Top investors and advisors give us their roadmap to navigate the new normal.
Dealmakers began the early part of Q1 2020 with the same sense of optimism and momentum as they had in 2019 and the result was a very active market for M&A and investment activity in beauty and wellness. Of course, the advent of COVID-19 and its economic impact significantly changed the story in March and, by all accounts, it looks as if most, if not all, of Q2 will suffer the same fate. Coupled with what will almost certainly be a gradual, potentially bumpy recovery and fundamental changes to the way companies do business, it looks as if we’re on the precipice of a seismic, global economic and social shift. To say the crisis has been disruptive to deal-making is as obvious as a connection error during a virtual team meeting. But, through all of the chaos, the crisis may help to create pockets of opportunity for smart companies and savvy investors and acquirers.
To help us make sense of it all, we’ve assembled a panel of experts, comprised of a few of the most active investors and advisors in the beauty and wellness industries, to collect their thoughts.
For a complete overview of all of the beauty and wellness deal activity in Q1 2020, along with unique insights and analysis, be sure to check out our exclusive report: Beauty Deals: M&A Transaction Q1 2020.
1. Let’s start by focusing on the disruption to physical retail. In 2019 we saw a huge trend around M&A activity and investments in brands with tremendous exposure to retailers like Sephora and Ulta. In your opinion, how significant will the impact on valuation be for brands that are reliant on retail wholesale? Or more specifically are reliant on an exclusive relationship with Ulta or Sephora for growth?
Ilya Seglin, Managing Director, Threadstone Advisors: Sephora and Ulta will still be significant distribution partners for brands – I don’t see that trend necessarily changing. If anything, with some department stores likely to close or reduce their store footprint, both Sephora and Ulta will be even more critical for brands to grow distribution. In the future, investors are more likely to focus on sales performance in stores vs. online at both retailers. Is the consumer still buying your brand / product online when stores are closed? It’s also likely that there will be less of a need for many brands to be present in all doors with those retailers.
William Susman, Managing Director, Threadstone Advisors: I agree. In the future, there will be a focus on whether or not customers bought your brand when stores were closed. One additional opportunity is for brands to be in direct dialogue with their end-user. Brands that learn how to monetize this will see higher valuations.
Katherine Mossman, Industry Partner, Brentwood Associates: Beauty M&A activity is often led by scarcity. Strategics are solving for something that they do not have today and prefer to buy rather than build because it can be more efficient. Businesses with strength at Sephora and Ulta were incredibly attractive in the earlier M&A waves, but the next wave is likely to focus more on strength with a profitable D2C business alongside those Sephora and Ulta relationships. Increasingly, it is becoming an expectation to have both to drive scale. Brands that can adapt and develop a profitable D2C business will help to temper the potentially negative impact of retail wholesale concentration.
Robert L. Brown, Managing Director, Encore Consumer Capital: Strong brands are unlikely to transact in this market, so short term it may be hard to tell. Valuations will be down, but that could be due to the quality of the assets transacting. It could take 12+ months post-COVID19 shutdowns for strong companies to be back where they want to be and the best strategic buyers to be prepared to offer up premium valuations. Exclusivity isn’t the only issue brands face right now. If you are in Sephora and Ulta, you are not necessarily better off than if you were in just one of those. They are both shut down. If one comes out materially sooner or stronger than the other, then we will know. The diversification that helps here is not customer diversification, but channel and geography diversification. For instance, if you have a strong Target or Whole Foods business, you have an active retail outlet right now. Same for CVS or Walgreens. If you have a strong footprint in China, which appears to be “breaking out” first post-COVID19, your business will restart faster. It goes without saying that DTC and Amazon are up and running right now, as well.
Michael Sampson, Advisor and Investment Operating Executive: There’s a big difference between a brand that is reliant on an exclusive relationship for growth and one that chooses exclusivity for growth. Retailers are great brand amplifiers but it’s up to the brand to ensure they drive the positioning and strategy. Certainly, retailer exclusivity can cause a risk profile in the early stages of a brand lifecycle, but it also brings opportunity for closer collaboration for mutual gain and, more importantly, service to the consumer. Assuming a brand is also driving growth in its own DTC channel, if it diversifies its retail mix too quickly, what was its largest profit center can start incurring incremental costs-per-click due to additional channels bidding in search and be dilutive to the bottom line. Downside protection specific to channel mix or lack thereof is only one factor in the growing list of considerations to underwrite.
Michel Brousset, Founder and CEO, Waldencast: A brand’s value is driven less by where they are distributed, and more by the strength of their brand equity and consumer following. Brands have to be where their customers are and this is different for different brands. Today, beauty consumers can discover new brands online on Instagram, YouTube, etc. as much as they do in Ulta, Sephora, and other retailers. It is important to keep talking to those consumers as they continue to engage with the beauty and wellness industries, despite the physical stores remaining closed. The disruption we are seeing today will eventually subside and it is the brands that continued to engage authentically with consumers through this crisis that will come out stronger.
