For what seems like years now, varied politicians, lawyers, economists and others have been predicting the next recession (with optimism that it won’t be like the Great Recession), and to the benefit of the livelihoods of M&A professionals, the predictions have been wrong. But, as with individuals that predict rain, as the adage goes, they’re bound to eventually be right.
So, the purpose of this article is not to (because we’re the first to admit we can’t) predict when the next recession will happen (or if we’re currently in one). Instead, it’s to offer hope and optimism in the face of adversity: specifically, to provide several mid- and post-recession considerations that prospective buyers and sellers may wish to keep in mind while looking at the deal marketplace and in structuring their deals over the next several quarters.
Countercyclicality: Some Businesses May Be More Attractive in a Downturn
The presumption is that, in a recession, businesses (outside of those involving bankruptcy and divorce) suffer slowdown and become less attractive. That is, buyers don’t want to buy tanking businesses and sellers, the owners of these businesses, don’t want to sell low. However, certain businesses and industries may be countercyclical or, at least, anticyclical. Countercyclical businesses are ones like education and, in certain instances, emerging technologies, in which demand may actually increase—education because individuals are more likely to go to school in a struggling economy (to “wait it out”) and emerging technologies because potential M&A buyers will trade current value for potential upside (reasoning that a high-upside business will have even higher upside once the recession ends). Likewise, anticyclical businesses are resilient—or at least more resilient, in that elasticity of demand is not as high—and less likely to face downturns, such as those related to medical necessities, transportation and food (though not Ferraris and caviar). As such, sellers should think critically about whether their businesses have countercyclical or anticyclical aspects that will be more resilient, or have more upside, in the event of an economic downturn.
Availability of Financing: It’s a Tough World Out There
One thing that is almost universally true in downturns is that financing is meaningfully harder to obtain. This has an especially heavy effect on leveraged buyouts in the private equity space, but in a broader sense, it means that any deal that involves financing is going to be harder to get to a closing (in the face of increasingly stingy and scrupulous lenders inserting additional closing conditions and credit agreement covenants). From a seller’s standpoint, this means that strategic buyers with available cash may be more attractive than private equity (leveraged-buyout) buyers from the perspective of closing certainty. From a buyer’s standpoint, a strategic buyer shouldn’t hesitate to emphasize this benefit in an economic downturn; conversely, a private equity buyer should recognize its comparative weakness in this area, and more aggressively look to manage its relationships with its regular and prospective lenders to help mitigate the necessary challenge of obtaining financing in a recession. (On the latter, we would recommend discussing with those lenders prerecession a variant of the very question this article discusses: “If the economy goes into a recession, do you anticipate still being able to lend for leveraged buyout deals?”)
Earn-Outs: Pay Me Later What I Wanted You to Pay Me Today
All other things being equal, as an economic principle, there is always a gap in expectations on price in any M&A purchase price negotiation: specifically, sellers always want to receive the highest price possible, and buyers always want to pay the lowest price possible. (Eventually, they meet somewhere in the middle.) Yet this gap in expectations can be exacerbated in a weak economy, since buyers (rightfully) see businesses with weaker metrics as offering an opportunity to pay less, and sellers (also rightfully) don’t like the idea of selling low. Thus earn-outs can help bridge the gap in expectations. While they can be a challenge to negotiate in any climate, the notion of an earn-out is that if a seller believes the economy (at a macro level) and its business (at a micro level) will improve—and in turn, if a buyer is skeptical of that optimism—then an earn-out can allow the parties to bridge the often-cavernous gap in purchase price expectations that arises during recessions. From the buyer’s perspective, by subjecting a portion of the transaction consideration to an earn-out, the buyer can effectively receive downside protection in the event the newly acquired asset does not maintain the same performance it did in a bullish economy. From the seller’s perspective, if the business ends up performing and hitting it out of the park (whether due to macro considerations, micro considerations, or both), then the seller can receive a similar purchase price to the one it would have wanted predownturn, albeit by waiting a little bit post-closing for the earn-out targets to be hit and to receive payment.
One fearless prediction we will make before closing: The U.S. economy will, one day, again be in a recession. But, all is not lost. We encourage buyers and sellers alike to think critically about the factors identified in this article (and, of course, to consult their M&A lawyers, especially on the earn-out piece) that might be most relevant to them in the event of that inevitable downturn—to think about which businesses might be more (or at least not less) attractive, to consider the significance of financing their deals and to act creatively in considering earn-out structures to manage differences in purchase price expectations.
On a more optimistic note, here’s hoping that this article proves particularly untimely, and that a recession is many, many years away.