US private equity deal-making plunged in the second quarter of 2020, according to PitchBook. As an unprecedented pandemic tore its way through the nation, forcing the population into lockdown and ravaging entire industries, completed transactions tumbled by more than a third on the previous three months. Deal value in the first half of the year was down almost 20 percent on H1 2019, and deal value for Q2 dropped by over a third compared with Q2 2019.

If anything, it is surprising that the decline has not been steeper. A lack of clarity around performance data, the impracticalities of remote due diligence and the prospect of second-wave outbreaks has made embarking on fresh negotiations perilous, while managers have also been pulling out of previously agreed deals citing MAC – material adverse change – clauses in their droves.

Indeed, beyond a smattering of opportunistic bolt-on acquisitions, activity in the mid-market in particular has been muted, with a focus instead on fire fighting alongside existing portfolio companies – coupled with urgent communications with both LPs and lenders. But as stock markets rebound and the world grasps tentatively at the semblance of a new normal, mid-cap managers are now turning their attention to the opportunities that lie ahead.

“From March through to mid-May, support took up a lot of time,” says Jon Marston, partner at advisory firm WilliamsMarston. “But as June approached, more time was spent scouting new opportunities – largely with projects or deals that were either already in a holding pattern or in the pipeline during Q1. As we’ve moved into Q3, however, it appears that the deal market is coming back to life.”

These opportunities are taking many forms. First, there are situations where GPs are going back through their “passed deals”, exploring conversations that may be reignited given the different market conditions. Then, of course, there is the prospect of providing rescue capital for those businesses that have been most severely affected by covid-19.

Lauren King, a partner in the private equity group at Goodwin Procter, points to the speed at which dedicated distressed vehicles were launched and closed as early as April. However, capital deployment in the worst hit sectors, such as travel and hospitality, has largely been restricted to the mega-deal market so far, and thus fulfilled by large scale public debt and equity capital raises.

“Frankly, we have been surprised by the lack of these opportunities in the middle market to date – as they have largely been limited to companies which had been having difficulties prior to the pandemic, and only made worse by the pandemic,” says Frank Schiff, managing director at MidOcean Partners. “We believe more of these opportunities will emerge, particularly if further lockdowns occur.”

And as they do, mid-market sponsors will be anticipating grabbing some bargains.

“As we emerge from the pandemic, we would expect targets to be available to mid-market funds at a discount to pre-pandemic levels in many sectors,” says Marston. “Those discounts would likely be due to either lower multiples driven by uncertainty or future growth prospects, as well as by lower trailing earnings.”

However, there are companies that have benefited, or at least fared well, over recent months. These businesses, particularly to be found in the technology, B2B services, healthcare, food and home improvement industries, are likely to attract a great deal of interest – at robust valuations.

“There have been certain sectors that will have been strong throughout. These sectors may get higher multiples as most expect economic uncertainty to persist for 12-24 months,” says Marston.

Meet the specialists

The ability to exploit sub-sector nuances in the aftermath of the pandemic will depend heavily on deep sector knowledge – something that has accelerated rapidly in the US mid-market over recent years. “It has been our belief that hyper-specialisation is the key to seizing proprietary dealflow,” says Mark Carter, managing director at TA Associates. “We believe that familiarity and trust built over years with a management team is a monumental competitive advantage in an era of Zoom calls.”

“Sector specialisation has been critically important during this time,” adds Thibault Basquin, head of Americas investments at Ardian Buyout. “When you know your sector inside out, and really understand the sub-sectors, you will make better decisions. At the macro level, while you may hear economists speaking about whether this is a V, U, W or L-shaped recession, and what that means for the recovery timeline, at the micro level, it’s different.

“Looking at this through a sector-specialisation lens, businesses are going to behave very differently depending on their actual situation. For some businesses, the impact will be cyclical, but for others it will be more structural. And when you have that deep sector knowledge, and networks, you can meter at the right level.”

