Crude Observations

More rambling about markets

Where last week I chose an opportune time to toot our own horn about some of the deals we have done recently, this week I’m going to take a slightly different tack and talk about deal flow and M&A in general, the current market and some tried and true bits of advice.


I promise that next week I will get back to discussing the state of the energy industry, making fun of various levels of government and politicians and further postulating on what our soon-to-be post-pandemic, inflationary, rising interest rate new world order world might look like. Doesn’t that sound like a whole lot of fun!


But sadly, this blog can’t always be fun – sometimes it actually needs to be about “work” and “markets” since, as my partner reminds me, it’s our job even though how we do that job seems to be in continual flux with the rise of working from home, an evolving M&A world, border complications and the use of technology, and all the other modifications or recalibrations of our collective working lives.


Some things about COVID we are all going to be glad will fade away and never return – any type of gathering restrictions, masks, restaurant weirdness, but some have actually been beneficial.


As I’ve alluded previously, our office never technically “closed”. We are a small shop, with a small office footprint and plenty of social distancing capacity with doors etc. We have always made a conscious decision to work from home on occasions where we could. Our analyst is a remote worker. This works really well. On the other hand, my family encouraged me early on to go back to the office, I believe it was “you can’t be here anymore”.


On top of that, with videoconferencing it is easier to be “in-person” with clients, capital sources and prospects than ever before and with everyone using the same technology and no one judging whether you have a bookcase, a cat or a motorcycle in the background, it has actually made some of our processes easier. Leveraging technology is a boutique firm’s dream come true. Not to mention that I have received no less than 5 offers to buy the Hiram Walker Whiskey picture that hangs in my office.

Of the five deals I described last week, only one had a traditional due diligence “site visit”. This is new to me. I am used to the “you need to touch and feel every piece of equipment” approach.


Our work environment had to adapt to the new realities because you know what doesn’t sit on the sidelines because of a pandemic? The relentless pursuit of business growth and opportunity that drives M&A.


It can get backed up for a period of time, but it can never truly be stopped because in every crisis lies opportunity and where one party may see chaos, others see profit and value.


Supply chain crisis? Onshore your manufacturing and services. Inflation? Energy prices out of control? Increase primary fuel production, processing and transportation. Human resource limitations? Automate processes. Energy transition? Throw government money around and create new industries from scratch like hydrogen and carbon capture. Interest rate increases? Alter your funding assumptions, adjust valuations to reapportion risk.


Look, this isn’t some kind of “new business reality” blog, because as I have made clear previously, I don’t really buy that. But, in all fairness, the pandemic and its knock-on effects can’t help but impact the M&A market.


As I mentioned last week, we are in fact increasingly fielding questions from clients and would be clients about the state of the M&A market for private businesses and what getting a deal done post pandemic and altered world order is going to look like.


As I discussed last week, the assumption that the M&A market was for all intents and purposes closed was incorrect. While this may have been true for certain companies or certain industry subsegments for a limited period of time (for example, who buys retail when the market is shut down), the reality is that markets never “close”.


So, circuitous route back to the original question – what does the M&A market look like? How are deals being done in the current environment? Are there sectors (energy) that are in favour? Are there sectors (energy) that aren’t? When should I go to market? Will I get the price I’m looking for?


All excellent questions which I will try to address as I continue to ramble.


First off, the short answer to the first question. The M&A writ large looks pretty similar to what it looked like before, and unlike anything you have ever seen.


Expanding on that, deals are still getting done but they are taking longer, uncertainty of the economic path forward and headwinds means that structures are going to have be more creative and return expectations all around are going to have to be recalibrated.


On the process side of things, as an M&A advisor, we run a file now much like we ran it before. We typically engage a client remotely, meeting in person perhaps once or twice but with new technology this is less a requirement. Targetted approaches to strategic and financial buyers are all done electronically and most datarooms are virtual. We can all handle the process online so that part of the execution is going to be easily managed. Deals will get done.