Jorge Cosano, Founder, Synchronicity Ventures: The impact on the valuations of these brands is going to be determined by their ability to pivot and adapt during this period to the new reality. In particular, how quickly they can build both their own DTC and e-commerce with their retail partners. Physical retail will suffer this year and I expect to see declines in foot traffic between 25-50% – not just coming from lockdown but from a more fundamental consumer behavior change avoiding crowds of people in store and being more comfortable with shopping online. Therefore, it’s critical for brands that built their success and exit on a strong physical retail to use this time to shuffle their strategy, organization and resources to support DTC and e-commerce. This will define the impact on their valuations, and if they leave this situation as winners or losers.
Alicia Sontag, Partner, Prelude Growth Partners: At Prelude, we believe in omnichannel brands. There is no question that the importance of digital channels (both DTC as well as the e-commerce of key partner retailers such as Sephora or Ulta) is paramount at the moment. We believe that even post-COVID-19, these channels will take on significantly increased and accelerated importance. Brands with strong capabilities in these areas are likely positioned to outperform the market.
David Olsen, Managing Director, Highlander Partners: First and foremost, I want to express a huge amount of sadness and support for all the people that work on the floors of all retailers. In this unprecedented situation, so many of these great people are out of work and struggling.
In general, a downturn always serves as an unpleasant reminder to focus on what should be fundamental valuation drivers. For years, beauty valuations have been steep. To a certain point, this has been well-justified: the fundamental backdrop for the sector has been generally strong, key retailers like Sephora and Ulta have been well-run, and there exists a universe of active potential strategic buyers. But, oftentimes, of course, specific company attributes simply do not justify valuations. Customer concentration in any industry should come with valuation considerations, as reliance on certain distribution points leads to a potential single point of failure. In beauty, this has been often overlooked in recent years.
One key reason for this is that certain investors have increasingly viewed beauty investing as a race to scale in order to get acquired by a strategic, where concentration is less of an issue, as it is diluted upon acquisition. All the while many companies have burned substantial amounts of cash year after year. This difficult time will serve as an instant and exaggerated reminder of what can happen when things get difficult. Basic business issues like customer concentration and profitability will become more front of mind.
At Highlander, we have met with many brands. Our message has consistently been: let’s build a fundamentally great business together. Let’s look to build out diverse channels and customers, let’s develop a resonating brand message, let’s drive growth profitably. We aren’t looking to play 5 or 10 cards and consider ourselves a success if one strikes gold while the others burn cash each year. I think now more than ever that message is critical and will be well-received.
I think everyone was already bracing for some sort of recession or reset, but no one could have imagined it would be accelerated by something like this.
2. With the disruption of physical retail and the logistical disruption of warehousing and shipping for “non-essential” products, it seems Amazon has emerged as one of the few reliable points of distribution for beauty and wellness brands during the COVID-19 crisis. In the past, investors and acquirers have penalized brands for an over-reliance on Amazon. In your opinion, will we see this mindset shift?
Ilya Seglin, Managing Director, Threadstone Advisors: It may shift somewhat. But fundamentally, a retailer like Sephora is still viewed as a brand-building partner whereas Amazon is viewed as a volume partner. I do think that other on-line beauty players, such as Skinstore, Cult Beauty and Beautylish, who continued to service customers when stores closed and continued to gain share, will see brands shift more volume to them.
William Susman, Managing Director, Threadstone Advisors: We tell brands that Amazon is like Goldilocks. A little is good; too much is bad. They have to find a balance that is just right. Post pandemic, I don’t see that view changing. Amazon serves a purpose but doesn’t build brands.
Katherine Mossman, Industry Partner, Brentwood Associates: I think we will begin to see the mindset shift. Businesses are unlikely to be penalized in the same way they have been historically for Amazon exposure as long as they present on the platform in a brand-positive manner. Amazon has been a great help to businesses during the COVID-19 crisis and that will certainly inform future perspectives. Ultimately, businesses need to prove they can grow beyond a single distribution channel or customer, and too much reliance on Amazon will continue to be a negative. That said, perhaps the “Amazon penalty” won’t be as significant post-crisis as it was previously.
Robert L. Brown, Managing Director, Encore Consumer Capital: Not necessarily. Amazon has always been a matter of degree. Does your footprint on Amazon harm you elsewhere, or is it something that gives you a rapid fulfillment arm and a window on the consumer? If you are dominated by Amazon, that is detrimental. And right now, you might still be dealing with shipment delays as a non-essential product, even on Amazon. Many brands are not yet opened up and are still experiencing two to four-week delays.
