Gloom to boom? Outlook for M&A in 2023

March 2023  |  COVER STORY | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

March 2023 Issue

Despite a backdrop of economic headwinds, the war in Ukraine, less financing availability and gaps in valuation expectations, the majority of dealmakers remain reasonably bullish and believe M&A activity will increase in 2023. While M&A activity has been described as slow and uncertain over the past six months or so – particularly compared to the records reached in 2021 – the deal forecast for the year ahead could see an uptick, although of course there are no guarantees.

2022 in review

2022 was a challenging year for the global economy. With the aftereffects of the coronavirus (COVID-19) pandemic and the war in Ukraine impacting confidence across the world, the total value of M&A fell 37 percent to $3.66 trillion by 20 December 2022, according to Dealogic, after hitting an all-time high of $5.9 trillion in 2021.

Total M&A value in the US fell by around 43 percent to $1.53 trillion, while Europe and Asia Pacific saw a 27 percent and 30 percent drop respectively, with values hovering just above $900bn. The fourth quarter of 2022 also saw a 56 percent contraction in global M&A to $641.2bn, partly caused by a 66 percent drop in private equity (PE) dealmaking.

However, even as macroeconomic and geopolitical headwinds buffeted the market, there were still 39 megadeals over $10bn announced throughout the year. Last year’s biggest deals included Microsoft’s $75bn all-cash offer for videogame maker Activision Blizzard, announced in January, and chip maker Broadcom’s planned $61bn takeover of enterprise software company VMware, announced in May.

Tough conditions prevail

Sentiment for the early part of 2023, however, is largely bleak. “It looks like global M&A deal value for 2022 will be about 40 percent lower than in 2021, and underneath the hood I think the trend to look at is how much it was a tale of two halves, with activity levels materially lower in H2 than H1,” says Chris McGaffin, a partner at Slaughter and May. “That means that we are heading into 2023 on a downward trajectory and the things really driving that – economic uncertainty, challenging financial conditions and a bit of a loss of confidence – will not turn 180 degrees immediately in 2023.”

Saskia Blokland, a partner at Norton Rose Fulbright LLP, is equally reserved. “Predominantly due to overall macroeconomic and geopolitical instability, recent figures indicate a slowdown in M&A activity in late 2022, and the generally prevailing sentiment is not optimistic,” she says. “Market circumstances in 2022 were not favourable to initial public offerings (IPOs) either, with various IPO processes either having been cancelled or delayed. And while special purpose acquisition companies (SPACs) caused a considerable IPO spike in 2021, this was no longer the case for 2022, and SPACs may very well prove to be a thing of the past.”

Reflecting on recent trends, Rudolph du Plessis, a partner at Herbert Smith Freehills, notes that the rebound coming off the back of the pandemic was relatively short-lived. “As the economic uncertainty surrounding the COVID-19 pandemic lifted, institutions adapted quickly and moved to capitalise on growth and value creation,” he recalls. “This, together with an abundance of cheap capital attributable to, among others, low interest rates and the global SPAC boom, resulted in increased M&A activity, particularly in relation to strategic and distressed assets.

“However, more recent geopolitical events in Europe have resulted in increased interest rates to curb soaring inflation, leading to many institutions reconsidering any aggressive plans for growth through acquisitions,” he continues. “Increased oversight from regulators such as the competition authorities has added to the challenge in completing deals in an uncertain economic climate across many jurisdictions.”

Better times ahead?

The outlook from Allen & Overy is that 2023 will likely be a strong year for energy and infrastructure dealmaking. Meanwhile, PE funds will look to create value through complexity, be it through targeting undermanaged carve outs or aggressively going after two or more complementary assets at the same time. There will also be hotspots of activity in the Middle East, Japan, Southeast Asia and the UK, and renewed interest in digital assets, non-fungible tokens (NFTs) and the metaverse.

“As the global economy recovers from the COVID-19 pandemic and adapts to the changing geopolitical and technological landscape, we expect a more normalised level of M&A activity in 2023 that will likely resemble pre-2021 levels and may look back to 2022 as a year of general reset,” suggests Dario de Martino, a partner at Allen & Overy LLP. “Some sectors that have been resilient or benefitted from the pandemic, such as technology or healthcare, may continue to see strong demand and valuations, while others that have been severely affected, such as travel or hospitality, may face more challenges and pressures to adapt or exit.

“Similarly, some regions or markets that have managed the pandemic better or have more fiscal and monetary support, such as North America or Asia Pacific, may have more confidence and resources to pursue M&A deals,” he continues. “In contrast, others facing more disruptions or uncertainties, such as Europe or Latin America, may have more caution or constraints.”

Although a culmination of factors is causing subdued activity, the pressure valve may soon start to ease. “It is unlikely that we will see a boom as such, until conditions support deal-doing again, at which point history says that the demand that has built up during the down period will be released and seen in higher activity levels, potentially in the second half of 2023,” opines Mr McGaffin.

Whether dealmaking returns to ‘normal’ in 2023 remains to be seen. One ongoing challenge that may hold back a rebound is regulatory scrutiny of transactions, under both the merger control and foreign direct investment (FDI) umbrellas, notes Mr McGaffin. “FDI review has quickly become a staple of the pre-deal assessment, albeit the substantive risk tends to be higher for Chinese acquirers, as the number of regimes and their breadth has expanded over the past few years, and can impact deal structuring, timeline and deal terms,” he says.

