As published in Forefront

By Andrew Malec, Ph.D.

The U.S. economy officially entered into a recession in February. According to the U.S. Bureau of Economic Analysis (“BEA”), real gross domestic product (“GDP”) decreased at a staggering annual rate of 32.9 percent in the second quarter of 2020 which followed a 5.0 percent decrease in the first quarter of this year.¹ Millions of Americans are unemployed, and the Federal Reserve has warned of an “extraordinarily uncertain path to recovery” with a fragile road back to steady growth and employment.² All else equal, this suggests lower company valuations for the near and foreseeable future.

According to the BEA, the decline in second quarter real GDP reflected across the board decreases in economic activity, which was partly offset by an increase in federal government spending (the trillions of dollars in governmental aid to households and businesses) and a decrease in imported goods. Otherwise, the decline in real GDP would have been even greater. Personal consumption expenditures reflected decreases in spending on services (led by health care) and goods (led by clothing and footwear). Exports primarily reflected a decrease in spending on capital goods. Investment primarily reflected spending decreases in retail (led by motor vehicle dealers), equipment spending (led by transportation equipment), and new single-family housing.³ The economic collapse in the second quarter was unrivaled in its speed and breathtaking in its severity. The decline was more than twice as large as in the Great Recession a decade ago, but occurred in a fraction of the time. The only comparisons in modern American history are the Great Depression and the demobilization after World War II.⁴

As of August 2020, the U.S. has experienced more than one million new weekly unemployment claims for 19 straight weeks. Further, about 30 million people are receiving unemployment benefits, a number that has come down only slowly as new layoffs — many of them permanent job losses, as opposed to the spring’s temporary furloughs — offset gradual rehiring.⁵ On August 8, 2020, President Trump signed four executive actions to provide economic relief amid the coronavirus pandemic.⁶ The three memorandums and one executive order call for extending some enhanced unemployment benefits, taking steps to stop evictions, continuing the suspension of student loan repayments and deferring payroll taxes. President Trump authorized a $400 weekly enhanced unemployment benefit for unemployed workers. The previous enhanced unemployment benefit, which added $600 a week to standard state unemployment benefits, expired at the end of July.

The Conference Board’s Consumer Confidence Index also decreased in July, after increasing in June.⁷ “Consumer Confidence declined in July following a large gain in June,” said Lynn Franco, Senior Director of Economic Indicators at The Conference Board…“The Present Situation Index (based on consumers’ assessment of current business and labor market conditions) improved, but the Expectations Index retreated. Large declines were experienced in Michigan, Florida, Texas and California, no doubt a result of the resurgence of COVID-19. Looking ahead, consumers have grown less optimistic about the short-term outlook for the economy and labor market and remain subdued about their financial prospects. Such uncertainty about the short-term future does not bode well for the recovery, nor for consumer spending.”

The impact of COVID-19 has been dramatic in scale and scope and something the world has not seen since the Great Depression or the Spanish Flu Pandemic of 1918-20.⁸ Further, increases in COVID-19 cases and deaths across the nation has led to a renewed pullback in economic activity, reflecting consumer unease and renewed shutdowns.

While the pandemic caused by COVID-19 has resulted in devastating consequences to the U.S. economy, it has also presented an opportunity to transfer wealth at lower value. Depressed economic conditions and uncertainty caused by the pandemic, coupled with an uncertain path out of this recession to economic recovery, suggests lower company valuations for the near and foreseeable future. Investors do not like uncertainty and require to be compensated for the additional risk of achieving a company’s cash flows through an increase in the required rate of return on an investment which translates into a lower valuation multiple for the investment. Alternatively, cash flow projections will be revised downward for those companies affected by COVID-19 which will also result in lower valuations.

Market transactions are also down significantly. According to PitchBook, U.S. private equity transactions decreased with 2,173 deals closed totaling $326.7 billion through the first half of 2020, a nearly 20 percent decrease in deal value compared to this time last year.⁹ Quarterly figures show an even steeper fall, with Q2 2020 deal value down more than a third from Q1 2019 values.

Although COVID-19 will likely be around for quite some time, it does present an opportunity to transfer wealth at lower value. As a result, gifting shares of privately-held equity interests in the current economic climate can take advantage of the increased risk and lower valuations caused by COVID-19.

1. “Gross Domestic Product, 2nd Quarter 2020 (Advance Estimate) and Annual Update,” U.S. Bureau of Economic Analysis, July 30, 2020.
2. Smialek, Jeanna. “Fed Warns of ‘Extraordinarily Uncertain Path to Recovery’,” The New York Times, June 12, 2020.
3. “Gross Domestic Product, 2nd Quarter 2020 (Advance Estimate) and Annual Update,” U.S. Bureau of Economic Analysis, July 30, 2020.
4. Casselman, Ben. “A Collapse that Wiped Out 5 Years of Growth, with No Bounce in Sight,” The New York Times, July 30, 2020.
5. Casselman, Ben. “A Collapse that Wiped Out 5 Years of Growth, with No Bounce in Sight,” The New York Times, July 30, 2020.
6. Schwartz, Matthew and Tamara Keith. “In Executive Actions, Trump Extends Some Unemployment Benefits, Defers Payroll Taxes,” National Public Radio, August 8, 2020.
7. “The Conference Board Consumer Confidence Index Decreased in July,” The Conference Board, July 28, 2020.
8. Lubik, Thomas A. and Sonya Ravindranath Waddell. “COVID-19 and the U.S. Economy,” Federal Reserve Bank of Richmond, March 31, 2020.
9. “US Private Equity Activity Slows in Q2 2020 As Global Economies Struggle Through COVID-19 Pandemic,” PitchBook, July 10, 2020.
10. https://www.justice.gov/usao-edmi/pr/detroit-resident-charged-covid-19-wire-fraud-scheme
11. https://www.latimes.com/politics/story/2020-07-23/feds-begin-prosecuting-fraudulent-ppp-coronavirus-loans-some-cases-will-be-hard-to-win
12. https://www.acfe.com/press-release.aspx?id=4295010491