Michael Sampson, Advisor and Investment Operating Executive: Over-reliance on anything can raise concern, but it’s how it’s managed and what makes sense for each individual brand. Amazon has proven it can satisfy demand for those that choose to use it as a channel. The infrastructure of a reliable supply chain, be it Amazon or your own, has always been a critical component to success. Today’s disruption causes a further look into business continuity planning. If a global crisis wipes something out, you need to have a safeguard and when necessary, be able to pivot to continue to build your business. This, of course, should never come at the cost of a brand’s positioning. There needs to be an alignment. The Amazon question, however, is bigger than the current crisis. It has changed 1P and 3P guidelines in exclusive and luxury relationships, how to win the buy box, what works in ranking and marketing which evolves the marketplace. For investors and acquirers, like anything, it’s important to not only understand how the system works at an operational level, but if it changes the perception and value of a brand. Many are developing a new thesis around Amazon already, while others are sticking to their prior opinions, but it’s still early.
Michel Brousset, Founder and CEO, Waldencast: Not really. The COVID-19 crisis will pass and supply chains and distribution channels will go back to normal, learning from the last few months and hopefully building more robust systems because of it. Amazon is a formidable player and will play an important role in the beauty industry. The issue is not the over-reliance on one retailer or another, the issue of “penalized valuations” is down to the strength of a brand’s equity and loyal consumer following, which is more difficult to build on Amazon because of the way the platform is built. The consumer’s desire for discovery, experience, and engagement cannot yet fully be met on Amazon alone and until that changes, the platforms better able to fulfill those consumer needs will continue to have a key role in a brand’s retail strategy.
Jorge Cosano, Founder, Synchronicity Ventures: I have always been bullish on Amazon. From my early days back in 2003 while working at the L’Oreal Incubator and helping launch the luxury beauty store on Amazon, I have always seen huge potential in them as a channel. I believe it is important as a brand to give options to consumers and let them shop wherever they like, and not force them into a specific model. The question is how you lay out your brand strategy by channel to have differentiated value propositions and offerings in terms of product catalog, services, loyalty programs, etc. Amazon is a great engine for brand discovery and trial and having a curated product offering I think is key to win in the long term. I have seen brands like Olaplex and Nutrafol build meaningful businesses in this channel that enhance the brand value. Obviously, the current situation is just accelerating this understanding and pushing brands to think that Amazon is a viable and important channel.
David Olsen, Managing Director, Highlander Partners: Amazon has become the most powerful retailer in the US, and with that comes the power to push down selling price and/or create copycats of well-selling items. Amazon can be an amazing channel; it brings eyeballs and customer traffic like no other site can. Yet it does not build as much brand equity or customer loyalty as other retailers do. Amazon customers are loyal to Amazon — less so the brand; that will not change. Brands also have very little visibility by working with Amazon—limited customer communications, inventory issues, and shipping issues. Although non-essential items are being shipped from Amazon today, they are rightfully deprioritized, and customers are receiving these items 2-4 weeks after they place their orders. I think this is one of the main reasons brands on Amazon are seeing a big lift on their own sites, which is better for margin and ultimately customer relations.
3. Even before the COVID-19 crisis, a mindset shift was underway in the investment community as it relates to DTC brands – from growth at all costs to a firm focus on profitable growth. Given that some of the buzziest DTC brands will likely see a material decline in sales during the crisis, in your opinion, how will this impact investment and M&A activity for DTC brands?
Ilya Seglin, Managing Director, Threadstone Advisors: Any DTC brand that wants to attract capital will need to have a business plan that shows profitable growth with a distribution strategy that can sustain shocks like COVID-19. There will also be more focus on the contingency plans that brands are putting in place to address future shocks to their business.
Katherine Mossman, Industry Partner, Brentwood Associates: The COVID-19 crisis is accelerating the structural change we have been seeing in retail for the last decade away from brick and mortar and towards DTC. As consumer behavior changes, DTC businesses will become more attractive to strategic and financial buyers if they’re able to find the right balance of topline growth and profitability. A temporary disruption in the financials of a business should not impact long-term investment prospects for a DTC business unless the business is damaged in a way that cannot be easily addressed once we are beyond the crisis. That being said, there will continue to be a heightened focus on profitable growth. There is a more disciplined focus on customer lifetime value (LTV/CAC), loyalty and building evangelists out of a digital base. Increasingly, investors will be unwilling to underwrite marketing spend to grow at any cost without special brand “DNA” and an organic following.
Robert L. Brown, Managing Director, Encore Consumer Capital: Strong companies will be able to wait it out on their own resources. Those who are forced to sell or raise capital may have to reset expectations.
