Nervousness and uncertainty prevail and for sure, dealmaking is slowing. Data from Bloomberg reveals that worldwide M&A activity during the third quarter of 2022 was $504bn. This is the second lowest quarterly total of the past five years; only the second quarter of 2020, at the height of the COVID-19 pandemic, recorded a lower figure. Transactions fell back at every level of the market, from mega deals to small and mid-market.
However, deals are still being done – and activity in the UK, where market volatility amid political upheaval might have been expected to derail M&A, has remained resilient. Deal values reached $65bn over the third quarter, according to White & Case’s M&A Explorer database. That might be down on the same period for 2021, but it was still respectable when compared to pre-pandemic norms.
Still, the question now for both buyers and sellers is whether to maintain such a resilient view. If the deteriorating economic outlook continues, should they stick with current acquisition plans? And if the answer is yes, how do they steer their way through the volatility to keep deal processes moving towards a successful conclusion for all parties?
Context is everything
One part of the answer, reflects Rob Baxter, UK head of corporate finance at KPMG, is that the extent to which dealmaking is in jeopardy will depend on the context. “It’s a very varied picture,” he says. “In some sectors, there still isn’t a cloud in the sky – where there is a strategic imperative for a deal, whether it’s digital transformation or energy transition, say, that is pushing the parties through the turbulence. In other areas of the market that are more exposed to difficulties – consumer discretionary spending, for example – the mood is much darker.” (Baxter is also global head of consumer goods and retail M&A at KPMG.)
One buyer definitely not retreating from deals is Rentokil, says Chris Hunt, the business services group’s head of M&A: “We do around 50 deals in a typical year and we’re not pulling back. Acquisitions are part of our growth plan and we can take a strategic long-term view over the cycle.”
Nevertheless, in the current environment Hunt does believe that all buyers need to be looking in even more detail at their potential targets. Key questions include the customer profile of the business; the extent to which it is exposed to more discretionary areas of the economy; the number of customers with recurring contracted revenues and whether these contracts are being suspended or even terminated; whether the business has had to resort to price discounting to maintain sales volumes; and current levels of bad debt and credit collection.
Unsatisfactory answers in any of these areas will potentially raise a red flag for buyers, but scrutiny also has to be applied to more positive indicators. For example, revenue and profit models constructed before the economic backdrop deteriorated may now look too optimistic. Inflation may not be fully reflected in cost projections. Revisiting these forecasts may not lead to the deal collapsing, but sellers may want to think again about pricing (see box, ‘Ups and downs of pricing’).
The price of completion?
Valuations, in any case, are adjusting in many areas of the market. The sell-off of publicly listed equities in both North America and Europe this year provides food for thought. It’s very unlikely to lead to sharply lower prices immediately, since sellers take time to come round to reduced valuations, but it could hit completions.
Certainly, processes are being stretched out. The average time taken to close a deal has increased in 2022, with 60% of transactions during the first six months taking more than 70 days, compared with 54% in the first half of 2021, according to WTW’s Quarterly Deal Performance Monitor.
One problem some deals are now running up against is a growing aversion to risk on the part of lenders, warns KPMG’s Baxter. Debt financing for M&A, which has gone through a period of plenty, is increasingly hard to come by, certainly at an affordable price, he says: “It’s a problem that can blow up quite late in a transaction process, as the banks wobble. In which case, you may need to be more imaginative about the structure, replacing more traditional lenders with alternative providers, or considering tools such as vendor loan notes.”
The latter enable the buyer to defer payment of a portion of the purchase price – the portion that would otherwise have been covered by debt in this case. The notes are effectively a loan from seller to buyer, enabling the latter to pay the full price in instalments.
Buying power
Sellers may now have to be more collaborative in order to get deals over the line. The ground has shifted rapidly from super-hot M&A markets, in which sellers held the power, to a time when buyers are becoming more discerning.
Garret O’Connor, a partner in the value creation services practice at Deloitte, says many sellers will therefore have to work harder to sustain the buyers’ interest. “One of the things we find when helping businesses improve performance is that management teams find out a great deal about their business in a short space of time,” he says. “They get new insight into what their people are doing and how effective their operations really are, as well as whether they’re getting value when they spend their money.”
