP loans coming in, most of them that we're seeing have been forgiven. And usually company companies are taking that into income. And so, making sure that we're stripping that out of the business. On the other hand, there are some employee costs that the company likely was paying for that was funded by the PPP loans that may not have been revenue generating and so, trying to figure out that side of that the PPP funds, it is definitely something that we're looking for in the quality of earnings.
[00:13:53] BR: It makes a lot of sense. I've seen to your point, a lot of funding come from PPP loan forgiveness, but you've got two sides of the coin, right? You've got reduced OPEX potentially, travel training and other potential OPEX costs. You've got personnel costs that could go one way or the others may have been supplemented or backfill or subsidized by the PPP, right? So, it's certainly a balancing act to try to identify those core underlying operations, if you will.
Jon, from an IB perspective, how would you and your team approach to thinking through, there are cycles every 10 years, right? So, how have you guys gone about that and kind of dove into those things as you present in market businesses?
[00:14:33] JH: Yeah, no. Glad to touch on that. But really quick on on PPP again, because a lot of our attendees today are controllers and CFOs. I would say in our closings this year, making sure that the PPP documentation, the forgiveness, all of that is buttoned up is a pretty essential item at the closing table, early, at the finish line as wires are getting ready to go. So, one encouragement I have for our attendees is, the more you can make sure that you have done everything you need to do documentation wise around forgiveness of PPP, that's one simple step you can take in terms of positioning for an eventual transaction, you might be a part of.
So, just wanted to mention that. But Ben, to your more broad question, along the lines of what Kate said. I mean, we are always looking at, if there are kind of unusual events that have taken place, and the pandemic was certainly that, we're always looking at how do you normalize what – buyers, we know buyers are going to look for a normalized perspective on earnings. And so, we focus very heavily on that, on every business that we have worked with this year. Some benefited pretty significantly from COVID. We sold a few outdoor, recreational product, consumer products companies, where one was a paddle board manufacturer, lots of paddle board activity and sales. Same, we were involved with a business that was related to recreational vehicles. Lot of RVs. Lots of demand spike there.
So, you've got to look at how much have sales that would have happened in future years been pulled forward, and all of those sorts of normalizing adjustments. And then certainly, having worked with a few dentists and orthodontists this year, we were looking at the impact of six weeks of mandated shutdown from their state dental boards. So, just the intensive study of what the impact was to get a normalized view of performance and another encouragement for controllers and CFOs, the more you can step away and say, “Hey, have we analyzed and documented what the impact was quantified what the impact was, what the business might have looked like without those disruptions”, that's something that you can do. We've got a topic we may get to later about just kind of being prepared for M&A opportunities. I would say to you all, that's something you can be working on now.
Certainly, advisors like DHG, transaction advisory or corporate finance will come in and help you think through these things. But you've got the raw data and to the extent that you can start teeing up that kind of analysis, or at least the raw input for that analysis, that's something you can be doing, because I believe for the next X number of years, everyone's going to say, “How did your business perform in COVID?” In 2019, we were being asked on every deal, how did the business perform in the Great Recession of 2008, 2009? Ten years later, we were answering that question. I imagine we're going to be doing that for COVID now for the next 10 years. So, the more as financial executives inside of the company, the more you can have your arms around that, the better.
End of Interview
[00:17:50] JL: For more insights from our executive briefing series, be sure to visit dhg.com/executive-briefing series. I'm your host, John Locke and I look forward to reconnecting with you soon on another episode of DHG GrowthCast. Until then, be sure to rate review and subscribe to DHG GrowthCast on Apple podcasts, Spotify, or Podbean.