Michael Sampson, Advisor and Investment Operating Executive: Investment 2.0 needs to be part of the new normal. High burn rates which, if the cash is shut off, causes a business to drop significantly, isn’t a good thing. The public markets have shown a similar view here in the majority of cases be it in those that have submitted S-1 filings in the past 12 months or are already on the stock exchange. Digital expertise will be evaluated in the diligence process earlier and I see this as a rise in the background of fund operating partners, as well as a continued investment area for the large multi-nationals. Brands have often been defined by their channel strategy – digitally native, retailer exclusive, omnichannel – as it is buzzworthy. But it only matters if the channel strategy emphasizes what the brand represents and brings validity to the narrative via a clear point of difference and belief system. Brand life cycles have become shorter due to increased availability through e-commerce, a constant push for innovation and social footprints. With so much capital that needs to be put to work, great brands and founders have choices and so wrongfully, it can come down to who offers the most compelling term sheet as opposed to a value-added partner. The crisis may bring declines in sales regardless of channel strategy but great brands will continue to be great. They will still be seen as a business in which to invest or acquire.
Michel Brousset, Founder and CEO, Waldencast: Buzzy and good are two different things. Growth at any cost never made sense, unless you were playing a “bigger fool game;” good DTC companies and the most strategic buyers are smarter than that. Consequently, sophisticated, strategic buyers are and will continue to be discerning with regard to where the most desirable opportunities are. In fact, beauty and wellness online engagement has increased significantly as consumers are home-bound. All the brands in our portfolio have experienced triple-digit growth in D2C online sales and much lower CACs. Additionally, all the various syndicated sources in the markets we cover more closely (US, UK, France, and Brazil), as well as many of the large strategics, are reporting strong growth in their D2C and retail partner eCom sales. In markets that are further ahead on the COVID-19 curve, like China and South Korea, beauty companies are seeing a strong rebound in sales.
Jorge Cosano, Founder, Synchronicity Ventures: The transition from a “growth at all cost” to a “sustainable growth” mindset was already underway before COVID-19 and the current situation has just accelerated it. For a long time, I have been a challenger of the idea that investors and founders had that you can apply venture capital principles to consumer categories like wellness and beauty. The reality is that you cannot apply the same principles. When you build consumer tech products e.g. Instagram or Spotify, scalability is endless and marginal product cost of scaling the customer base is practically zero. However, when you are selling physical products there is always the hard reality of cost, including product and logistics. For this reason, my approach over the last few years has been to always focus not on profitability but on unit economics and healthy unit margins. If your brand has healthy unit margins (60% range), then it’s highly likely you can build a profitable business. The other principle I have always questioned is the idea of building large teams and organizations like they do at tech companies. Throughout my career, I have seen brands run efficient businesses with very lean structures. If you focus on these two principles – healthy unit economics and low fixed costs – then you can navigate a situation like COVID19 easily, as the only thing that it requires is adjusting your variable costs (mainly marketing in many cases) to see things through.
Alicia Sontag, Partner, Prelude Growth Partners: Prelude believes in sustainable business models. DTC brands that have healthy models, where the cost of acquisition relative to contribution margin on the first order as well as retention is favorable, will likely be well-poised during this time – if, of course, that model is paired with a distinctive brand and product that is compelling to consumers. If a DTC brands’ model was not healthy and not sustainable, they will have a difficult time.
4. While the P&L impact of the COVID-19 crisis is an evolving story and yet to be fully quantified, do you think investors and acquirers will think of the crisis period as a one-time event and allow for EDITDA addbacks and adjustments?
Ilya Seglin, Managing Director, Threadstone Advisors: Yes. But valuation is as much of a forward-looking exercise as it is looking at trailing performance. I think there will be much more focus on what a business is forecasting. Companies will be having conversations about performance pre-COVID, during the crisis, and growth post-COVID.
William Susman, Managing Director, Threadstone Advisors: For this to be seen as a one-time event, it needs to be just that; not a sustainable change in trends. The more it is in the rear-view mirror the more it looks one-time.
Katherine Mossman, Industry Partner, Brentwood Associates: I think investors will generally remain open to adjusting financials to reflect one-time events, both positively and negatively. As you say, this crisis continues to be an evolving story, so we will have to see how it plays out!
Robert L. Brown, Managing Director, Encore Consumer Capital: Yes. As investors, we’ll be focused on understanding how you managed the challenges you’re facing during the crisis and how you used them to make your business stronger.
Michael Sampson, Advisor and Investment Operating Executive: There’s so much unpredictability today, as this has never been seen before. This is an anomaly but, unfortunately, that isn’t to say it can’t happen again – albeit so many are doing such incredible things in response to help others and with such resilience. There will be degrees of addbacks and adjustments but the current environment can and is changing the face of a lot of businesses who had to pivot to survive. Some opted to add Amazon, some to add other retailers that also have strong e-commerce businesses and some to add international players. Businesses looking for investment or acquisition could be viewed in 3 timeframes – pre-COVID-19, during and post. A healthy discussion on both sides of the table around those eras is important relative to understanding the full picture.
