Co-Authored with Michael Butler (Founder, Chairman and CEO, Cascadia Capital) and Dan Gaspar (Partner, TZP Group)
GHJ Managing Director David Horwich sits down with Michael Butler (chairman and CEO of Cascadia Capital, a leading West Coast investment banking firm) and Dan Gaspar (partner at TZP Group, a private equity firm based in New York) to discuss their experience working in 2020 ─ the bumps, the lockdowns and the lasting effects of the COVID-19 pandemic.
COVID-19 TRANSACTION LANDSCAPE
David Horwich: For companies you are reviewing with negative growth results during the 2020 shutdowns, how do you determine whether or not it is a project you want to engage in?
We spend a lot of time comparing the individual enterprise to industry-comparable companies to see how they fared. We look for an emerging trendline that is getting back to the growth curve that existed pre-COVID and look for compelling proof that above average growth will be returning.
I agree that it is critical to study those industry “macro” metrics. We also like to focus on company-specific criteria, such as how the management team responded and adapted to COVID-19 and if the business is now better equipped to withstand future exogenous shocks.
For those that had a positive impact to their stories, how do you ensure that it is not a temporary bump to return to “back to normal” growth with pre-shutdowns as the starting point?
In cases where the business was growing meaningfully entering 2020, isolating the portion of 2020/2021 growth that stemmed from a “COVID-19 bump” compared to continued organic growth is very challenging. That said, studying the source of revenue can provide helpful insight. For example, with consumer companies, we look at new customer versus existing customer sales, sales by customer vintage, repeat-purchase trends, changes in average order volume, order frequency and SKU mix, amongst other factors to educate ourselves on what is truly driving growth.
MB: Similar to Dan, we are going to look for evidence of sustainability through new products, new sales infrastructure and new uses of existing products that will continue after COVID-19. We want to know what has changed pre- to post-pandemic.
DUE DILIGENCE DURING DISRUPTION
How do you value either of such occurrences mentioned above when it comes to working with or offering pricing guidance?
We work very closely with our clients to create a defensible, sustainable EBITDA and then work with buyers/investors to price off that number. The easier case is when a company expects to see a post-pandemic bump because an earnout can be structured that is win-win.
The harder case is when a company has had a significant upturn during COVID-19 that is probably not sustainable. We oftentimes find in these situations that sellers have an unrealistic valuation expectation and are unwilling to take a haircut. Upfront independent diligence prior to marketing the business is important here to help set expectations and also pre-empt an adjustment that a buyer might otherwise make.
Every situation is different. If the changes are significant and meaningful, we will use “earnouts” based on future performance to align interests and fairly compensate sellers for sustained high performance or for what proves to be a one-time negative blip.
Are there general transaction structures you have developed that sellers/issuers received with positive reactions?
We have found that being open and direct with concerns that arise during the transaction process and treating our future partners fairly will always engender the best results. At TZP, we focus on “Partner of Choice” transactions, where sellers and management teams roll over or invest alongside us in the new company. This ensures that all sides have interests aligned post-transaction.
Again, to Dan’s point, we are seeing earnouts becoming more and more commonplace. While earnouts can be challenging to negotiate and quantify post-closing, many of the earnouts we are seeing will be based on revenue rather than profitability. Revenue is far easier to measure and implement post-closing.
As you perform diligence transactions or provide advice to buyers/sellers/issuers, what procedures have you instituted that provide comfort?
We will not take on transactions (possible exception of software companies) without the seller or issuer getting a Quality of Earnings report from a reputable firm. We learned the hard way on this.
DG: That is great advice. While a sell-side accounting report will not substitute for our own buyside work, it does help streamline the diligence process and highlight the diligence issues upfront that might cause potential conflict later in the process.
CLOSING IN COVID-19
Please talk about one or two transactions that had significant COVID-19 lockdown changes to growth and how you successfully addressed them.
We have acquired several direct-to-consumer brands over the past 12 months, and in each case, we had to undertake the analysis mentioned earlier in order to underwrite the sustainability of revenue trends or to ensure that appropriate working capital targets were negotiated.
MB: We recently closed the sale of several fertility clinics. These clinics were mostly located in California and experienced shutdowns during the pandemic. As California began to open up, we got several months showing a strong revenue recovery and were able to create a “normalized and sustainable” forecast that buyers agreed with and passed on a normal valuation.
As seen in the conversations above, COVID-19 has affected today’s transaction environments and will continue to impact the current and future marketplace. Whether companies are looking for growth opportunities, a transaction pre-market or diligence services, these opportunities are attainable with an experienced team of advisors.
If you have any questions about post-pandemic M&A landscape or other advisory services, please reach out to GHJ’s Advisory Team, Cascadia Capital or TZP Group.