COVID-19 crisis brings fresh attention to distressed M&A as valuations reset

Hogan Lovells Deal Dynamics

The coronavirus outbreak and its widespread financial repercussions are widening the divergence in fortunes between buyers and sellers

Unlike during the 2008/2009 global financial crisis, there is plenty of cash on the sidelines waiting to jump in

Valuation expectations may take some time to reset

Late last year, market commentators and investment professionals were increasingly talking up the possibility of an economic downturn, but very few believed one was imminent.

Today, we are looking at a fundamentally different picture. The spread of COVID-19 is unfolding as a global human catastrophe unlike anything seen in our lifetimes, and necessary actions to curb the pandemic are causing a dramatic economic slowdown. With stocks plunging into a bear market and with governments scrambling to craft appropriate measures to support the economy, comparisons with the last crash a dozen years ago are inevitable.

But, this is not 2008/2009. In that crisis, as credit markets froze and the financial stability of so many companies was called into question, buyers were nowhere to be found. This time there is a lot of capital on the sidelines, waiting to jump in.  As economic disruption across industries and geographies creates opportunities, the investment landscape is setting up for what could be a significant uptick in M&A activity in the distressed space.  

Haves and have-nots

In many ways, M&A activity over the remainder of 2020 will be a story of haves and have-nots.

In the first category, there are strategic buyers who have accumulated cash through a record economic expansion that saw extraordinarily favorable business conditions for many companies. In this category are the well-known technology businesses reported to have ended 2019 with almost a quarter of a trillion U.S. dollars in cash on hand. But, there are other companies across a number of industries that also have the financial power to expand through acquisition.

Financial buyers are similarly arrayed. Private equity firms are sitting on about US$1.45 trillion in dry powder, or uncommitted investor capital, waiting to be deployed. Some large hedge funds, having learned the lessons of the financial crisis and moved away from the quarterly redemption model, also have money that investors cannot take back on short notice. With the economy having just come through a very prosperous period — which has now seemingly come to an end — there are many entities well-positioned as buyers for whatever comes next.

The have-nots, on the other hand, include companies that work with low margins or have perhaps overextended themselves, and these companies are very dependent on their ability to borrow. There are startups in this group, and companies that are still in their first years as public companies.

And then, of course, certain industries are getting pummeled amid the crisis: hotel and rental car companies, airlines, aviation manufacturing, and restaurants, among others. These are companies that are going to have to revisit their strategies and form new plans. The squeeze on brick-and-mortar retailers has tightened as the prospects for e-commerce competitors have strengthened. The U.S. oil and gas industry has been hit over and over, not just by the demand slowdown that the COVID-19 response has caused. Small- and medium-sized energy companies were already facing concerns about low commodity prices that would make it hard to service their debt, and that is now exacerbated by the price war between Saudi Arabia and Russia.

In no big hurry

While this splitting of fortunes should help fuel an increase in M&A, it likely will not happen right away. In fact, there are considerations that may slow dealmaking in the short-term.

Foremost, there is the virus itself. Everything is highly uncertain as long as the spread of the virus persists and confirmed cases continue to rise. Any sign that the outbreak is beginning to wane will be encouraging, but investors will need to be certain that the pandemic is being brought under control. Only then will it become possible to begin to assess the true depth of the global economic impact and the outlook for individual companies and sectors.

In the United States, both buyers and sellers are also in wait-and-see mode on the monetary and fiscal policy fronts. They are simultaneously trying to assess how the Federal Reserve’s moves to support liquidity will impact the debt markets, and how the unprecedented US$2 trillion economic rescue package that Congress rushed to President Trump’s desk at the end of March will affect the economic trajectory. Even companies with significant borrowing needs and teetering on real distress may still have access to bank lending or public debt markets, if these interventions are effective. 

Scuttled deals

When the markets abruptly reset as they have in the first quarter, announced deals tend to start falling apart. This is just starting to play out. A few offers have been pulled already, including Gray Television Inc.’s bid to buy Tegna Inc. and SoftBank Group Corp.’s planned bailout of WeWork. The sudden collapse of funding availability will be a key determinant in whether many more deals will ultimately be scuttled.

Shifting the mindset

Despite these lingering issues and great uncertainty, not everyone will be sitting on their hands. Some potential buyers will get comfortable with the new state of play more quickly than others and will start to engage.

But, as in any dramatic and sudden repricing event, many dealmakers will first need to get comfortable with where valuations now stand. Sellers in particular may take some time to get used to the idea that the sale price they thought might be possible just a month ago is long gone. Relative valuations in stock deals may be more attractive in the near term. 

How long might that take? If COVID-19 cases and deaths peak four, six, or eight weeks from now, and the health care system has not been totally overwhelmed, then it is possible that the third or fourth quarters of 2020 may be a very strong period for distressed M&A activity.

Outside of the 2008/2009 era, there has typically been a very strong bounce in M&A after a period of economic and market disruption similar to that of the current environment. And that could very well happen again. But, at this juncture, predicting the future of this disease is very hard for anyone to do, and it is vital for knowing what comes next in terms of dealmaking.   


Authored by David Gibbons and Christopher Donoho.


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