The survivors

The bulk of the mid-cap opportunities on offer, however, are likely to comprise those companies that have muddled through the pandemic and can be anticipated to grow again when an end to the crisis is in sight. “These companies are likely to have performed well prior to the pandemic and may even have been slated for sale. They are also likely to be able to resume growth, post-pandemic. We believe these types of companies will appear as opportunities a bit later in this cycle,” Schiff says.

In particular, covid-19 is likely to push many corporates to rethink their asset allocations, potentially bringing a wave of mid-cap divestitures to market. “These companies may accelerate those decisions as a way to bring in more cash,” says Thibault Basquin, head of Americas investments for Ardian’s buyout business.

“In a similar vein, we are seeing some family businesses in North America which want to step up their ownership transition plans that they had previously mapped out on a slower timeline,” Basquin adds.

Marston agrees. “There could be a continued and accelerated social shift as baby boomer owners move toward retirement,” he says. There are also whole sectors that are being re-energised and re-designed as a result of the pandemic, creating exciting opportunities for firms that are thinking ahead. Ardian is particularly interested in trends that are emerging in the food chain and healthcare sectors, with a push towards shortening supply chains – essentially producing and sourcing more locally.

“This was already a consideration underway with tariffs, but with more potential pressure due to travel restrictions, this type of analysis has taken on a new level of importance,” Basquin says. “Post-pandemic, countries are thinking about how they can become more self-sufficient, and so this is emerging as one of the macro drivers of this trend at the company level.”

Basquin also points to online education as a sector to look out for. “For obvious reasons, improving the experience of online education was already an important topic,” he explains. “But it has taken on more urgency with the understanding that we could be facing future situations that require pivoting to virtual learning on a dime.”

The power of communication

Good communication has been imperative for mid-market GPs during the crisis. Over the first four to six weeks, most GPs worked closely with portfolio companies to assess the impact of the pandemic, develop plans, cut costs, assure liquidity and manage constituents from employees to customers to lenders. MidOcean’s deal teams, for example, met daily with portfolio companies and held weekly calls portfolio-wide with chief executive, CFO and marketing and HR leads, in order to cross-fertilise ideas and best practices.

Of course, the biggest transformation for an industry which thrives on personal relationships and gut feel as much as data is that all communication is now remote, which brings with it its own challenges.

“All of my board meetings in the first and second quarters have been virtual,” says Mark Carter, managing director at TA Associates. “However, if you are up-to-speed on your investments, virtual delivery of board content can prove to be quite effective and efficient.”

TA’s annual meeting for LPs in May was also held virtually. “We adapted by shipping recording equipment to the homes of each of the TA partners, so that each of us could record our presentation sections in advance. I believe that we made the best of the situation,” says Carter.

The resilience challenge

Whatever the sector, there will undoubtedly be significant challenges executing mid-market deals in the months to come. Investment committees will be faced with difficult choices when making go/no-go decisions in the face of economic uncertainty and local lockdowns. We can also expect lenders to be conservative with both leverage multiples and the covenants behind that leverage, potentially changing the capital structure and therefore the ultimate economics of some deals.

Practically speaking, it is likely to remain difficult to have widespread in-person management meetings and, therefore, to develop relationships as fluidly as in the past. Yet in offsetting these challenges, there will also be some advantages. One potentially transformative impact of the pandemic may come in the form of management and operational talent. The US has been operating at near full employment in recent years, which has brought with it its own constraints on growth. A stark rise in unemployment, however, could bring with it a shift in talent towards more sustainable businesses; a transfer of management practices between industries and the potential to strengthen management skillsets across the board.

Meanwhile, covid-19 has also provided mid-market investors with the ultimate test of resilience. “For businesses that have thrived, they will likely have multiple suitors. For those that have struggled, but pivoted, buyers will likely be very interested,” says Marston.

“For businesses and sectors where pivoting was not an option, there could be significant roll-up activity as buyers seek to expand their own market share at potentially distressed prices. In any case, buyers will have a much better sense of how the business and its management will have responded to the market and to future economic uncertainty.”