In this update we offer some early observations of the COVID-induced slowdown of the economy generally and of the M&A and private placement markets in particular—and how this affects our clients and other companies considering strategic alternatives.
For a PDF download of this Client Update, click here.
The M&A and private placement markets are currently stalled because of general uncertainty, the dramatic drop in consumer demand, and retreating business valuations. It is still too soon to predict when and how quickly we can get back to normal. Regarding a likely recession, the press has reported the views of many top financial leaders and economists. (See sidebar discussion on the next page.)
Timing of a recovery may be impossible to predict, but the key accelerators will be (1) positive social response to mandated public health measures to contain and eliminate the virus and (2) the effectiveness of monetary and fiscal actions of governments to offset the staggering economic impact of those measures.
If the pandemic is quickly abated, the economy should recover quickly—mainly because the slowdown is caused by mandated measures to slow the pandemic and not systemic economic failures. Consumer confidence in the economy should rapidly return and already strong businesses with cash reserves and access to liquidity should quickly recover. If the pandemic drags on and economic activity does not resume soon, the recovery and its velocity will be uncertain.
Meanwhile, business owners and managers should identify and address any weaknesses in their business operations, especially those exposed in this crisis.
Trying to Catch a Falling Knife
The M&A and private placement markets are tied to the globally integrated economy at large, and so depend for their vitality and valuation on high confidence, consumer demand, and commercial and industrial economic activity.
The markets are swinging wildly in this unprecedented situation. We have all watched the market set two records in less than a month: the first, peaking at 29,551 on February 12th and the second, plummeting to bear market territory twenty days later—sadly, a Dow record.
Behavior of the private markets is highly correlated to behavior of the public stock markets. The precipitous declines and volatility of the stock market indicate enormous uncertainty about the economy and imply corresponding deterioration of private-market confidence and valuations.
Sudden drop in consumer activity
Of course, the sudden drop in consumer economic activity, which makes up about 70% of total GDP, together with uncertainty of when that activity will return, have dramatically affected the public and private markets.
Consumer spending has slowed, with people forced to stay at home, loss of jobs, and the absence of discretionary income. This loss of spending affects every other part of national and global economic activity.
Are we in a recession? If so, for how long?
With the end of the pandemic not yet in sight, we are likely at the front end of a recession.
Federal Reserve Chairman Powell has said “we may be in a recession.” He promised that the Fed has more ammo to help—beyond bond purchases and the historic slashing of interest rates. This would include exercising emergency lending power to banks to maintain business lending. Powell has also voiced his opinion that once COVID-19 is under control, the economy will continue its strong growth.
Similarly, IMF Chairperson Kristalina Georgieva told CNBC that “the world is now in a recession and the length and depth of this recession depend on two things: containing the virus and having an effective, coordinated response to the crisis.” She expects the recession to be “as bad or worse than in 2009,” but expects a recovery in 2021, stating, “in fact there may be a sizable rebound, but only if we succeed with containing the virus—everywhere—and prevent liquidity problems from becoming a solvency issue.” She applauds the US $2.2 trillion relief package.
Global financial firms have also offered their best guesses about the length of a recession and timing or recovery, as reflected in the following chart. With some more conservative than others, they predict GDP will fall dramatically in the second quarter before the economy restarts and resumes growth in the third quarter. For example, Goldman Sachs’s forecast was revised on March 31 to reflect its prediction of a significant V recovery, if the virus is contained with an immediate, positive social response to public health mandates and monetary and fiscal policies being quickly implemented.
Drop in valuations
The stock market is one reference point for business valuation. For that reason, public-investor valuations can be predictive of private-company investor valuations. However, the laws of supply and demand are the same in both markets. Investors with capital will continue look for and invest in good deals for solid private companies, albeit at potentially lower valuations. Dollars will continue to chase quality.
Thus, the impact on a private business, which pre-crisis was ready for a sale or private placement, will depend on the quality of the company and its industry, as it may be amplified by its ability to maintain activity in the slowdown. Such companies include those that were already operating virtually or were quickly able to transition, as well as companies able to efficiently deliver products and services to their stay-at-home customers or companies doing the same.
The potentially devastating social and economic impact of the pandemic can be mitigated by implementation of smart global government fiscal, monetary and public health policies.
Regarding monetary policy measures, the Federal Reserve has lowered interest rates to almost zero in an attempt to keep credit flowing and is buying government bonds to put money back into the system.
Regarding fiscal policy, the government enacted a historic relief package, the $2.2 trillion Coronavirus Aid, Relief, and Economic Security Act (CARES Act), to keep businesses solvent while keeping employees at home. The CARES Act includes the Paycheck Protection Program (PPP), which provides for emergency SBA loans to small businesses—employers with 500 or fewer employees—to fund payroll, rent, utilities and mortgage interest.
For a copy of our Client Update on the PPP, click here.
Return to normal employment levels and consumer activity are objectives of the CARES Act, but these are, frankly, completely dependent on the social response and efforts to “flatten the curve.” The level of collective social cooperation will affect timing of the end of the pandemic and the beginning of the economic recovery.
As dire as the situation looks in the US and elsewhere, pandemics eventually end, and can be shortened by more diligent individual and social response and by scientific discovery and development, as with recently announced progress toward promising vaccines.
Do past pandemics provide guidance?
This is a natural question. Our research revealed the critical importance of social cooperation (social distancing) and hygiene to containment and conclusion of a pandemic. The following paragraphs describe the unique features of past pandemics with approximate numbers for infection rates and deaths.
