M&A considerations beyond COVID-19

Companies in the government market still have announced acquisitions here and there in the three months that the coronavirus pandemic became a national emergency and economic crisis.

But as if COVID-19 were not enough of an overhang, a panel of investment bankers offered their views during a webinar Thursday regarding how the November elections and any potential changes to the tax code could shape transactions for the rest of this year and in 2021.

Panelists for the discussion hosted by law firm Pillsbury Winthrop Shaw Pittman LLP said the latter two factors are ones to consider as tax law changes, including capital gains, seem inevitable given the economic stimulus spending.

“What really is on the table is do the current favorable capital gains tax rates, which are lower than ordinary income tax rates, disappear and for higher income individuals, do they end up paying ordinary income rates on what historically what was capital gains,” said Joel Kallett, managing director at Clearsight Advisors.

Current capital gains rates have been at lower rates of 15-to-20 percent for the past two decades. Kallett said that in previous years, sellers have tried to get ahead of potential rate changes when comparing what today’s price would be versus holding and running out the cash flows over time.

“We may actually see and people were even talking about it pre-COVID, that people want to get their transactions done before a tax rate change, so you may see flurry of activity. I think that’s much more dependent on what happens to the Senate and the House vs the presidential election as to how that plays out.”

Any discussion over what could happen to the tax code and the merger-and-acquisition landscape also comes with further needed considerations as prospective sellers at least start to return to the market.

“Taxes are only a problem if you actually can get your deal done,” said Bob Kipps, managing director at KippsDeSanto & Co. “If it’s indifferent and the valuations are going to be similar and the feasibility is going to be similar, it certainly is a consideration and I think it’s on everyone’s mind.”

To what degree are transactions getting done in the current landscape and what’s needed to restart new M&A activity?

“A lot of the deals that been announced are lagging indicators, those were started almost exclusively before the pandemic and many of them were negotiated before the pandemic as well,” Kipps said.

“There’s maybe a hope for buyers that there will be a little more balance and maybe a little less than a seller’s market,” he added. “The companies that we’ve all started taking out to market here over the last four-to-six weeks have been strong businesses. I think that’s what’s kind of needed to navigate and pioneer through the nascent opening of a market.”

For prospective sellers, RW Baird & Co.’s John Song pointed to some familiar and evergreen questions about their key milestones that buyers will want to know more about.

“if there is a significant pipeline pursuit in which their future growth is predicated on winning, buyers will want to see and have some real visibility as to what’s happening with that contract or how well-positioned you are,” said Song, managing director of the Baird government services practice. “If a big part of their contract portfolio is at risk and it’s going to be up for recompete, and as we know it’s a very competitive market, it’s a question that would ultimately impact the timing of when to engage with the (M&A) market.”

One follow-on question from there is when is the timing right for businesses to start seeking an acquirer?

“If it is a well-positioned business, we would recommend they go to market as quickly as possible. There is no reason to slow it down, the buyer demand the appetite is palpable,” said Greg Van Beuren, managing director at Houlihan Lokey’s aerospace, defense and government services practice. “Everybody’s open for business… there’s going to be a rather significant increase in supply over the next six months out and the earlier you can get out and be the first thing that folks have to chew on the better.”

But for the buyer’s side especially, the recovery of government contracting M&A also has some dependence on the health of the credit markets.

“While the general trend is positive in the (GovCon) space, one interesting thing to play out next month or two is how the credit markets support deals because not everyone can over-equitize, not everyone can use all cash,” said Cameron Hamilton, managing director for FON Corporate Finance’s defense and government services group.

“For us to truly be in phase three recovery in activity mode for the M&A world, we need to see some further stability in the credit markets.”