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Geoff Morgan featured in Crain’s M&A Roundtable Discussion

As published in Crain’s Content Studio

September 05, 2019 | U.S. deal value increased 28 percent to more than $2 trillion in 2018—its highest point in three years, according to PwC’s quarterly Deals Industry Insights.

Year-end surveys of U.S. corporate dealmakers and private equity firms predicted more and bigger M&A deals in 2019. Are current global political tensions, trade wars and volatile markets changing the trajectory?

Three advisors who work with business owners looking to buy or sell a company shared their insights with Crain’s Content Studio on the ever-changing state of the deal.

What types of M&A clients does your firm typically represent?

Bill Doran: We advise firms commonly referred to as “strategic”—including private and public businesses—as well as those referred to as “financial,” such as private equity funds and independent sponsors. Our private equity practice has traditionally been a part of our firm’s M&A work, and we’ve experienced recent growth in that area. Our practice is squarely in the middle market, with our typical M&A transactions ranging between $10 million and $500 million.

Carina Markel: Our clients include multinational and domestic corporations, as well as private equity firms. We have expertise across several sectors, including technology, industrial products, consumer markets, pharma and life sciences, healthcare and financial services.

Geoffrey R. Morgan: We represent both buyers and sellers in small and middle market M&A transactions. Many of our clients are family-owned or privately held businesses that were sold to private equity buyers. We’ve also represented private equity sponsors in their acquisitions—often add-on acquisitions for existing portfolio companies. Our experience includes technology, manufacturing, packaging, food and beverage and real estate.

How do you help clients add value when buying or selling a business?

Morgan: Many clients need help getting their house in order and understanding the ins and outs of market deal points. For the first, we help identify and address business and legal issues that typically come up in due diligence and among selling stakeholders. We frequently encounter issues related to resolving and documenting equity holdings and options that may have been agreed to in principle but never documented; addressing issues that may impact the quality of earnings analysis ahead of time; and helping manage expectations on sales price by pointing to objective factors that will impact what buyers are willing to pay.

Markel: We provide insights and digital tools through each stage of a merger, acquisition, divestiture and capital market transaction. Our deals team also offers a diverse range of services, including capital markets, accounting advisory, valuation, tax and human resource transaction services. This holistic approach gives our clients the information needed to effectively close a deal and drive value. For example, when a large multinational technology distributor looked to acquire another multinational business, there were many challenges, including the size of the deal and the number of people, facilities, cultural differences and systems involved. With PwC’s help, the client was able to acquire the business and successfully create one of the world’s largest technology distributors.

Doran: One of the most important ways we add value is by keeping the deal moving at the desired pace while avoiding surprises. Buying or selling a going business concern is never entirely straightforward because each business has a unique ownership profile and set of facts. It helps to follow the “three Ps.” We strive to bring a good plan to each transaction, use our experience to predict issues and negotiation points, and remain proactive to stay ahead of small matters so they do not become big matters that might impede the deal. We also help with deal structuring to enhance value. And we provide thoughtful negotiation to improve deal terms and rigorous legal due diligence to identify and properly allocate risks and benefits.

How would you describe the level of 2019 M&A activity thus far?

Doran: M&A activity has been steady and very active this year. At the same time, many deals have had a somewhat deliberate pace and tone. Buyers are definitely doing their homework, looking for businesses with “good bones” that will perform well in the inevitable softening business cycle to come.

Morgan: While the cryptocurrency and blockchain spaces are hot areas, we’ve had deals crater because of Bitcoin’s decline in value earlier in the year and the uncertainty that came with that. Otherwise, there’s a lot of money chasing a finite number of deals, so activity has been robust.

Markel: While the total number of U.S. deals may be lagging compared to 2017 and 2018, total U.S. deal value and the number of megadeals—transactions of at least $5 billion in value—were up in the first half of 2019, following a dip in the second half of last year. The high deal values and growth in megadeals signal a continued appetite for transactions that can help companies chart a course for sustained growth.

What external and market forces do you currently see impacting the M&A landscape?

Doran: On the positive side, there’s a large amount of undeployed investment capital, innovation, strong employment and consumer demand. On the negative side are international trade issues and the age of the current business cycle.

