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long read

Perceptions of value

Author: David Prosser

Published: 11 Sep 2023

shapeshifting purple shapes mirrors sand desert ICAEW Corporate Financier M&A valuations

M&A is facing many challenges at present. To complete a deal, vendor and acquirer need to agree on a price. David Prosser speaks to investors and advisers about the different ways valuation can be viewed.

How much will buyers and investors pay for up-for-sale businesses or those raising money? In very many cases, the answer right now appears to be considerably less than they might have done even a year ago.

Indeed, PwC analysis of M&A market activity suggests the gap between the expectations of buyers and sellers on pricing is so wide that it “may be preventing some assets from reaching the market”. Anecdotally, it definitely is. It is also bringing anxiety to investors – in June, soda ash producer WE Soda pulled what would have been the biggest UK IPO of the year, blaming “extreme investor caution”.

Clearly, the economic backdrop is not supportive. Inflation is proving more persistent than expected, growth forecasts are down, and geopolitical tension further muddies the waters. “Dealmakers are hitting the pause button,” says Adrian Nicholls, global valuation, modelling and economics leader at EY. “We are just beginning to see some tentative signs of recovery, as people adjust to the volatility, but deals are inevitably taking longer to complete.”

For all that, capital markets advisers say the picture is nuanced. “We are seeing a decline in both volumes and valuations, but it’s a really varied picture,” says Jason Whitworth, BDO M&A advisory partner. “Deals are still getting done at full valuations at the higher quality end of the market.”

In public markets, there is no doubt that valuations have tumbled. By the end of the first half of 2023, the UK stock market was trading on a price-to-earnings multiple of around 10.3, well down on its three-year average multiple of 23.6. There was a steep decline between December 2020 and June 2021, and since then there has been a slow, steady decline in multiples, which mirrors similar falls on other Western stock markets.

shapeshifting purple shapes mirrors sand desert ICAEW Corporate Financier M&A valuations

In some sectors, moreover, valuations have collapsed. The obvious example is technology, with the world’s biggest companies plunging – the valuation of Facebook owner Meta fell from 26x earnings to 16x, below the average multiple for the S&P 500. Google-owner Alphabet was valued at more than 30x earnings at its peak, but has been as low as 17x over the past 12 months.

By contrast, the situation with private companies is much less clear. Data from BDO reveals that for the 650 privately owned businesses in the UK that changed hands during the first quarter of the year, buyers paid a typical multiple of 9.8x EV/EBITDA. That figure has fallen only modestly, having peaked at 10.7 in late 2021.

That said, deals involving private equity bidders have taken place at multiples that have fallen further. BDO says the average such deal was completed at 11.1x EV/EBITDA, down from 12.4x in 2021.

ESG value enhancer

The evidence that there is a direct link between companies’ performance on environmental, social and governance (ESG) issues and their financial returns continues to stack up. In a review of more than 1,000 studies into this link by the NYU Stern Center for Sustainable Business, 58% of them found a positive relationship between ESG and financial performance.

In which case, says Tomáš Sys, a principal specialising in environmental consultancy at Ramboll, ESG has to be a key consideration in any deal process. “ESG has become a diligence stream that is now routine,” he says. “Buyers are determined to understand the ESG risks and opportunities that a transaction could expose them to.” Moreover, once they reach that understanding, buyers’ views on pricing may change. “Materiality mapping is essential to this process,” Sys adds. “Any buyer that doesn’t attempt to assess that materiality will risk overpaying or underpaying.”

The key, he argues, is to look at this in the broadest context possible. The ESG debate increasingly focuses on the idea of “double materiality” – that it is important to assess both financial materiality and impact materiality, with the latter covering the business’s impacts, direct or indirect, on the environment, society and people. “It is a challenge to quantify ESG,” Sys concedes, “but this is work that deal teams now have to embrace.”

Moving dynamics

Part of the story is that with fewer deals being done, the balance between demand and supply is shifting. PwC points out that M&A volumes globally in the first half of 2023 were around 8% down on the second half of 2022, itself a relatively subdued period. In the UK, looking specifically at private companies, transaction levels fell 6% quarter-on-quarter during the first three months of 2023 according to BDO, though it also reveals that private equity investors actually did more deals.

Ultimately, however, it is the fundamentals that are putting pressure on valuations, and hitting volumes. “It is very difficult to commit to a deal as a buyer right now when it’s really hard to be certain about inflation, interest rates and growth assumptions,” says Robert Baxter, UK head of corporate finance at KPMG. “You don’t necessarily need a bull market to have M&A activity, but you do need some certainty and stability.”