Michel Brousset, Founder and CEO, Waldencast: It will depend on how well each company and brand goes through this unprecedented crisis. What is clear is that the recovery will take time and given the time value of money, valuations will be impacted.
Jorge Cosano, Founder, Synchronicity Ventures: It is difficult to tell at this point, as it all depends on what measures are taken and how quickly we will be able to return to a normal economic situation. From my extensive conversations with investors, executives, and founders, I believe that we will lose at least 20 to 25% of the original budget projections for the year (both revenues and investments) just between the lost months of normal business and the months of return to normal, which will happen in phases and will take time. I think both investors and corporates will fall into buckets with different approaches depending on how they have handled the interim and left this period as winners or losers. The most important question for me for investors and acquirers to think about is what changes in consumer behaviors and attitudes post COVID-19 are going to be fundamental and will be here to stay and which brands out there are well-positioned to take a leadership position in the new market.
Alicia Sontag, Partner, Prelude Growth Partners: We believe it is important for small, high growth brands to outperform the market in terms of sales growth during this time. Paired with a sustainable business model and sufficient liquidity, the goal is to emerge stronger on the other side.
David Olsen, Managing Director, Highlander Partners: As we sit today, I think there will be an understanding among investors as to the one-time nature of the coronavirus. Public equity market levels today are an indication of that. However, mentalities can change very quickly. There is a very wide range of outcomes from here and more than ever no one knows what the future holds. We may only be beginning to see P&L impacts and, if we are ultimately talking about many months or years of weakness, the conversation may be much different. These times can also expose fundamental issues in businesses that will be put under a microscope going forward.
5. The COVID-19 crisis has created opportunities for certain subsegments of beauty and wellness. Initial research has shown that categories like skincare, self-care, body-care and supplements have been fairly resilient thus far. Other categories like color have been very negatively impacted. Once high-flying brands like Anastasia Beverly Hills, for example, saw its debt downgraded to CCC- (junk) status by Fitch in early April. Should we be prepared for a spate of bankruptcy filings in categories like color and beauty services or will investors and acquirers come to the rescue with additional funding?
Ilya Seglin, Managing Director, Threadstone Advisors: A strong brand that is in bad financial health will likely find a home (albeit, at a price). An average brand with a weak operating structure will just go away. We’re most likely to see a rise in bankruptcies in beauty retail / services – businesses with lease obligations they cannot service on a sustained basis going forward. The story is a little different for pure beauty and wellness brands, as fewer of them have long-term obligations like leases or debt. In terms of categories, I believe color cosmetics will actually have a big comeback. Once the world reopens and people go back to work, out to dinner and on vacation, they will seek the emotional, feel-good boost that color cosmetics provides. A hair mask is not what the consumer will be craving when social distancing is relaxed.
William Susman, Managing Director, Threadstone Advisors: I agree. This pandemic has only exacerbated trends already in place. Good brands are still good brands.
Katherine Mossman, Industry Partner, Brentwood Associates: Businesses with strong growth prospects ahead of the COVID-19 crisis that find themselves with temporary, COVID-induced liquidity challenges will find solutions. That being said, those solutions will likely be expensive and dilutive. Meanwhile, I think we are witnessing a re-ordering of consumer priorities and brands that were resonating in a boom economy may find themselves having to pivot to resonate with consumers in the new reality, where wellness and self-care are paramount. Businesses that were already facing challenges prior to the COVID-19 crisis may have fewer options at their disposal and bankruptcies are certainly possible.
Robert L. Brown, Managing Director, Encore Consumer Capital: Yes, and yes. The strong will thrive, the weak will go out of business. Those in between will raise capital and survive.
Michel Brousset, Founder and CEO, Waldencast: I believe that we should expect to see bankruptcies of companies that have unsustainable business models, weak brand equity and consumer following, and weak balance sheets. That said, we have seen in the past (and are starting to see clearly again), the famous “lipstick effect” which has protected the beauty business through previous recessions and that has caused the rapid explosion of the business as soon as the economy is in recovery. So far, we are seeing that the categories you mention are proving to be quite resilient, but if we look back at previous economic crises, we have always seen a strong rebound particularly in self-expression categories like makeup, hair color and hair care/styling.
We believe that today, the fundamentals are more important than ever. Quality early-stage companies that have a strong consumer proposition, an engaged community following, strong and experienced management teams, and a healthy balance sheet, will survive and come out of this crisis stronger. The beauty and wellness consumer will be ready to engage, celebrate, and buy – albeit more consciously and discerning than before. And when that time comes, smart beauty and wellness entrepreneurs will be there waiting for them.