Morgan: The expanding legalization of cannabis continues to drive M&A activity in that sector. Additionally, the availability and growth of representation and warranty insurance—with more providers and more known terms and pricing—is helping fuel the M&A market. Finally, technological innovations are clearly impacting deal flow, both providing direct targets for acquisitions and tools to accelerate evaluation, analysis and closure of deals.

Markel: Geopolitical tensions like the trade war between the U.S. and China, as well as the dynamic between Europe and the United Kingdom over the extended Brexit situation are impacting M&A activity. The day-to-day economy remains relatively stable, and there’s an incredible amount of capital available for investment.

What sectors or industries are particularly active with respect to M&A?

Markel: Nationally, the technology sector continues to be the most active in the M&A market as companies look to drive innovation through strategic acquisitions. We’re in the beginning of the Fourth Industrial Revolution, where entire business models stand to be revolutionized with the emergence of technologies like artificial intelligence, virtual reality, blockchain, 3D printing and automation. In Illinois, we’re seeing a lot of activity in the financial services and consumer markets sectors.

Doran: We’re seeing activity in transportation and logistics, healthcare, financial services and financial technology. Even the nascent cannabis industry is experiencing rising M&A activity, as a precursor to the consolidation wave that has already begun and will only accelerate following broader legalization.

Morgan: We’ve been involved in several cryptocurrency transactions, which continue to spark interest for investors. Some deals didn’t make it to the finish line due to the uncertainty surrounding Bitcoin. We’re watching Illinois’ emerging cannabis industry very closely, and our early experience suggests this will be a hot area for future M&A activity.

What changes are you noticing regarding deal size?

Markel: Megadeals—deals valued at more than $5 billion—just keep getting bigger. In fact, the average megadeal so far in 2019 is nearly $21 billion, compared to $12 billion to $15 billion in the last few years.

Morgan: Private equity firms are interested in identifying smaller “bolt-on” acquisitions for their existing portfolio companies, resulting in more competition for smaller deals. Our firm generally focuses on deals valued at up to $50 million, and we’ve seen substantial activity, even though 2019 has been marked by increasing deal size and a surge in mega deals.

What concerns are you hearing from your clients who are undergoing or contemplating an M&A transaction?

Morgan: Uncertainty about the process and impact of due diligence and the myriad obstacles buyers and sellers face in getting a deal closed. With the increased use of quality of earnings analysis, sellers are worried about the impact revenue stream weaknesses may have on the financing sources. Our PE clients try to address those issues early on so neither party wastes time or expense if a deal isn’t going to happen.

Markel: Hackers are monitoring M&A within specific industries, especially technology. Companies are particularly vulnerable to cyber threats during the period between a deal’s announcement and closing. When large companies announce a deal, it’s not uncommon for hackers to attack the smaller company, knowing it may be an easier target. Since most breaches typically aren’t identified until 18 months after the attack, proactively managing the risks is imperative.

Doran: Two versions of the same song. Buyers are building downturn resilience into their operating assumptions, pricing models and due diligence. At the same time, many sellers who have been waiting on the sidelines are now approaching—or asking whether they should approach—the market for fear of missing an opportunity.

What trends are unique to middle market M&A?

Doran: One big trend has been the rapid adoption of representation and warranty insurance. The efficient market for this product has made it cost-effective and available for an increasing number of M&A deals. This is streamlining the negotiation and documentation process, and provides buyers and sellers with greater certainty.

Morgan: Because of the relative expense, we’re seeing less use of representation and warranty insurance in deals valued at under $25 million. In smaller deals, parties need to more heavily negotiate the caps, baskets, escrow and other indemnification terms. We’re also seeing buyers and sellers unable to agree to these terms, resulting in the loss of deals entirely. Finally, we’re seeing more and more deals with earnouts and small or no up-front payments, which often allows the parties to bridge the gap on valuation discussions.

How has increased shareholder activism impacted M&A campaigns for public companies?