Against the market backdrop of monetary policymakers having to fight a much more enduring battle against inflation than they – and most (but not all) market commentators – had previously expected, it is a struggle to value deals. That applies doubly to leveraged transactions – how do you plug in a discount rate when interest rate visibility is so lacking? And in other deals there is the difficulty of predicting earnings and profitability.

Inevitably, this difficulty means disagreements over valuation. “There is always a lively negotiation between buyer and seller, and rightly so,” says EY’s Nicholls. “But amid the uncertainty, we are seeing their expectations drift further apart.”

However, there is still an appetite for deals. Trade buyers have important strategic ambitions to address through M&A or are anxious to secure scale. Private equity fundraising, although slower, is continuing – and many funds have yet to deploy the significant pools of dry capital built up in recent years. “Diligence is being extended and buyers are looking for downside protection, but deals are still happening,” says Adam Bunch, M&A director at Grant Thornton.

Sellers in the UK, meanwhile, have their own reasons for wanting to move forward. Not least, there is the prospect of a general election and the possibility of changes to the capital gains tax regime. And there is the simple maths of owners and founders not getting any younger. “Some sellers may take the view that they’d rather take a percentage hit on valuation today than face a capital gains tax bill that is an even larger percentage in a few years’ time,” says Bunch.

Cyber risk

For businesses anxious about securing a full valuation from a sale or investment process, one priority should be to ensure cyber security is in good shape. Research from Deloitte suggests that last year, 60% of acquirers included an assessment of their target’s cyber-security resilience and vulnerability as part of due diligence. Two-thirds of acquirers see acquisitions as potentially exposing them to additional cyber-security risk.

Indeed, cyber-security issues can – and do – make a tangible difference to deal pricing. Just ask Yahoo – in 2017, it agreed to knock $350m off the price tag it had previously agreed with acquirer Verizon after news broke of three major data breaches at the internet search firm. If anything, Yahoo got off lightly, with reports suggesting Verizon had initially demanded a $1bn reduction.

Importantly, cyber security can cut both ways. A study published last year by Columbia Law School in New York found that businesses with weaker cyber security were less likely to be active acquirers. The study concluded that sellers were conscious they would need to merge IT systems and consolidate data following a deal process, and that they were therefore reluctant to accept offers from such companies. Columbia’s researchers also found that deals were more likely to fail before reaching completion if the target company had poor levels of cyber security.

The bottom line is that deal advisers expect buyers to focus ever more closely on the issue of cyber security. One question to consider is whether a material adverse change (MAC) clause in a deal agreement would give the buyer the ability to walk away in the event of a cyber-security incident or data breach occurring prior to completion.

“It is easier to rely on a MAC if it is drafted very specifically, so this is something we would ask our cyber team to look at very carefully,” says Gibson Dunn’s Selina Sagayam.

Bridging that gap

In which case, both sides need to find a way to ensure their transaction does not fall into a gaping pricing chasm. “The key to bridging a valuation gap lies in understanding the reasons for the different views in the first place,” says Selina Sagayam, senior of counsel at City law firm Gibson Dunn. “Does the buyer have a liquidity issue, perhaps because of the increasing cost of capital and added financial pressure, or are there genuine uncertainties about the value or potential of the business in the light of market and economic uncertainties?”

In cases of the former, agreeing deferred consideration can help both sides move forward. The buyer pays part of the purchase price now and the rest on a pre-agreed future date, potentially subject to the target hitting certain, in the main, financial criteria. In which case, sellers are likely to push for some sort of uptick – a premium added to the deferred consideration if the target is met.

shapeshifting purple shapes mirrors sand desert ICAEW Corporate Financier M&A valuations

Another option for publicly listed buyers is to pay part of the purchase price in their own stock, rather than in cash. Sellers must decide whether they’re comfortable with taking a stake in the buyer’s business, which will subsequently fluctuate in value depending on performance and market conditions.

Similarly, buyers – both public and private acquirers – may seek to pay some of the purchase price in loan notes. Again, the seller has to decide whether to accept the risk implicit in such arrangements. What is the danger of the buyer defaulting on the debt, particularly if it is subordinate to commitments made to other creditors? The interest payable on the loan note provides some compensation for this risk, but sellers may also look to mitigate in other ways – through a parent company guarantee, perhaps.