Jorge Cosano, Founder, Synchronicity Ventures: As I just mentioned earlier, the key question is whether these trends are just conjunctural and temporary or are here to stay. Obviously, categories like wellness and skincare are holding up well because consumers are not spending in other categories and they want to at least treat themselves at home, while color is suffering, as no one needs it to go to work, on dates, etc. However, what is going to happen once we are out of lockdown? My point-of-view is that people are going to flock into the street and back to work, social life stronger than before, but avoiding large gatherings such as concerts or sports. If this is the case, we are going to see a strong comeback of make-up and color, in which case, brands like Anastasia will fare well. With this said, I think we are going to see a major peak of bankruptcies in the market, mainly driven not by category but by the fact that companies out there are in shock or trying to run business as usual and not to adapt to the new reality and are not going to make it. This is going to create a great opportunity for investors and corporates to acquire good quality brands and assets for a deal if they are cash-rich and liquid.
David Olsen, Managing Director, Highlander Partners: I think we’ll see some rationalizing of existing brands across all categories. Over the past few years, with “easy” VC money flooding the beauty market, we’ve seen rapid growth in the number of brands. I think this will be the catalyst that causes some of those to go out of business and see the cream rise to the top. This is not to say that only small brands are at risk. Larger businesses with poor capital structures are having difficult conversations with lenders today and, depending on the length of this crisis, we’ll inevitably see some level of restructurings. Overall there are company issues and then there are balance sheet issues – good companies with poor balance sheets will be rescued. Categories that were struggling pre-COVID-19 are obviously going to have a more difficult time. Color was headed in the wrong direction pre-COVID-19 but the segment will come back, as it always does, likely reinvented
6. Although it’s hard to know how many deals were in the works as we entered into the COVID-19 crisis but have since been postponed, it’s safe to say that a number of investments / acquisitions have been disrupted. In your opinion, what factors will determine if these deals will actually get done down the road as the economy emerges from the crisis?
Ilya Seglin, Managing Director, Threadstone Advisors: I think the biggest factor will be what the target looks like post-crisis – how did the business fare when things shut down, how has the business model evolved for the future, does the business have contingency plans in place. Investors will want to see what the revised financial outlook looks like under the new normal once the world starts opening back up for business. Some businesses may actually become more attractive targets after the crisis.
William Susman, Managing Director, Threadstone Advisors: From a deal perspective I do see this as a pause moment more than a total cancellation or reset. A key will be how the economy rebounds (or doesn’t).
Katherine Mossman, Industry Partner, Brentwood Associates: Deals will likely remain on hold until volatility in the debt and equity market subsides and investors are able to better understand the duration of the COVID-19 crisis and nature of the recovery. Some businesses experiencing significant financial disruption may see the impact of the disruption last longer and that impact may dampen their sale prospects. Other businesses that return to their run-rate trajectory more quickly, will have fewer issues being sold.
Robert L. Brown, Managing Director, Encore Consumer Capital: The resetting of expectations will be key. Investors will be more timid out of the gate and, if brands have not reset expectations a bit, the market will restart very slowly.
Michael Sampson, Advisor and Investment Operating Executive: There’s a lot to list but a few shifts to consider would be a change in bids from 1st rounds, a downgrade or uptick in the business, credit markets, interest rates, fund / asset manager appetites, vehicle structure i.e. SPV’s vs. Committed Capital, founder sentiment and personal balance sheets.
Jorge Cosano, Founder, Synchronicity Ventures: I think that all investors, no matter if they were in the middle of a deal or not, are in a wait-and-see position. There has been a lot of capital in the market in recent months flowing into VC and PE with new, freshly raised funds and they are ready to deploy them. They are just waiting to see and make decisions based on two factors: what brands are taking the necessary measures to come out of the situation as winners, and what brands are not and where they can get a great deal for assets that are worth it. My advice to any brand that was in the middle of a deal right before COVID-19 is to forget about the deal or raising capital and turn full focus on getting things right to survive the situation and come out of this in a stronger position than they were before. If they do this, I have no doubts that they can resume the negotiations after COVID-19 and get a very favorable deal completed.
Alicia Sontag, Partner, Prelude Growth Partners: We believe that fundamentally two key factors will be important. First, has the company been able to continue to deliver on its unique compelling value proposition to consumers and outperform the market during COVID-19. Second, Strategic’s overall strategies, inclusive of their inorganic strategies, may shift given COVID-19. Will the shifts make the original deal, as contemplated, more or less attractive.
