How to prepare for M&A in a recession

Part 4 of the PwC series

Winning through M&A in uncertain economic times

During any period of uncertainty, public companies, private equity firms and other potential acquirers are weighing adjustments to investment strategies. Compared with previous economic cycles, the amount and diversity of capital available for M&A is greater than ever. Companies that can use that capital and make deals early in a downturn could see better returns than others in their industry, a PwC analysis found. But for that growth to be realised, those companies have to be prepared. As we approach times of greater uncertainty, it is important to revisit M&A best practices and how they have changed over this past economic cycle.

How do you position yourself to make acquisitions that could drive long-term growth? A thorough diagnosis can reveal specific actions to navigate challenges and exploit opportunities. Getting ready now allows buyers to act decisively during a period of uncertainty. It also can limit the anxiety that often comes with making aggressive bets in a contracting economy.

Issues to address include deal strategy and leadership, capital, customer experience, operations and workforce. Actions and tools include scenario planning, cost optimisation, data analytics, reskilling and automation. In these critical areas, companies need to consider three key things:

What we know from before: lessons and best practices from past recessions
What is happening now: the characteristics of the current cycle and differences from past cycles
What you need to do: the levers companies can pull to be better prepared to do deals

Agree on growth opportunities and act with confidence

The psychological effect of downturns: A struggling economy understandably tests the risk tolerance for company boards, management teams and investment committees, often causing hesitation in deploying large amounts of capital. At the same time, a declining stock market can make shareholders more anxious. Previous downturns have seen increased shareholder activism, as some investors pushed for action to cut losses and inject capital, such as divesting certain businesses.

New business models will emerge: As established companies, entrepreneurs and consumers adjusted to shifting conditions, new business models have emerged during past recessions, disrupting the M&A environment. The rise of ride-sharing firms after the global financial crisis is one example.

More stakeholders are watching: Greater connectivity means greater visibility of businesses, and a downturn would likely bring more scrutiny not only from investors but also the public in general. Reporting and criticism of companies has expanded beyond newspapers and television to social media. The consequences of actions during a slowdown—from short-term employee layoffs to acquisitions aimed at long-term growth—would be judged not simply as dollars-and-cents decisions but for how they reflect on a company’s contributions to society as a whole.

4IR investing opportunities: Artificial intelligence (AI), the Internet of Things (IoT), 3D printing and other emerging technologies continue to mature, and companies in many industries are exploring how the Fourth Industrial Revolution (4IR) could upend processes, operations, products and services. Unlike traditional bids to grow scale, investments in 4IR technologies do not necessarily have to be substantial to help a company start down a path of transformation.

Consider strategic divestitures: Investors should proactively assess their portfolios and determine if a near-term divestiture aligns with their business strategy and could boost their capital position even more. Connecting the growth strategy to portfolio management creates a feedback loop that allows the company to adjust for various scenarios—including the severity of the next economic cycle. This is a contrast to reactionary moves that too often result in strategic misalignment and value leakage.

Update the deal funnel: The above actions can put a company in a better position to reassess the corporate development deal funnel and determine which prospects are clear priorities and which assets may come to market in a tighter economy. Recent history is less relevant than scenario analysis, which will be critical for target assessment.

Keep communication front of mind: Proactive dialogue between management and corporate development teams and the board of directors and investment committees can build confidence that the company is current on the competitive landscape, monitoring warning signs and prepared for a range of scenarios.

Robust due diligence is critical when navigating through financial reporting complexities as a result of COVID-19

Businesses are experiencing unprecedent changes across all sectors. Stabilisation following the initial COVID-19 impact and the resulting economic crisis means something distinct to each sector and every company, with some benefiting and others going through a significant disruption. More than ever, robust diligence is required to establish and understand the financials of a company.

During diligence it is important to consider how the timeline of events has impacted and will impact the target’s business model and the industry it operates in. Companies should then consider COVID-19-related lost revenue, incremental costs and savings as well as any cash-flow and balance sheet implications in a robust manner that is consistent, verifiable, and subject to scrutiny by a range of stakeholders including investors, lenders and insurers.

Analysing the business with a multi-stage approach is critical

Key areas to consider when assessing potential financial impacts of COVID-19 across phases and scenarios

To what extent was the company impacted by COVID-19 and have the key drivers that caused destruction in value now abated to the point where the business can be considered stable? On the contrary, if there was a pickup in activity, is the benefit also going to last during a recession?