What’s going to be hard is getting the deal the attention it needs. We believe it is going to be an exceptionally busy market in the coming years as the economy and industries continue to recalibrate and get themselves used to the new post pandemic world.


Let me explain what I mean by that by putting it in the context of the energy services space.


In the first part of the pandemic, as the price war unfolded and capex budgets got slashed many companies in the energy services space saw dramatic impacts to their bottom line and many experienced existential threats that they have never had before. Too many to count took their equipment to auction, others simply closed their doors.


Typically, after that type of bloodbath, the survivors will emerge and carry the day in an altered market as activity levels pick up and prices recover.


Since then, we have seen energy prices go on a tear while at the same time we have experience unprecedented “capital constraint” on the part of the producers, which has allowed them to return absolutely ridiculous sums to their shareholders through slashing of debt, share buybacks and massive dividends. And capex and energy services suffers. All the while, energy scarcity continues to grow, inflation runs rampant, Putin goes out and Putinizes and the world screams as one for more production. At some point, the dollars coming in are just too big to ignore, the pressure to grow will be too intense and the capex floodgates will open and for a brief moment of ecstasy, the service sector will have its moment in the sun.


In anticipation of this, those pandemic survivors that are well-capitalized or had low debt levels will seize the opportunity to consolidate market share. Those that have had it with the cyclicality will put their companies up for sale. Hungry entrepreneurs looking to execute on the latest seven step plan to global domination will also be on the hunt for assets and corporate acquisitions. The market will be full of companies looking to do something including both the walking dead and the diamonds in the rough.


And as the pressure on the sector ratchets up, there will be a tsunami of capital looking for a home. ESG be damned, because the goal is to reduce runaway energy costs that are choking economic growth. The capital is largely already there, it’s just currently on the sideline waiting to pounce.


The issue of course is how do companies looking to sell find the right buyers – those with the vision and drive to build something of lasting value. And how do those buyers know that they are buying a good business and not just over-paying an owner who was otherwise circling the drain.


In a market where there was so much distress, sorting out all the options in front of you as a buyer is a major challenge, never mind being the seller of a viable business trying to get the attention you need.


And that’s just the energy sector which in Canada is 10% of the economy. Extrapolate that out to the other 90%, regardless of relative performance.


Now take that noise, multiply it by 15 and roll it into the United States market.


Getting attention for your deal or company is always a challenge because there will always be so many others opportunities out there competing for attention. Doesn’t mean it can’t be done, it’s just going to need a lot of work.


Oh, and everyone will need capital to do their deals.


Where does that come from? Certainly not from banks, instead it is most likely going to come from private equity – either directly or through existing platforms.


That’s not really that different. Over the last decade, the main driver for M&A activity has been the private equity market, where trillions of dollars have been invested in private companies ranging in size from sub $2 million in EBITDA to mega-investments with hundreds of millions in cash flow.


There is a well-worn path of US PE coming to Canada and vice versa. It is rare to meet a business owner who at some point hasn’t had a conversation with a PE fund somewhere. They are ubiquitous.


What’s different now is if you are a seller trying to attract attention or a buyer trying to raise cash to execute an acquisition strategy, you have to fight to get the attention of these funds in a world where tens of thousands of companies are competing for the same dollar. Pre-pandemic, private equity found you. For the foreseeable future, you will increasingly have to go find it.


There are close to 5000 private equity firms in North America with more than 100,000 portfolio companies. Collectively they have close to $1 trillion in “dry powder”.


They are all open for business and recognize that even with the inflation trade and the shine on tech being slightly less bright, this is still a historic buying opportunity, but many also still have major problems in their portfolios, taking away from the time they can allocate to going out and finding deals.


So if you are a seller or a buyer, to succeed in this M&A market and access the capital required to close on your project, you need to figure out a way to stand out so that when your opportunity hits the desk of some PE guy, they have a reason to look at it.


