Three main factors drive mergers and acquisitions (M&A) activity – supply, demand, and the availability of capital. This year has offered its own unique set of circumstances that have changed the sentiment of sellers, buyers, and lenders alike as they adjust to current market conditions.

Sellers Are Ready to Sell

There is no shortage of supply when it comes to business owners who are ready to sell. Many of today’s business owners are part of the baby boomer generation and have started to take a serious look at their succession plan. As a result of the aging population of current business owners, it is anticipated that over the next 10 years, 70% of U.S.-based businesses will transition to new ownership. For some, the motivation to sell is to create a liquidity event to fund their retirement. Others are looking to free up their time for family, travel, or perusing their hobbies. This generational shift of business owners is expected to create a high supply of businesses for sale over the next few years.

The COVID-19 pandemic and pending capital gains tax increase have also affected the way business owners view selling.  The effects of COVID-19 impacted seller psychology as it reminded owners of the 2008 financial crisis and the hardships they experienced while operating under a massive economic contraction. As the economy begins to recover, sellers are taking this opportunity to exit before another economic downturn negatively impacts their business.  The potential tax increase under the Biden administration has also increased sellers’ desire to sell. President-elect Biden has been clear on his stance when it comes to taxes and has plans to raise capital gains taxes to almost double their current rate (from ~24% to ~40%), once in office. Many business owners, who were considering a possible sale, are now feeling the pressure to exit before these tax increases go into effect.

Buyers Wanting to Buy

While buyer confidence remains mixed, there are still investors looking to deploy capital in the right investments. As a result of the recent market conditions, some companies are operating at less profitable levels than in prior years. Fortunately, for those types of sellers, there are always buyers interested in these types of distressed assets, at a discounted price. Other buyers are looking to lower the risk of their investment by acquiring companies that remained profitable through the first half of 2020 and continue to have a bright outlook going forward. Buyers are willing to pay a premium for the reduced amount of risk. In both situations, buyers have become more selective in the opportunities they choose to pursue, which has lowered overall demand and decreased M&A activity in 2020.

The events of 2020 have had a greater impact on the M&A activity of strategic buyers compared to financial buyers due to the strain of operating under a global pandemic and increased restrictions. Many strategic buyers are not in the position to spend financial or human capital on acquisitions at this time. Companies who have the capital to invest, have narrowed their focus on 1) acquiring distressed companies for a lower valuation, and/or 2) purchasing higher performing assets to de-risk their financial profile, and/or 3) diversifying their revenue streams through acquisitions outside of their typical target criteria. Financial buyers, on the other hand, have more cash than ever to fund transactions (as mentioned in our previous article, Valuations during Record-High Cash Levels) and are mandated by investors to deploy their capital to acquire companies.

Availability and Cost of Capital

Currently, interest rates are at historic lows as the federal government uses monetary policy to combat an economic downturn caused by Coronavirus. Low-interest rates are attractive to buyers as they allow them to generate stronger returns when leveraging their investments. As a result of the lower cost of capital, the demand for debt has increased. Lenders, however, have become more cautious in providing loans due to the uncertainty surrounding the global economic outlook. In order to lower banks’ risk profiles, underwriters are more selective in the industries they choose to lend to. Industries that have recently seen disruptions, such as airlines, hospitality, restaurants, and leisure facilities, are deemed to have excessive risk and, as a result, they may struggle to secure debt funding in the current lending environment. Buyers consider these lending restrictions when looking at acquisitions.

Conclusion

M&A activity saw a sharp rebound in the second half of 2020 due to sellers and buyers restoring their confidence levels, and, due to transactions that were once halted, reemerging with the same or new buyers.