Is the company able to generate the right level of information in a timely fashion in order to make informed decisions? Have scenarios been considered?

How have the competitive landscape and relevant consumer behaviours changed as a result of COVID-19 and with the beginning of the recession? What are the political, economic, social, technological, environmental and legal changes? Are the changes temporary or will they be sustained?

Which industry and societal trends have been accelerated and will persist as a result of COVID-19 (e.g. working remotely, social distancing, digital strategy, shifts in consumer preferences)?

What level of government and industry assistance is made available and used (e.g. short-term work and government-backed loans)? Will this continue going forward, or will there likely be a secondary impact when this assistance stops?

How will the long-term impacts of social distancing and health considerations change the industry? How will the company adapt to these?

How will the company return to pre-COVID-19 levels (unlikely in many cases), or is there a “new normal”? How is the business equipped for a second/returning COVID-19 situation? What are the possible recovery scenarios?

How is the company planning to seize opportunities that will allow it to grow and create value after COVID-19, during a recession and also thereafter? A comprehensive understanding of the business model and resilience along the value chain is required (covering sourcing, operations, HR, R&D, Capex, financing and working capital).

Preserve access to and efficiency of capital

M&A capital declines in a downturn: Public equity, private capital and borrowing have all played a role in helping companies acquire others. The 1990s saw public equity play a larger part, as private equity firms had yet to assert themselves and interest rates—while falling—still were not as competitive. But declining stock markets reduce the value of shares, limiting their attractiveness in trying to assemble deal funding.

Debt can be more difficult to manage: Borrowing also became harder for companies in previous downturns. Rates typically fall, but so do companies’ values and performance trajectories, which can affect the risk conversation. Companies also may face more pressure to meet loan terms and covenants that may have seemed favourable in an expansion but do not hold up as well amid declining revenues. Working capital also becomes a more critical focus, as financial and operational inefficiencies can jeopardise stability in a downturn.

Private capital flourishes: Compared to the last recession in 2007-2009, capital available for investment is not as closely linked to economic trends. While bank lending into deals has declined as a part of overall M&A capital, the rise of private debt funds, venture capital and private equity has greatly expanded the amount and mix of capital.

Companies hold more cash: Corporate cash has grown substantially over the past decade. Profits are generally up, while spending on tangible assets has tapered off, as a greater percentage of investments has shifted to intangible assets. Low corporate tax rates have helped balance sheets swell further, giving companies that see limited paths for organic expansion more liquidity to pursue deals.

More debt options, but with potential risks: While abundant and diverse, the capital mix is not bulletproof. Debt markets have expanded significantly, and loans issued by some institutions typically have fewer covenants and more flexibility than those from banks. But some of that capital could cost more in a contracting economy. In the bond market, the lower investment-grade bonds that have become more common could put some companies at greater risk of downgrades and default as economic conditions worsen.

Explore where to restructure debt: On the borrowing side, companies should review their current plans and determine where they could restructure or refinance. They also should review how covenants could change in a downturn, as some alternative lenders may seek more protections, even if not at the level of those required by banks.

Right-size working capital: Focus on improvements in the relevant operating levers to ensure working capital is tuned to a declining cycle. Reductions in inventory (which could be affected by decreased demand) and receivables (declining revenue growth) and improvements in payables are reasonable aspirations during periods of reduced top-line growth—or actual declines. These can increase operational efficiency overall and result in a stronger capital position going into a downturn. Benchmarking, data analytics and other tools can reveal both quick wins and long-term opportunities.

Take advantage of capital mobility: Private equity firms should determine where they could move capital among their various pools to maintain adequate returns as some portfolio companies feel the impact of a slowdown. Firms engaged in alternative investments and private debt as well as equity should leverage that flexibility to avoid capital being trapped in non-productive situations.

Plan for customer experience challenges and opportunities

Customers feel the pressure: The rules of customer engagement change with the economy. Companies that fail to understand financial pressures on their customers and do not anticipate changes in buying patterns can find themselves facing sudden, unexpected revenue declines. And when management focuses primarily on cutting costs to offset declines, a company can lose sight of the impact on clients and customer experience.

Internal issues can affect external perceptions: There is also the potential impact of internal communications on customer experience. Employee anxiety in a recession can spill over into customer engagement, damaging relationships at a critical time. Customers who sense a company is vulnerable and has neither a plan for shortterm survival nor a long-term vision are more likely to consider alternatives that could better serve them going forward.