Similarly, on the strategic side (whether independent or private equity owned), many companies will be looking to expand, and given the constraints on capital, labour, supply chain and equipment, the current mantra is that it will be easier to do this through acquisition as opposed to organically. A nimble and well-capitalized buyer should be able to quickly build market share or enter a new vertical as long as they can find you. But again, to be an acquisition target, you still need to tell a compelling story and stand out from the rest.


So how do you stand out?


In an environment where deal flow is going to be so high, you need to be able to immediately grab attention with a clear value proposition. Whether it’s an industry consolidation, emerging technology, a recession-proof service line, it is critical to understand your story and present it in a compelling and targeted way to a properly qualified list of targets to get the conversation going. If you can articulate the economic opportunity compellingly and upfront, that is a significant part of the battle.


Make sure management is front and centre. This is something that we find many companies overlook and too often gets less attention than it should. But as capital gets tighter withy higher interest rates or you are in a more competitive market, bench strength matters. Given the carnage in their portfolios during the pandemic, private equity funds will be paying increasing attention to the management teams that are going to be stewarding their capital, assessing bench strength and trying to figure out who can manage through the next calamity.


Further to the preceding, it will be more important than ever to understand your financial reality, have realistic forecasts where that is even possible in this evolving market and have a firm grasp on where profitability comes from, key margins and what an optimized capital structure for your business should look like. Presenting the financial information in a structured and credible form will allow the capital source to quickly execute a financial analysis and remove that obstacle from the assessment process.


Don’t overthink the valuation or the multiple. Conversely don’t just take the first offer that comes along because it seems expedient. Look, this is true in any market, but in one as volatile as this one, multiples could be all over the map. The COVID trade has now evolved into the inflation trade and could soon also encompass an expected recession trade.


No one is going to value you on the basis of 2019 and similarly, if you are one of the industries growing through this current environment, understand you will only get the premium for that if that growth is sustainable and exceeds the inflation trend. Similarly, anyone who seeks to apply an opportunistic 2020-2021 COVID type discount to a business that should be able to snap back should be sent packing.


Finally, understand that while rates are still at historic lows, there is an effect on buyer valuations and cost of capital. Higher rates model out as lower values in any discounted cash flow analysis so the forward curve needs to include everything.


We expect that valuations for good businesses will continue to be competitive for their current economic environment but to get there, vendors and purchasers will need to be prepared for creative deal options. This is going to be mainly driven by the debt markets which may not be willing to stretch as far they have traditionally given the exposures they have to both corporate and personal defaults in a rising rate environment. Don’t be surprised to see deals with an increasing use of earn-outs, vendor notes and equity swaps – not just to address valuation gaps but to derisk deals for buyers and help them close. This will be especially true in inflation-exposed sectors.


That said, don’t try to manage timing – go to market when you are ready not when you think the market is ready. Timing the market rarely works. The repercussions of the pandemic and the current inflationary and rising rate environment are not transitory, they are going to be measured in years – waiting it out could add 5 years to a succession plan. On the other side of the transaction, buyers will expect to get deals but the reality is that to encourage targets to transact now and get ahead of the curve, they will have to sweeten the pot.


Finally, this may sound completely self-serving (and it 100% is) but hire an advisor. They will be the key to getting your deal on the radar of the most likely buyers/investors. It’s their job to sift through the multitude of opportunities out there and help your deal get to the top of the pile. With the amount of deal flow that PE firms continue to see, advisor led mandates will get more attention because they will have properly prepared the marketing material, organized the financial story and will also have clearly defined the process. Advisor led mandates have higher success rates and generally lead to better outcomes, particularly on the sell side. In a market that is going to be as crowded as it is shaping up to be, having that edge really matters.


In conclusion, the M&A market is big, volatile, robust and at times terrifying. Never make assumptions about how a process will unfold or who an ultimate buyer will be. Be organized and market your deal as broadly as possible. At any one time there are tens of thousands of deals in the market and buyers looking for them. It’s noisy. Make your deal stand out through the strength of your team and your business. Quality businesses will ALWAYS eventually find a buyer – do everything you can to stack the deck in your favour.

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