Yet, despite tightening review processes in a number of jurisdictions, cross-border transactions are tipped to pick up as 2023 progresses. Analysts expect to see not only US companies making acquisitions in other markets, but European and other international buyers making moves in the US.

Executing deals

Those companies pursuing deals in the current uncertain economic climate need to take a number of important factors into account. For Mr McGaffin, three areas are expected to demand greater focus going forward.

“The first is due diligence to support the valuation, especially on the financials and the business’s robustness to downturns, such as supply chain exposure,” he says. “The second is deal terms to support the valuation or bridge gaps between buyers and sellers, in particular the use of deferred consideration and other mechanics. And the third is agreeing when exactly a buyer can walk away from a deal if things get worse between signing and closing, which means taking a hard look at any material adverse change (MAC) clauses and other termination rights.”

For Mr de Martino, robust due diligence, standalone indemnities and other constructs that focus on closing certainty will require careful consideration. “For buyers, it is more important than ever to conduct disciplined due diligence and dive deeper into potential deficiencies in a target, including business, legal and regulatory liabilities that may affect its valuation,” he says. “To the extent a buyer discovers a matter that poses an unusual or unexpected risk, it should consider requiring the seller to provide a standalone indemnity to cover any associated losses. Standalone indemnities are not typically subject to indemnification limitations, nor do they depend upon an underlying breach by the indemnifying party, typically the seller. As such, they shift the risk back to the seller.

“For sellers, limiting the buyer’s termination rights will be critical,” he adds. “Among others, sellers should consider whether to pursue specific performance and compel a buyer to close or seek liquidated damages. Finally, both parties should consider focusing on a few key provisions, including the scope of the MAC clause and its exceptions, the size of any termination fee, and regulatory ‘ticking fees’ to compensate for delays and termination triggers.”

Private equity in the picture

2022 activity in the PE industry remained above pre-pandemic levels, and the market share of PE transactions as a proportion of global M&A activity continued to steadily grow, reaching a record 23 percent as of Q3 2022, according to Refinitiv. Going forward, Mergermarket and Dechert suggest the middle market may be the most active PE space.

As Mr de Martino points out, current market conditions appear to reflect a more positive outlook going into 2023 due to unprecedented amounts of committed capital; US PE firms, for example, hold $1.1 trillion in dry power. Creative deal structuring and easing of conditions such as inflation will also fuel dealmaking in the PE space.

Beyond that, PE continues to prove itself a resilient, adaptive asset class. “I expect that sponsors will continue to create value through more complex structuring – for example by using accruing, participating and payment in kind (PIK) dividends with a senior liquidation preference to structure around the interest, targeting undermanaged carve outs, or aggressively going after two or more complementary assets at the same time, and pursuing a wider variety of post-closing ownership models, including investing in assets via joint ventures with strategics,” says Mr de Martino.

If it pushes on to deploy record amounts of dry powder, PE could drive up valuations in 2023, especially in sectors that have benefitted from the pandemic, such as technology, healthcare, e-commerce and digital services. “PE firms may also seek to capitalise on the low interest rates and high liquidity that have supported debt financing and refinancing, as well as the strong demand from public markets and strategic buyers for quality assets,” says Mr de Martino. “Additionally, PE could leverage its expertise in operational improvement, digital transformation and environmental, social and governance (ESG) factors to enhance the value of its portfolio companies and exit at higher multiples.

“That said, PE could also face downward pressure on valuations in 2023 if the industry encounters more competition and regulation, as well as higher risks and uncertainties,” he continues. “For instance, PE may face more challenges in finding attractive deals and generating returns in a crowded and expensive market, where valuations may have already reached or surpassed their pre-pandemic levels.”

Capitalising with caution

Undoubtedly, the current deal environment is challenging. But for acquiring companies, there are tremendous opportunities to explore. “I do think we will continue to see deals being done, and there are some specific factors to drive activity – in particular, the high levels of capital held by both PE funds and corporates, energy transition and energy security, and the continuing appeal of the tech sector for investment by PE and corporates,” says Mr McGaffin. “We are also seeing acquirers getting creative to get deals done.”

Buyers will also be motivated to tap into new products and markets. “Depending on the degree of adoption, innovation and disruption of new technologies and digital platforms, M&A activity could be influenced by various factors, such as customer preferences, competitive advantages, operational efficiencies or value creation,” says Mr de Martino. “For example, the increasing use of artificial intelligence, cloud computing, blockchain, 5G or IoT could create new markets, products, services or business models, or challenge existing ones, and thus drive M&A activity to capture or defend market share, enhance capabilities, or access data or talent.”

Another area of the market expected to yield deal opportunities is distressed M&A. “The volume of distressed M&A activity is likely to increase, especially in sectors including retail, hospitality and travel,” says Ms Blokland. “In these sectors, decreasing consumer confidence, fuelled by double-digit inflation figures, is expected to prevail.

“Due to various forms of government support provided to soften the impact of the COVID-19 pandemic, the volume of insolvencies in recent years has been lower than normal, which of course is exceptional in view of the scope and impact this pandemic has had. We expect this to normalise in the foreseeable future.”

2023 may be a year of significant growth for buyers that approach dealmaking in the right way. They will need to dig around for potential fragilities in target companies and weak links in their supply chains. Effective due diligence will be critical from both a performance and risk management perspective.

Though buoyant dealmaking may not return immediately, every cycle comes around eventually. Experts are scanning the horizon in hope of a resurgence in the second half of the year.

© Financier Worldwide

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Richard Summerfield