Spanish Flu of 1918
Worldwide Infections: 500,000,000 or 19.30% of the worldwide population
Worldwide Deaths: 50,000,000
US Deaths: 675,000
Historical Context: Populous cities (like Philadelphia) did not mandate social distancing until two weeks after the first reported cases. Rather than cancel a scheduled parade, Philadelphia allowed the Liberty Parade to take place, drawing over 200,000 people. Within one week, hospitals could not handle the number of infected and over 2,500 people died. By contrast, St. Louis took action within two days of the first reported cases, forcing social distancing by shutting down schools, churches, dance and pool halls, and theaters. Citizens were instructed to wash hands, to wear masks, and to clean surfaces. On a per capita basis, St. Louis had an eighth the number of deaths compared to Philadelphia.
Economic Impact: The stock market was up significantly during the Spanish Flu, but that was attributed to the ending of World War I and the euphoria of the time. Compared to today, the levels of market participation, global travel, commerce, and the ubiquity and speed of information dissemination were dramatically lower.
Asian Flu 1957-58
Worldwide Infections: 500,000,000
Worldwide Deaths: 1,100,000
US Deaths: approximately 116,000
Historical Context: The US was in a recession from August 1957 to April 1958, but the recession was attributed to the Fed’s contractionary monetary policy to control inflation.
Economic Impact: Estimated to have reduced total GDP by approximately one percent during the recession. During the same period, the stock market was up approximately 17%.
Hong Kong Flu 1968-69
Worldwide Deaths: 1,000,000
US Deaths: 100,000
Economic Impact: The Dow lost about 13.5% during the pandemic; at its lowest point, it was down 21%.
Swine Flu 2009
Worldwide Infections: 1,400,000,000 or 20% of the worldwide population
Worldwide Deaths: 575,000
US Deaths: 12,500
Historical Context: Given its recency, it is interesting to note that social distancing worked when implemented, although when children returned to school in the fall, there was a second wave of infections in the US.
Economic Impact: The stock market during the Swine Flu Pandemic was viewed as under-valued after the mortgage crisis, so investors took advantage. As a result, the market rose approximately 40% during the pandemic.
How do you explain today’s stock market?
We believe a number of unique factors are affecting today’s market, including:
- Fears of impending recession were in the market before the crisis, coming at the tail of the longest bull run in the history of the Dow.
- There are have also been a number of measures that made investors wary, including:
- Robert Shiller’s CAPE ratio (a cycle-adjusted price-to-earnings ratio) being well above historical average;
- Public debt to GDP being at historical highs, growing from about 65% of GDP in mid-2008 to over 100% in 4Q2019, among other ratios and metrics.
- A black swan event—the virus—played into investors’ fears, resulting in the fastest fall from a record high to bear market territory in the history of the market;
- The rapid infection rate across the globe together with today’s ubiquitous and rapid dissemination of information showing cities shut down, businesses closed, countries in lockdown, travel restricted, hospitals overflowing, and a chilling death toll; and
- Conflicting government information on impact and response.
Our Observations and Recommendations
Investment activity has slowed because of uncertainty and employees being shut in. As the models of the pandemic become more accurate and the end better defined, normal investment activity should resume quickly. Meanwhile, deals will still get done, albeit at a slower pace. Private equity and venture capital firms still have capital to invest; strategic buyers still seek to innovate and grow quickly.
As always, deals will get done with quality companies with solid management teams, strong operational and financial controls, quality of earnings, and revenue growth. Companies negatively impacted by the crisis, with less experienced leadership and inadequate operational controls will have a more difficult time with a sale or capital raise, or they will be acquired or recapitalized at depressed values.
We expect due diligence to be more rigorous now and in the future, especially taking into account the lingering effects of the pandemic—for example, the financial condition of suppliers, distributors and customers will be especially relevant.
Business continuity plans, Work from Home (WFH) policies, contingency plans, insurance, and other risk mitigants will become critical in analyzing the strength and attractiveness of a company to buyers and investors.
We expect to see more attention given to material adverse change (MAC) provisions in documents and to earn-outs based on future performance.
Business owners and management teams should identify and address any weaknesses in business operations, especially those exposed in this crisis.
Finally, business owners and managements teams should take advantage of the enhanced SBA loan programs, particularly PPP loans to cover payroll, rent, utilities, and mortgage interest during the crisis.
These are unprecedented times. It is clear that work stoppages, historic levels of unemployment, plummeting consumer spending, and a dramatic multi-trillion dollar fall in global equity market valuations have negatively impacted the middle-market M&A and private placements markets.
Although the pace of deal activity has slowed, good deals with quality companies will still get done. At the same time, there is bound to be an uptick in acquisitions of distressed companies. For now, it is impossible to predict when things will return to normal.
However, the depth and breadth of the slowdown will depend on more than government response and the speed of developing a vaccine. It will depend on the social response and require collective and individual adherence to health care guidelines. All of us have ownership in the solution.
DISCLAIMER: THIS DOCUMENT EXPRESSES OPINIONS OF GALENA CAPITAL BASED ON PUBLICLY AVAILABLE INFORMATION AS OF APRIL 6, 2020. AS THE COVID-19 CRISIS CONTINUES TO EVOLVE, OUR VIEWS MAY CHANGE. OUR READERS ARE ENCOURAGED TO CONTINUE TO REFER TO ALL AVAILABLE SOURCES OF CURRENT INFORMATION AND CONSULT WITH THEIR PROFESSIONAL ADVISORS.