Markel: We frequently see activists pressing for the sale of a company as the primary goal of an M&A campaign. Other objectives include improving the terms of an existing deal or calling for a company to split up or divest underperforming assets. It’s important for companies and their boards to remember that the market in general, and activists in particular, continue to look to M&A as a strategic way to add value. To prepare for—and possibly even avoid—shareholder activism, companies should thoroughly evaluate where the opportunities for value creation exist and communicate this growth plan to shareholders.

Morgan: It’s definitely made public companies consider the societal and environmental impact of target companies before proceeding with an acquisition. Institutional shareholders now meet more regularly with company executives and express their opinions about non-monetary aspects of M&A transactions. For that reason alone, executives must be prepared to discuss both the monetary and societal results and implications of their M&A activities, as well as potential effects on customers and employees.

How is artificial intelligence aiding the due diligence process?

Markel: Technologies like optical character recognition, natural language processing and automation can save hours of time by combing through hundreds of documents for specific keywords or clauses. Our deals professionals believe in a future where the labor-intensive and administrative tasks involved in the diligence process are fully automated. While a human touch will always be key in delivering deep insights and high-quality services, we’re excited to leverage technology and AI to improve efficiency and boost productivity. These technologies will allow diligence professionals to spend less time on data wrangling and more time on the critical deal issues, increasing the value we provide to clients.

Doran: AI has begun to influence the legal due diligence process by streamlining the workflow—and work time—involved in document analysis and contract review. The full effect is likely still a few years off, but as the systems proliferate and user confidence continues to grow, it will play an increasingly bigger role. This will allow human M&A advisors to provide faster, more thoughtful and ultimately more valuable conclusions and advice to clients.

Morgan: On larger deals, AI is being used to identify anomalies in contracts. However, once anomalies are identified, the qualitative analysis is largely driven by humans. In the small deal setting, clients haven’t wanted to incur the expense of AI-powered due diligence tools as they can be cost-prohibitive. Similarly, as we discuss the quality of earnings process with the financial and accounting firms that perform them, it’s still primarily a human process.

How can pre-acquisition planning by target companies streamline the sale process and maximize the sale price?

Morgan: Identifying and addressing issues in the revenue and earnings stream will go a long way to making price negotiation and due diligence easier. Also, the sale process is measurably more streamlined if the tax and legal work has been done on all of the compensatory and stakeholder agreements and arrangements. We see cases where employees believe they have equity or contingent equity interests but those haven’t been documented or no one has gone through the necessary tax analysis to minimize tax consequences. These obstacles can slow or derail a deal.

Doran: This gets back to the “three Ps” I mentioned previously—have a plan, predict and be proactive. A company that’s planning to sell needs to organize its documents and affairs so that it can present a crisp and credible picture to potential buyers, and inform the chosen buyer with confidence and consistency all the way to closing. In preparing to sell, a company should develop a list of what it would ask for if it were the buyer, including financial information, key customers, key employees, ownership and succession planning, technology and data security, facilities and assets, contingent liabilities and litigation, contracts, leases and documents, regulation and permits, and tax statements. By engaging in this type of self-audit, the seller can better prepare for the buyer’s review, which will be even more exacting. Also, sellers need to develop their external and internal sale team, line up an investment banker or sell-side financial advisor, and make sure that their accountants and attorneys have relevant deal experience. It’s critical to make sure that the internal team is prepared and aligned with the vision for selling the company.

Markel: Companies should engage deals professionals early on to identify potential challenges in order to streamline the diligence process and maximize the sale price. This minimizes surprises, improves speed to market, helps avoid business disruptions and ultimately enables target companies to remain nimble throughout the negotiation process.

As we approach year end, what’s the outlook for M&A?

Morgan: Strong. We’re in a period of consolidation, and as long as acquisitions will be accretive to earnings of acquiring companies, we expect to see M&A activity continue to strengthen. There’s plenty of money available for deals and plenty of dealmakers anxious for their next opportunity. As long as that holds steady, we believe activity will remain strong.

Doran: I think that the M&A activity will remain steady and likely accelerate slightly into and through the fourth quarter, as more businesses that have been considering a sale enter the market.

Markel: The prevalence of megadeals combined with the amount of private equity dry powder that’s sitting on the sidelines signals to us that M&A activity will remain healthy, even in the face of a potential slowdown and looming geopolitical tensions.

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