How COVID-19 Is Changing M&A Due Diligence

The pandemic is making M&A due diligence even more important. Here’s what you need to know.

COVID-19 has caused mergers and acquisition volume to drop to levels not seen in more than a decade. But that’s not the only change, as M&A due diligence will look different going forward. That’s according to BRG Managing Director Andrew Eckstein, who works with companies on buy- and sell-side diligence for middle-market healthcare transactions. We asked Eckstein about his predictions for the coming months.

How has COVID-19 affected the M&A deal environment? How does it compare with other economic downturns?

We see a light at the end of the tunnel—but there is no mistaking the massive impact COVID-19 has had on M&A. Every industry has felt it, but in the area where I focus—healthy (non-distressed) healthcare deals—I see three distinct phases.

The first was “Stop Everything and Focus on Portfolio/Operations.” Now we’re in the second phase, “Add-On Only.” The third phase looks to be “Let’s Get Back Out There.”

There are exceptions, and perhaps folks are still doing due diligence. But in terms of closing a transaction, the speed of this M&A freeze rivals, if not exceeds, 2008. Even with the uncertainty of the pandemic’s severity (or of the government’s response), dealmakers stepped on the brakes quickly and moved into survival mode. It will be interesting to compare M&A trends from immediately after President Trump declared a national emergency with what happened right after Lehman Brothers collapsed. My prediction, at least for this year: The slope will be steeper in a negative way in the early months and steeper positively in later months.

How has financial due diligence changed in the deals? How have expectations and timelines changed?

Financial diligence in a deal that closed in March 2020 may show minimal impact related to COVID, while diligence completed in May or June will be a different story. But the unknowns in terms of how quickly companies can rebound to the new normal, and whether those cashflows are the same as pre-COVID, are extending deal timelines longer than normal.

Those extended timelines are happening because, beyond financial diligence, it’s harder to find time for management meetings, to reach financing terms with lenders and to determine if valuations have changed.

Have projections for future performance (post-COVID-19) become more important? Is it possible to provide accurate projections?

I do not envy management teams. On top of incredibly difficult business and personnel decisions, they are being asked to direct their attention to forecast 13-week cashflows, revised 2020 monthly budgets and five-year projections—in that order.

Knowing weekly cash positions (and shortfalls) for the next quarter allows management to make decisions that ensure there’s a business to come back to after COVID’s impact on revenue begins to abate. So being able to pressure test and sensitize these short-term outlooks—and identify areas where more attention should be paid to optimize working capital—is of utmost importance.

Thinking that someone can predict full 2020 (or beyond) results or know the speed of the recovery is setting yourself up for disappointment. I heard good advice from a private equity client: Keep the scenarios simple, be transparent with the assumptions used and don’t forget to let management teams run the business.

Generally, how will deal volume and deal structures change over the next 12 months?

I’m an optimist, and I think that add-ons in the healthcare world are going to continue to roll in and that the speed to close will soon (perhaps in the mid-summer) revert to pre-COVID velocity. Backing a known portfolio company in a known industry is a much easier process for an investment committee and a lender.

Private equity and corporate buyers will also see opportunities to expand their provider bench, geographic reach and service offerings—and it won’t hurt that valuations may be lower. Let’s see how states’ reopenings go, but investment banks are champing at the bit to start their processes again. These bigger deals, likely platform investments for most buyers, will ramp back up and hit the market a couple months after travel restrictions are loosened.

My crystal ball says these deals will start coming back early this fall. As for changes in structure, I’m betting on bigger management rollover requirements, more earnouts and potentially higher equity checks (with an expectation of refinancing within the year).

Are buyers handling a lack of transparency from sellers differently than they did pre-COVID-19? 

Generally, it’s not that sellers are not transparent, it’s that most companies in lower- and middle-market healthcare haven’t invested in back-office accounting and reporting functions. So, accepting that valuations are fragile, sell-side diligence is important to protect value—including preparation of the pro forma adjustments for how you want the buyer to see the adjustments. If buyers find that the presented EBITDA is not supported, the chances of delays, re-trading or walking away increase immediately. There was already a movement toward parties recommending sell-side diligence before going to market. Now the benefits of this strong diligence—including securing valuation, increasing probability to close and confirming management readiness—will make it a no-brainer.

I asked my colleague, BRG Managing Director Jennifer Mannino, about the integrity due diligence side. She said that, pandemic or not, there is an expectation that sellers will be transparent on reputational components that can affect the transaction. “Our lower- and middle-market private equity clients in particular value the management teams they invest in and walk into deals as business partners, not as ‘big brother,’” she said. “The buyer’s psychology has shifted in the sense that the lack of transparency is affecting the relationship between buyer and seller. We’re seeing less tolerance for inadvertent omissions surrounding undisclosed conflicts of interest, fabricated credentials and concealed (double) billing practices.”

How is this affecting deal work in healthcare specifically? Are there developments (e.g., the growing use of telehealth) that could lead to new deal opportunities?

Financial diligence in healthcare is focused 75 percent on revenue. It is inherently complex and incredibly important in valuing a business, which entails evaluating things like procedure and payor mix, changes in reimbursement or payment velocity, provider production and even converting from cash- to accrual-basis accounting.

This pandemic obviously impacted patient volume, but the subsequent government relief will also throw a wrench in evaluating revenue.

But different subsectors of healthcare are being impacted differently. Home health and hospice care may see minimal volume declines, while physical therapy locations stayed open and saw 20 percent to 30 percent declines in volume. Dental offices closed their doors completely.

There are bright spots, with telehealth leading the charge. Through necessity, more providers offer it, more patients are willing to use it and payors need to figure out how to reimburse for it. The pandemic accelerated the timeline for telehealth becoming mainstream—including it as an established ancillary revenue for practices that will eventually return to primarily in-person visits.

It will be interesting to see how buyers will value this new revenue stream at a healthcare company that recently skyrocketed. What’s the new normal? How much does telehealth cannibalize office-visit revenue? How are staffing models (and therefore payroll costs) within practices changing to address the shift in delivery of care? Where will the government finally land on increasing the reimbursement for telehealth services? We can’t answer these questions yet.

Will diligence efforts change when we establish a new normal? Will things ever return to 2019 practices?

Sell-side diligence will become the norm. There are too many other unknowns, and locking down good historical numbers is an easy way to remove one variable. We will see a standard diligence calculation for pro forma adjustments related to COVID. There may be a short period of throwing methods at the wall to see what sticks, but the market will align eventually to what is accepted in diligence adjustments. Tax diligence and structuring will become more complex and valuable given the opportunities provided by the CARES Act and other regulation.

Overall, diligence will be even more important—as the complexities in sorting out the financial, tax, reputational and compliance noise brought by the pandemic are even greater.