Balancing act

As buyers and sellers structure transactions in ever more complex ways in order to overcome the valuation gap, it is crucial that their sale and purchase agreements (SPAs) give both sides the protections they need.

“Many of these provisons can be a challenge to negotiate or monitor in practice because they require an ongoing relationship between buyer and seller post-completion,” says Gibson Dunn’s Selina Sagayam. Earn-out arrangements, for example, will typically require the seller to remain involved with the business to deliver the value promised, but the buyer will now have taken control.

The potential for conflict over a missed target – and where the responsibility lies – is significant. Similarly, with deferred considerations, sellers will want to be confident that the buyer is able to make good on its promises.

And in the case of embarrassment clauses, there may be arguments about the extent to which a premium achieved in the subsequent sale was achieved through the buyer’s efforts post-completion or because the original deal was priced too cheaply.

Getting the SPA right can be challenging. “It’s vital that conditions are very clearly defined so that there is no dispute about what is owed, when and in what circumstances,” says Sagayam.

“But you also need simplicity – it is a challenge to accommodate for all outcomes and contingencies and it is in both parties’ interests for there to be clear mechanisms or frameworks in the contractual terms bolstered, where appropriate, with provisions to verify or objectively test implementation in practice,” she explains.

In that sense, the SPA requires some careful balance. Sellers may naturally feel anxious that the buyer is trying to ‘pull a fast one’, but complicated agreements that try to ensure that every eventuality is watertight may actually turn out to be difficult to enforce because they are much too specific.

Alternative routes 

As for deals where there is fundamental disagreement on price, there are plenty of ways to structure the transaction in order to try to address the uncertainty at the heart of any discord. 

“Where buyers are cautious about the sellers’ ability to deliver future earnings, they are addressing that directly in the deal structure because no one wants to be embarrassed by overpaying, even for the right business strategically,” says BDO’s Whitworth.

For example, adds Grant Thornton’s Bunch, “earn-outs can provide the buyer with some downside protection, so we are seeing those being employed very commonly”. The buyer pays some of the purchase price upfront, with the remaining payments due only if the target company hits agreed milestones during the earn-out period. Those milestones can vary enormously – anything from an earnings target to securing a regulatory approval – but the idea is to hold the seller to their claims about the future value of the business.

In other cases, says KPMG’s Baxter, sellers are moving to selling a minority stake in the business rather than cede full control. “They take some capital to de-risk, even though they may feel the valuation is underwhelming, but they still have the prospect of their big capital event in the future.”

Deals structured in this way will often incorporate provisions that ensure both buyer and seller are able to realise their ambitions for a minority stake to develop into a majority purchase at a later date, says Gibson Dunn’s Sagayam. “The transaction terms will typically incorporate both call and put rights with defined triggers so that both the buyer and the seller know the deal will proceed to a full acquisition or sale in the event that certain conditions are met,” she explains. Those conditions might include, say, the business delivering a certain internal rate of return.

Transactions may also incorporate what Sagayam describes as an “anti-embarrassment clause”. The buyer agrees to pay the seller an additional sum if it sells the business on at a premium within a set period. The idea is to give the seller some comfort that they are not being ‘ripped off’ at the price being offered today.

There are, in other words, plenty of options for buyers and sellers determined to move forward. Some deals, inevitably, will fall by the wayside in the current environment. But where both sides are prepared to be flexible about deal structure, there is scope to keep the transaction alive, even where a significant valuation gap threatens to derail it.

Early birds…

Are investors in early-stage businesses marking valuations down in line with the rest of the market? Not necessarily, says Doug Lawson, co-founder and CEO of the data provider Mark to Market. “We have seen quite a bit of pain for Series B fundraising and beyond and, to a lesser extent, at Series A, but valuations for seed-round businesses seem to be holding up,” he says.

In part, that may reflect a degree of survivor bias, he adds. “It may be only the higher-quality businesses that are getting funded and those are the ones that attract the fuller valuations,” he says. “Still, valuations definitely feel more sustainable now – some of the froth we were seeing previously has now gone.”

One complicating factor for some of these deals is that tax incentives, available through the enterprise investment scheme and the seed enterprise investment scheme, provide comfort for investors concerned about the risk of investing in young and immature businesses. That offers support for parts of the market to counteract the negative impacts of macroeconomic and political uncertainty.

It’s also the case that investment into the smallest businesses inevitably requires something of a leap of faith.

“Valuations are naturally going to be a little more detached from the fundamentals for a business that has no EBITDA or little in the way of revenues,” Lawson says.