Data delivers deeper ties with customers: Whether it is B2B or B2C, customers are open to deeper relationships with companies through technology. They recognise the benefits of connectivity and customisation, and the proliferation of e-commerce business models and social media platforms has made for a richer customer experience in many industries. Social listening and sentiment analysis provide more insight on consumer preferences and behaviours that can be used to strengthen ties.

Relationships can change quickly: But customer loyalty is also more complex in a digital world. Products and services tailored to specific needs have appeal, but customisation does not displace traditional demands, such as competitive pricing and fast service. Customers are more mobile than before and can quickly end relationships if they experience gaps in key areas.

Prioritise customer needs: Companies should determine what aspects of their particular customer experience are most important and what they need to do to preserve them. This could vary by industry, and concrete resources should be identified to safeguard the quality of engagement and maintain a company’s customer base so it can consider building on it through M&A.

Capture sentiment directly: In executing on an acquisition in the downturn, understand sentiment and develop a process to conduct that analysis early in the deal. Learning from customers of a target business can be a valuable complement to dialogue with management. Listen to the themes. In addition to customer opinions and expectations, sentiment can provide greater insight into the workforce—a key part of the customer experience.

Analyse to retain and expand: Use analytics to determine what customer retention incentives are more important in a slower economy. Being able to deploy those quickly in response to customer anxiety will ensure a company remains stable and better able to acquire in a downturn. Analytics can also identify areas of potential customer expansion in acquisition targets, which can increase deal value as the economy eventually improves.

Ensure consistency while adjusting operations

Strategic and focused cost-cutting: Companies that move earlier on strategic reductions to offset revenue declines can outperform others that wait and sometimes overcompensate, often with indiscriminate, ineffective slashing. Focused cuts should be calibrated to lower volume expectations.

Opportunities to simplify: Prudent reductions can do more than compensate for less revenue. They have allowed companies in past downturns to invest in simplifying processes and improve productivity, putting them in a stronger position to potentially acquire other assets later.

Shifting supply chains: The extension of supply chains to countries around the world over the past two decades has made the companies that rely on them more vulnerable than in previous recessions. The outbreak of coronavirus (COVID-19) is the most prominent example, but also other events—such as the trade war between the US and China as well as Brexit—pose threats to long-standing supply chains and processes. Swiss companies must now consider the financial impacts of such events and a more protectionist world.

Digital tools expand: Increasingly sophisticated digital tools and data analytics have improved visibility and information across operations as physical locations have become far flung in many industries.

AI and other techs emerge: The person vs. machine dynamic continues to shift. Worker productivity has declined over the last few years, requiring acquirers to consider what they would need to do to improve efficiency in potential targets. Further adoption of 4IR technologies ultimately could have a significant impact on how business models evolve in several industries.

Revisit pricing and incentives: Adjustments to revenue paths cannot wait until the recession fully hits. Companies should revisit pricing strategies, as well as sales force incentives, and plan for various degrees of decline.

Position supply chains for the long term: Supply chain agility will be more important going forward. Along with adapting their own chains, companies should secure capabilities to evaluate how tariffs—existing or possible—could affect the supply chains of acquisitions.

Find efficiencies in shared services and PMO: Corporate and private buyers should have clear plans for shared services—locations, automation or otherwise—that can then be used for potential acquisitions to generate immediate savings. Procurement, demand planning, accounts payable and performance reporting are a few areas where a buyer could quickly fold in a new asset. Project management office (PMO) practices and discipline can also pay significant dividends in times of turmoil, whether for integration readiness of an acquisition or effective execution of organic transformation initiatives.

Next steps for successful deals in a recession

The prospect of making a deal in a slower economy can be daunting. But the idea of acquisitions being off-limits in a downturn is living in the past. Companies that leverage historical best practices, informed by the recent changes to the business environment over the past decade, can have significant success in creating value.

Deal strategy and leadership confidence: Consider strategic divestitures and adjust metrics and benchmarks. Update the deal funnel for various scenarios and keep communication front of mind.
Capital availability: Explore where to restructure debt, right-size working capital and take advantage of capital mobility.
Customer experience: Prioritise customer needs, capture sentiment directly, and analyse to retain and expand the customer base.
Operations: Revisit pricing, position supply chains for the long term, and find efficiencies in shared services and the project management office.
Workforce: Assess the people in place before acquiring more, keep growth in mind during cuts and provide skills that help in the long run.

How to prepare for successful M&A in a recession