For O’Connor, putting in that work ahead of a sales process will be increasingly integral to deal success. “If sellers can identify those issues, put them right and show the effect of that in the P&L, buyers will see the value,” he says. “But sellers should not expect to get away with telling buyers that they’re working on solutions because acquirers will take the view that they can pay less and do the work more effectively for themselves.”
One possibility is that as more corporates do such work, particularly while business stress mounts, carve-outs will actually drive increased M&A activity. “We often end up telling businesses what it will cost to put a problem right and then discussing whether they have the appetite to do it,” O’Connor adds. “If the opportunity cost of devoting resources to the fix is too high, the alternative is to sell.”
Shelter from storm
Another support for M&A may come from businesses having an increased desire to be part of a private equity portfolio during tough times, says David Wardrop, partner at Rutland Partners: “We saw during the COVID-19 crisis that privately owned businesses benefited from the shelter of a private equity blanket. Private equity provides financial support, but it can also provide practical assistance with operations and execution.”
Processes involving private equity buyers are continuing, Wardrop suggests, although sellers may look to retain larger shares of their businesses in a market where valuations are under pressure: “Perhaps you sell the majority stake you need to get the private equity support, but you don’t sell as much of the business as you otherwise would.”
It’s a further example of where, if uncertainty continues, flexibility will become increasingly important to getting deals over the line. Transactions that may have seemed straightforward a year ago – whether for corporates or for private equity – may now require extra creativity and compromise from both parties.
The benefit of foresight
The key will be to plan ahead in an attempt to anticipate potential shocks. Sellers may be able to foresee last-minute financing problems, for example, by studying the extent to which loan agreements feature material adverse change clauses, and in what circumstances they apply. Buyers may need to supplement the warranties and indemnities they have previous relied on with additional protections. Both sides must be patient – taking longer to complete due diligence, for example, and even accepting extended payment terms.
In this new environment, moreover, advisers will be even more important. The best businesses will continue to be in demand, but securing top-dollar prices may become more challenging. As for second-tier prospects, they will need even more support to get sales done at prices they deem reasonable. At the least, advisers will provide an intelligence-led view on what a realistic price for the business might be. And that will support management teams making an informed decision about whether to proceed.
Ups and downs of pricing
Price is inevitably a potential sticking point in ongoing M&A. Negotiations on deals now moving towards completion will have begun some time ago – probably before central banks began tightening monetary policy in earnest over the autumn as inflation spiked out of control, and possibly before the conflict began in Ukraine. Many buyers may be concluding that a valuation that felt reasonable a few months ago now looks expensive.
However, persuading sellers to drop the price, having agreed a higher valuation, is a big ask. “These situations tend to be quite fraught, but there are ways to protect both sides with a revised deal structure,” says KPMG’s Rob Baxter. “The vendor may feel confident enough in the business to offer the seller some sort of recompense if the reality disappoints.”
Prior to completion, for example, an agreement that the final price will be based on the business’s accounts or balance sheet on the closure date – rather than a set value – provides mitigation against volatility during the intervening period.
For those buyers looking for protection beyond completion, building additional contingency into the deal structure can work well. The most obvious example is an earn-out clause, under which the buyer only pays the full price if and when agreed performance milestones are hit following closure of the acquisition. Deferred consideration or true-ups are options for vendors to get a deal through to completion.
Warranties and indemnities also have a role to play here. These provide a means for the seller to assert that there is certainty in particular areas of the business – that it is currently securing a set level of contract renewals, for example, or achieving a particular level of profitability. Such assertions are legally binding, giving the buyer greater confidence to proceed at the agreed price.
For all that, however, buyers and sellers may simply be unable to reach agreement, particularly where the latter’s expectations are rooted in what they hoped for when considering a sale. “There does come a point when one party or the other will simply feel they are better off not proceeding,”
Baxter says.
New role for debt
Private equity funds face a dilemma in the current marketplace. On the one hand, the use of debt in any acquisition has the potential to reduce risk – they simply have less of their own cash exposed to the business’s future fortunes. On the other, with debt costs spiking sharply – and borrowing becoming harder to come by – private equity investors fear overloading targets and undermining future profitability.
