Viral Impact: How COVID-19 is Affecting M&A and Private Equity

The Dow Jones Industrial Average fell nearly 125 points Wednesday, erasing earlier gains. The index fell a total of 1,800 points Monday and Tuesday, underscoring fears that manufacturing shortages caused by the coronavirus will have far-reaching global ramifications. How it will play out in M&A and private equity is difficult to discern this early in the spread of the virus. To get a sense of the ramifications for the middle market, Mergers & Acquisitions examines several factors, including the current impact on China’s economic growth; how the virus was discussed in the earnings calls of U.S. public companies in January and February; and the views of two prominent dealmakers who are based in Hong Kong. As this is an ongoing story, we’ll continue evaluating the economic and business effects.

First, let’s consider the impact of the earlier severe acute respiratory syndrome virus. SARS claimed around 800 lives throughout the world and shaved 0.5 to 1 percentage points off China’s growth in 2003. Back then, China was the world’s sixth largest economy. Today, it is the second, behind only the U.S.

Analysts are already forecasting slowed growth for China, due to COVID-19. While the country’s economic growth was 6.0 percent in the fourth quarter of 2019, it may fall to as low as 3.5 percent in the first quarter of 2020, if the spread of the virus is not contained fast enough for manufacturing production to resume to normal levels, Morgan Stanley analysts wrote in a Feb. 19 report. While factories had started to come online, analysts found that production had only reached 30 to 50 percent of normal levels.

Earnings calls

With China’s factories producing a huge range of goods and parts, including autos, apparel, toys and smartphones, for customers all over the world, it’s not surprising the impact is already being felt far beyond the country’s borders. The coronavirus emerged as a dominant theme in the earnings releases and conference calls of S&P 500 companies. The term “coronavirus” was used at least once in 38 percent of the 364 earnings calls that were held from Jan. 1 through Feb. 13, according to FactSet. The industrial, IT and health-care sectors accounted for the highest number of companies discussing the topic.

MarketWatch compiled a slew of the announcements in mid-February. Here are a few:

Apple Inc. (Nasdaq: AAPL) warned it would not meet second-quarter financial expectations, because production had slowed or been halted in China due to the outbreak. “Work is starting to resume around the country, but we are experiencing a slower return to normal conditions than we had anticipated,” the company said in a statement. Apple generates about 15 percent of its revenue from China, and many of its products are manufactured there.

Coca-Cola Co. (NYSE: KO) CEO James Quincey said the outbreak of severe acute respiratory syndrome (SARS) in 2003 and 2004 was less of a concern than the current virus. The Chinese market makes up 10 percent of Coca-Cola’s global volume. “China’s economy was in a different place when SARS happened,” he said. “It’s worth noting that China’s economy is much bigger, and this could become more connected to the rest of the world.”

Hasbro Inc. (Nasdaq: HAS) continues to have office and third-party factory closures in China as a result of the outbreak. The company said that China is responsible for about two-thirds of its global sourcing. “The biggest unknown right now is how quickly the manufacturing factories can get their production ramp back up,” said Hasbro CFO Deborah Thomas. “Travel is limited, [and] places are still closed.”

Walmart Inc. (NYSE: WMT) anticipates a financial impact in the first quarter and potentially the second quarter to its China business. “Due to the current sales mix slanted heavily toward food and consumables, as well as some increased expenses related to the outbreak, we could see a couple of cents negative impact in Q1,” Walmart CFO Brett Biggs said on an earnings call.

In addition, Bradley Jacobs, the CEO of XPO Logistics (NYSE: XPO) told analysts during a fourth quarter earnings call in early February that the coronavirus outbreak and travel restrictions have not damped demand for logistics yet. A significant acquirer of middle-market companies, XPO, headquartered in Greenwich, Connecticut, operates 8 million square feet of warehouse space in Asia, including more than 1 million square feet in China. “We have not seen a noticeable impact as of now,” Jacobs said. “We are watching it. Anything that slows down the global economy is not good for the transport and logistics industry.”

The impact is already being felt in the world of venture capital, and private equity may not be far behind. Chinese startups are struggling to raise funds as the coronavirus epidemic complicates deal talks, reports PitchBook. Since the beginning of the year, venture capital fundraising in China has fallen by more than half, compared with the same period last year. It’s yet another blow to the region’s venture capital scene, which has suffered from waning confidence from investors in recent years. The backup of capital poses a threat to cash-strapped companies but could also lead to a rush of deals later in the year, predicts PitchBook.

Nevertheless, most dealmakers are taking the developments in stride, as you can see from our interviews with two middle-market professionals.

Brian Bunker
Managing director, Commercial Growth, The Riverside Co.

How are factory closings affecting the supply chain?

The virus hit over Chinese New Year when factories were closed, and the high number of migrant workers had returned to their home town/village. Fortunately, large orders are shipped prior to the holiday to cover 2-3 weeks of factory closure. However, eventually, there will be inventory shortages at overseas and domestic customers, stock-outs will, inevitably, impact 1H revenue at portfolio companies. It is still too early to scope the full impact; however, portfolio companies are implementing action plans, assessing stock levels, communicating with customers and trying to shift sourcing to other countries. Fortunately, due to the tariff dispute, this process began 18 months ago, so, in general, dependence on China has been somewhat reduced during that time. In general, extended closure of factories impacts sales as well as Ebitda; staff still have to be paid and the facility/equipment maintained.

How is the virus affecting sales of consumer goods in China?

In some cities, residents are only allowed out once every 2 days to buy essentials; in general, the population is not venturing out, thus consumer spending in China will be heavily impacted. This will affect our portfolio companies that sell through Chinese retail outlets. Given road transport restrictions, e-commerce sales will also be affected as goods cannot be delivered. Staff are mostly working from home and need to be paid even though they are not generating much revenue apart from essential sales. Obviously, there will be some winners such as suppliers of face masks and hand sanitizer.

Neil Torpey
Partner, Corporate Development, Paul Hastings

What is the impact of the coronavirus on middle-market deals and private equity-backed portfolio companies?

There was a momentary pause in activity when travel restrictions were announced and certain transportation industry players curtailed their China-related activities, but the markets snapped back into shape fairly quickly as it has begun to appear likely that the issues relating to the coronavirus outbreak, while serious, will be manageable and (as with SARS) the situation will stabilize over the coming weeks as Spring and warmer weather approaches. I don’t expect there to be any material long-term negative impact on the markets or deal activity as a result of this outbreak.

Does the inability to travel to and from China make it difficult to close deals already underway?

Not really, unless the investor is still doing due diligence involving travel to China (e.g., to visit physical facilities or meet with management teams) or needs to conduct face-to-face discussions with a portfolio company or its customers or suppliers—and even in those cases, lots can be done by phone or video conferencing. Once a deal is ready to be closed, most of the execution can be done by phone, email and wire, so the China travel restrictions would not tend to cause problems in doing a closing that cannot be worked around.

Does the possibility of China being cut off for a long period affect dealmakers’ confidence in investing in companies there?

So far, this seems to be a low-probability issue. It is in everyone’s interest to have China back to ordinary course operations, and we would expect enormous efforts and resources to be applied to achieving this outcome.

What about other risks?

The deluge of media coverage regarding the outbreak has put every country in the world on alert to the risks associated with the virus, and governments and enterprises are responding to the potential public health and other consequences of the situation. Different countries and companies will prioritize the issues presented by the crisis in different ways and allocate resources to detection and prevention and amelioration in accordance with their respective individual circumstances.

How are issues related to the virus affecting potential investments?

As far as I can ascertain, the situation is not leading investors to make material changes in their medium- or long-term investment programs or strategies.