Evaluating the potential of M&A, divestitures and other deals to deliver value is becoming increasingly sophisticated, and understandably so. With company valuations remaining high, more players chasing any given deal, and deal structures growing more complex, the margin for error or misjudgment is small. The pandemic has only exacerbated challenges by rewriting certain assumptions and injecting uncertainty about the global economy, disrupting several industries and raising the stakes in deals.
Against this backdrop, dealmakers must address elements that have taken on greater importance in determining a transaction’s value. Along with the fundamentals of hard assets, management quality, market opportunity and strategic execution, buyers and sellers face a host of new considerations and potential complications, often at a faster pace than before. What other potential risks are out there that could drive valuations in the future?
The new sources of value creation and value destruction cut across industries and are testing corporate and private investors alike. Many of these sources emerged by way of the pandemic. Your access to liquidity during the first few months of the crisis, for example, revealed financial fitness. Then came the tests of your remote capabilities. And as the pandemic tide appears to be ebbing, we can see which companies can better sustain operations, access to talent, supplier networks, customer relationships and brand value.
But factors related to the pandemic aren’t the only challenges ahead. Others emerged in the past 12-18 months, partly due to the increasing diversity of players in deals. Special purpose acquisition companies (SPACs) have accelerated timelines, while corporate buyers have driven up valuations for targets. Against all this is the growing awareness that hidden risk can harm a company’s market or mission in an instant.
And even with the rollout of vaccines, the economic and political outlook remains uncertain. Consider the supply disruptions driven by tariff wars in 2018-2019, the March 2021 blockage of the Suez Canal and the May 2021 cyberattack on a major US oil pipeline — all of which have tested supply chain resilience. Another example is environmental, social and governance (ESG) issues, which are often elevated by external events but still play heavily in a company’s mission, market and talent goals. How a company responds can have a meaningful impact on its valuation.
By themselves, none of these constitutes a discrete and objective screen through which you can evaluate your deal options, but they do represent what can emerge in a more sophisticated review of the whole universe of deal dynamics. Taken together, it’s a combustible mix. Today’s market is defined by historically high valuations, tight timeframes for execution and more buyers with incentives to strike deals first and ask questions later. Here are some of the new dimensions of deal value you need to consider in your M&A valuation process.
Adapting for this new reality should start even before a bid is submitted, when you’re doing the initial valuation work. We’re seeing companies overhaul their total shareholder return models so they can bid more aggressively on earlier-stage assets. This is because the assumptions that support valuation are different when the target is valued mostly, if not only, for its technology, partnership ecosystem or talent. Calibrating valuation assumptions to accurately account for soft assets is essential to striking a deal in the first place. Other bidders can influence the market using their own assumptions, and the value of those soft assets in your hands may be different than in someone else’s.
This points to a significant driver of the new deal ecosystem: Organizations with the strongest intangible assets — namely quality of intellectual property, management and leadership — are in a strong position regardless of their size or whether they’re buyers or sellers. Dealmakers should sharpen their focus on the valuation and potential of intangible assets as well as the risk of lost value if those soft assets aren’t optimally leveraged after the transaction, such as key players leaving the acquired entity.
Corporations are increasingly taking more active roles in managing portfolios of businesses, similar to private equity (PE) firms. But corporations aren’t private investors by training or nature. PE firms are designed to identify a path to growth, build out a company’s team and capabilities, patiently support it through challenging periods and, perhaps most important, keep a fixed gaze on a moment of value discovery through exit. That’s when the PE firm realizes value.
By comparison, the typical corporation tends to have other top priorities, such as meeting near-term financial milestones, maintaining order around key strategic decisions, balancing demands for investment or realizing return on past investments. Cultivating a business that may be built around a still-developing product or service isn’t a typical core corporate capability, and your organization might not have much experience in retaining key leaders of another business. Therefore, corporate dealmakers need to understand what it takes to nurture another, usually smaller company to capture the value that drove the transaction. If they can’t commit to that, the expected returns are much less likely.
Trust and purpose, which can build or damage your organization’s brand strength, talent position and relationships with key stakeholders, are increasingly measurable and comparable, and they can better equip you to produce value more quickly. Organizations with these qualities enjoy strong market positions, and many benefited during the COVID-19 crisis from a “rush to security” in which familiar and responsive brands were preferred over novelty and differentiation.
We’ve known for years that ESG issues can be a source of opportunity as well as risk in deals. That consideration is getting both broader and deeper. The range of ESG issues is expanding, public and private investors are taking a more systematic, investment-centric interest in those issues, and reporting requirements and stakeholder expectations are increasing. Transactions driven by ESG considerations in particular should be analyzed rigorously. But it’s also fair to say that — to get maximum value — any business that could be sold or expects to go public should have a specific ESG strategy and tangible metrics as part of its pitch to potential investors. And those should be established well ahead of a deal discussion — at least a year and preferably two — to ensure adequate investment and higher credibility.
The deal review process typically includes a comprehensive understanding of supply chain resilience. Yet the pandemic — as well as the tariff wars that began before it — has made businesses more sensitive to the second- and third-order impacts of faraway disruptions. Practices such as delegating to third-party manufacturers, relying on single sources of supply and low investment in supply risk sensing tools or alternative logistic playbooks can pose great risks to stable production and can damage your company’s value in a deal.
To better prevent value destruction and be in a stronger position — as a buyer or a seller — you should reassess operating models and consider investments to help address current and future volatility. Such investments can provide not only more flexibility but also playbooks that can be rehearsed so you can be ready to rapidly address such disruptions as natural disasters, sudden trade policy changes or civil unrest. Businesses that clearly show they’re prepared to weather many different types of turmoil have more leverage in a deal.
With transactions at higher values and often involving still-developing businesses, you may need to spend more time evaluating a target’s technology infrastructure and digital acumen. The former has become standard in due diligence, but the latter requires just as much work to confirm an acquisition delivers value beyond hard-wired assets.
Your timeline is another crucial factor. A transaction that’s expected to create value in two to three years may not require major investment in capabilities. But for a target that needs more time to blossom, you should more carefully consider those issues, pricing into the deal the costs of needed improvements.
This is particularly true when the target’s core value is a digital product or platform, such as a service-based or subscription-model offering. These kinds of products typically come with a contact center and other meaningful back-office supports that you can’t overlook or abandon. If a transaction is intended to create an end-to-end solution — such as bolting software onto an existing hardware-based offering — the entire software experience should be integrated fully to create value. Deals now require an awareness of this expectation.
Understanding the new dimensions of deal value can empower you to take decisive action beyond traditional targeting and basic due diligence.
Deals Leader, PwC US
John D. Potter
Partner, Consumer Markets Deals Leader, PwC US