David Olsen, Managing Director, Highlander Partners: This crisis is going to be an incredibly difficult stretch for many businesses, but it will also shine light on company attributes. Businesses with strong margins, the ability to generate cash flow, great management teams, and brands that are important to their customers will survive this period and thrive when the world normalizes. Companies that can point to how their strengths helped them navigate this climate will have a great story for investors.
Relatedly, I think you’ll also see buyers that can offer more than just capital have more success in approaching and partnering with brands. Management teams will increasingly appreciate hands-on ownership that can help guide a business through turbulent times and is focused on long-term value creation through profitable growth.
After the world returns to normal, we’ll see transactions pick up again, but both buyers and sellers may have different expectations.
7. Aside from a possible impact on valuation, how will the COVID-19 crisis change the way deals are structured going forward? How will the due diligence process be impacted?
Ilya Seglin, Managing Director, Threadstone Advisors: I don’t expect significant changes to the due diligence process. I do, however, think there will be more scrutiny of the assumptions that underlie future financial growth and what would happen to the business if there is another shock to the system like COVID-19.
Katherine Mossman, Industry Partner, Brentwood Associates: We have been in a long-term trend of seller-friendly transaction structures and process timelines. With the advent of the COVID-19 crisis, you may see a move towards more buyer-friendly terms and longer process timelines. Investors will likely be more discerning in their diligence, with a laser-sharp focus on understanding the sustainability and growth prospects of the brand under this “new normal.” In the near term, we would expect to see a greater percentage of deals that include some additional downside protection to new investors, likely in the form of a first-out liquidation preference and potentially higher minimum return requirements.
Robert L. Brown, Managing Director, Encore Consumer Capital: It’s hard to say but a premium will be placed on things like redundant sourcing relationships, access to key ingredients, and diversification of customer base.
Michael Sampson, Advisor and Investment Operating Executive: Diligence on how brands react during a crisis, as well as safeguard against future crises will be an even larger part of consideration. Governance and crisis management practices, as well as, the action and reaction to teams, partners, community, customers and suppliers will be evaluated much more closely.
Michel Brousset, Founder and CEO, Waldencast: Hard lessons learned during the COVID-19 crisis mean that the security of the supply chain will become a more relevant aspect in due diligence, as too much dependence on international suppliers will come into question. Other than that, investors should be even more cautious with regards to how much money each business should be funded with and what the uses of those funds are.
Jorge Cosano, Founder, Synchronicity Ventures: I do not see major changes in the ways deals and due diligence processes will happen. Buyers will be more rigorous in evaluating financial performance and not just focused on growth – but this is something that was already happening. They will also value brands that are nimble and flexible and can adapt quickly to the changing social and economic landscape, as changes in the market and volatility are much higher now than it was just a few years ago. This may have an impact on how some investors structure deals – to be more performance-based versus a straight-up acquisition. But again, none of this is new and smart investors have been looking at things this way for the last year or two.
David Olsen, Managing Director, Highlander Partners: I think it will remain on investors’ minds as a worst-case scenario that previously was unimaginable, and I think it will further stress cash flow because we’ll see many companies fight for survival due to liquidity problems. Private equity firms that employ excess leverage on deals will think twice about capital structures.
8. Recent actions by the Federal Reserve have brought interest rates down to historic lows. In your opinion, will this drive increased M&A / investment activity by private equity funds?
Ilya Seglin, Managing Director, Threadstone Advisors: Rates were near historic lows even before COVID-19 and I don’t think interest rates necessarily are a driving factor in beauty and wellness investing. I think overall beauty and wellness deal activity by private equity will probably slow down as: 1) the crisis will reveal that many brands aren’t actually good businesses; 2) growth prospects for many brands will become less certain given the disruption to sales channels and supply chains (private equity likes predictable growth); and, 3) M&A activity by strategics will likely slow down as they focus more on managing their core businesses, which, in turn, will cause private equity to become more cautious.
William Susman, Managing Director, Threadstone Advisors: I agree. In beauty and wellness, most transactions are in the form of equity, so, leverage and cost of debt has not been a primary driver to getting a deal done. Lower rates are always good but not as relevant as growth.
Katherine Mossman, Industry Partner, Brentwood Associates: This is a tough question to answer in isolation. Yes, low-interest rates have historically helped fuel M&A activity, all else being equal. But we are in a “new normal,” so the interaction of many other factors needs to be considered as well.
Robert L. Brown, Managing Director, Encore Consumer Capital: No. Money was already pretty cheap pre-crisis. Marginal companies will actually be tougher to finance, so, just because money is cheap, doesn’t mean it will be available to as many companies as it was pre-crisis.
Michael Sampson, Advisor and Investment Operating Executive: Typically, lower interest rates can increase a PE’s outcome due to a reduction in outflow and a better internal rate of return, so yes, there is a good chance we will see more activity. The counter-argument to this, of course, is the result of now numerous funds being able to use the lower rates to their advantage, causing a surplus in buyers which could actually push valuations higher.