“Debt funds and other mid-market lenders are still there, at least for now, and private equity is definitely keen to get debt into the deal,” says Rutland Partners’ David Wardrop. “But there is no doubt that the cost of debt continues to rise.”
The impact of this dilemma on current M&A negotiations is nuanced. The early evidence from market data shows that private equity investors are now backing away from fully fledged leveraged buy-outs, given the cost of such finance. In the US, for example, the third quarter saw a significant fall in the value of leveraged loans to fund buy-outs – the UK looks likely to have seen something similar.
Equally, however, the desire of private equity investors to have at least some debt in a deal process to mitigate risk is heightened. For sellers, this may make it more difficult to push back against such structures. The scale of competition for the best corporate assets among private equity firms sitting on record amounts of dry powder has, until now, meant management teams could shop around for an investor prepared to write an equity cheque in full; now those investors are thinner on the ground.
Elsewhere in the M&A marketplace, meanwhile, the availability and cost of funding now represents the most likely brake on dealmaking activity. As lenders become more risk averse and interest rates rise courtesy of central banks, buyers may struggle to secure the funding they need. “Funding issues are now the problem most likely to kill deal impetus,” says KPMG’s Rob Baxter.
More haste?
Logic would say that accelerated M&A processes, conducted by financially distressed businesses looking to secure value for shareholders – or for a parent company in the case of a carve-out – will increase in number as the economic backdrop gets tougher. While stronger businesses have the luxury of conducting extended deal processes, those in distress need to move quickly. For example, almost half the deals in the UK retail sector in the first half of the year were distressed M&A transactions.
However, while the timelines of such deals may be compressed, both sides must proceed with caution. Sellers need specialist corporate finance and legal advisers with experience of distressed M&A. Thorough upfront preparation work is needed, so that data is ready to inspect and questions can be answered quickly. Vendors will also need to keep stakeholders such as creditors fully informed.
On the buyside, due diligence is still vital, particularly as the opportunity to secure warranties and indemnities (of any value) from struggling sellers may be limited. One important question will be workforce costs, particularly if redundancy costs down the line are likely to be necessary. Sellers may also need specialist advice on whether to go for a solvent sale or to buy out of insolvency.
In non-distressed sales, meanwhile, the temptation to rush a transaction to completion is understandable for dealmakers concerned about gathering storm clouds – particularly if significant resources have already been committed to a process. But the risk of moving too quickly should not be overlooked; in a marketplace where risk is heightened by external factors, skipping on financial and commercial due diligence adds to the danger.
Some buyers will feel more comfortable moving more quickly than others, says Rutland’s David Wardrop. “If you’re a trade buyer and you’ve been tracking a target for some time in a core sector for your business, you may have the confidence to move more quickly,” he says. “Equally, if you’re a private equity investor operating a buy-and-build strategy, you may know the market and the key players well enough to move at an increased pace.”
Vendor Value
When negotiating with corporate sellers, Rentokil’s Chris Hunt says: “If you’ve had the pricing conversation at the beginning, it’s very difficult to return to it unless you’ve subsequently found something that is absolutely glaring,” says. “Your expectations may have lowered, but theirs take longer to adjust and they may simply decide to keep the asset if they’re confident of its value.”
Finding a way to deliver value for vendors can make the difference between successfully completing the deal and seeing it collapse. And broadly speaking, if the seller is not prepared to budge on the headline price, then the only other likely area of compromise is deal terms. “Contingent payments are going to play a much larger role in deal structures,” Hunt adds.
Effectively, buyers are asking sellers to put their money where their mouth is. If the sellers really are so sure that their businesses can deliver the benefits promised – and therefore justify the agreed valuation – they won’t be afraid to make some of that valuation dependent on execution.
Sellers, clearly, need to think carefully about whether they’re happy to take back some of the risk of a transaction.
In the meantime, there are also steps they can take to help protect the deal. For example, those sellers who are absolutely prepared for the transaction, with crystal clear information and data ready for buyers, will be in a stronger position to eliminate any uncertainty.
Those who are prepared to put resources into the deal process – so they can respond at speed to their buyer’s queries – will also have more chance of keeping the deal on track at the agreed price.