Sellers pick their poison: higher taxes in 2021 or lower valuation now

01 September 2020

  • Election, Biden tax proposal spur dealmaking
  • September deal deluge expected

A potential change in tax regime following the US presidential election is pushing dealmakers to close transactions before the end of this year—potentially yielding a significant increase in M&A activity during a year that has seen serious lulls, industry sources said.


Despite knowing that launching a process now could yield bids that undervalue assets, many sellers are eager to transact in advance of the upcoming presidential election in November—which could usher in a new tax regime if Democratic hopeful and former Vice President Joe Biden is elected. Biden has proposed raising the top capital-gains tax rate to 39.6% to match taxes on ordinary income, compared with President Donald Trump who said he was seeking a 15% rate, down from the current-day 23.8%.  


Companies looking to exit are forced to weigh the cost-benefit of selling in the near-term and settling for a lower-than-desired valuation multiple because of the economic devastation wrought by COVID-19—versus waiting and potentially securing a higher valuation that is subject to ordinary income tax after close, said Hector Torres, managing director and co-leader of healthcare at boutique investment bank FocalPoint Partners.  


“The question is, do you risk the potential of a diminution in the purchase price multiples knowing you’ll get capital gains treatment, or do you risk waiting and getting a higher valuation and being subservient to ordinary income tax upon liquidation?” he said.


“Clients are telling us, ‘I’d much rather go [to market now],’” said Torres.


The upcoming election is driving increased M&A activity across the entire market, one bulge bracket banker said.  

“There has been an increase in focus on getting deals done by year end,” the banker said.  


Middle market investment bank Houlihan Lokey’s consumer team released a report cautioning clients to model valuation scenarios in a potential capital gains tax regime.


Many founder-owned businesses that had been considering a sale are now eager to transact before year-end, particularly those in sectors that were hit hard by COVID-19, according to one middle market banker.  


“Certainly for founders, it’s definitely a consideration,” this banker said. “We saw this back in 2012 as well,” he added, referencing the 2012 US presidential election. At that time, the capital gains tax was set to rise to 20% in 2013 from 15%, provided then-President Barack Obama was reelected.  


Labor Day weekend is expected to be a significant launching point for many planned auctions, said a middle market financial sponsors banker, who predicted a deluge of deal flow in September.  


But some sellers may have already missed the boat on transacting before a new tax regime is installed, as sale processes are taking longer than usual to complete in the age of the coronavirus, the sponsors banker cautioned. Depending on the sector, a transaction might take one to two months longer than normal due to logistical constraints with site visits and other due diligence, he noted. 


 The era of private equity   


Dealmaking in the US declined drastically after the coronavirus pandemic shut down much of the country in mid-March. M&A dropped 72.4% by value to USD 274.5bn in 1H20 from USD 996bn in the same period last year, while the number of transactions dropped 32.6% to 2,139 in 1h20 from 3,174 in 1H19, according to Mergermarket data.


Following that M&A lull, private equity investors are taking this opportunity to be extremely opportunistic, several sources across a swath of sectors said. As funds scour the market for discounted assets to bulk up their portfolio companies that may have been hit by the pandemic, FocalPoint’s Torres predicted the coming months would represent the “era of the bolt-on”. Private equity has been ramping up their prospecting considerably in the last month alone, Torres said.  


“One sponsor told me they’ve seen a fivefold increase in the number of opportunities coming to market in the last 30 days,” said Torres. “Everyone is really concerned about tax reform and wants to get a deal done by end of the year.”  


One middle market private equity partner echoed that, saying the last four to six weeks have represented a dramatic increase in M&A activity, with new deal opportunities emerging alongside revived pre-COVID processes.  


Founder-owned businesses recovering from the economic shellshock of the pandemic are more willing to come down on valuation expectations, the partner said. Additionally, the looming tax regime is now being baked into the initial outreach from sell-side bankers, he said.   


“I’ve seen it on the buyside where part of the pitch is, ‘Hey, move quickly, the owner really wants to close before year-end,’” the partner said.   


Also driving deals is the debt markets, which are back, but only for a narrow sliver of deals, said the sponsors banker. “Every bank says they are open for business, but the only deals getting done are COVID-resistant,” he said. Multiples for strong businesses that have continued to perform during the pandemic are up 2-3x, he noted.


From an exit standpoint, the private equity partner said a potential tax change is somewhat impacting the timing of when his fund brings portfolio companies to market.  “If we have a company that we know we were going to sell in the first quarter next year, or the first half of next year but we could sell it now, [our preference would be to] get going now and close by year-end,” the partner said.   


With renewed market enthusiasm for dealmaking and uncertainty ahead, middle market processes moving forward are doing so on a crunched timeline.  


The private equity partner said many bankers are now running tighter processes to accelerate close.


“We’re compressing eight months of work inside of four, maybe five months,” added Torres. 


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