Michel Brousset, Founder and CEO, Waldencast: That will depend more on the availability of private credit and corporate spreads than on the government interest rate. It will certainly be more of a buyer’s market for some time.
Jorge Cosano, Founder, Synchronicity Ventures: Absolutely. For smart investors, this is going to become a perfect market where you can get access to cheap capital and deploy it in great deals with strong underlying assets. We are going to see a boom in the number of deals and a steep decline in valuations and multiples.
Alicia Sontag, Partner, Prelude Growth Partners: Prelude is a boutique growth equity firm that provides capital and value-added support to high growth, high potential brands. Prelude invests behind brands that are $5-$25M in sales at the time of investment. We believe that, although we are in a difficult macroeconomic environment, the right opportunities will continue to deliver strong returns. We will continue to selectively evaluate investment opportunities over the coming weeks and months.
David Olsen, Managing Director, Highlander Partners: Right now, the uncertainty facing lenders has made it very difficult to actually secure debt capital. But, as in all cycles, this will dissipate. There will be a lot of distressed PE-owned assets across the world, but there is also an immense amount of cash on the sidelines. Combined with continued, ultra-low rates, yes, I think you’ll see continued high levels of PE M&A activity.
9. How will the crisis affect venture / early-stage investment activity?
Ilya Seglin, Managing Director, Threadstone Advisors: Venture and early-stage investment activity will become more challenging. In the beauty sector, brands will increasingly need to show that they have a realistic path to becoming profitable businesses. The days of simply funding top-line growth are probably gone for now.
William Susman, Managing Director, Threadstone Advisors: Warren Buffet says that when the tide goes out you see who isn’t wearing a swimsuit. Early-stage is often just that – trying to be real and sustainable but often not there yet. Early-stage investing will slow down.
Katherine Mossman, Industry Partner, Brentwood Associates: The bar will be higher for early-stage investors and the areas of focus could be different from what we see now. Time periods of disruption generally cause innovation and another wave of innovation is likely to come out of the COVID-19 crisis. Those innovations will spur new areas of investor focus. Some of the areas where I see innovations relevant to beauty include telemedicine, Do-It-Yourself services and education. Alongside these areas, the wellness trend will continue and we will see more innovations with clean ingredients, sustainable products and a greater emphasis on social impact.
Michael Sampson, Advisor and Investment Operating Executive: More will wait on the sidelines to see how things settle. Those that historically took larger swings earlier may step more cautiously. Where firms started digging deeper and investing in earlier stage companies than their fund thesis typically spoke to, we could see a pullback. There are a lot more seed 2.0 & bridge rounds already happening, often facilitated on the brand side as a reaction to continue to prove product-market fit, growth potential and financial stability.
Michel Brousset, Founder and CEO, Waldencast: It will depend a lot on how long the symptoms of the crisis will be felt. These are uncertain and unprecedented times and so it is very hard to make any predictions at this point. That said, there will always be funding for good ideas and strong teams and at Waldencast, we are certainly still actively scouting and screening opportunities.
Jorge Cosano, Founder, Synchronicity Ventures: Early-stage will still keep a high level of activity for two reasons. First, there will be capital for early-stage investments given the check sizes versus growth capital or private equity. Second, this new market coming out of COVID-19 will present a great seeding ground for new ideas and brands that will become major players in few years – let’s not forget that some of the most iconic companies of the 2010s were all children of the 2008 crisis (Airbnb, Uber, Glossier, Drunk Elephant, etc.). As I have been telling entrepreneurs these past weeks, a challenge always brings opportunity and we have in front of us one of the best markets to start a new brand. What these entrepreneurs need to keep in mind is the need to have more sound, robust and proven concepts, with clear strategies, roadmaps and unit economics to drive sustainable growth. I think this is what early-stage investors are going to be looking for. Last, there is also the possibility that we may see a new type of deal in the market that I called “distressed venture” meaning start-ups that have solid proven concepts but that run out of cash and that will probably be acquired at very low prices. I have been talking about this concept even though it seems counterintuitive to the idea of venture capital, but I think this market is going to be the catalyst for these types of deals.
To Learn More About Our Experts, You Can Find Them Here:
- William Susman, Threadstone Advisors
- Ilya Seglin, Threadstone Advisors
- Katherin Mossman, Brentwood Associates
- Robert L. Brown, Encore Consumer Capital
- Michael Sampson
- Michel Brousset, Waldencast
- Jorge Cosano, Synchronicity Ventures
- Alicia Sontag, Prelude Growth Partners
- David Olsen, Highlander Partners
Photo: Visuals via Unsplash