Q&A: Outlook for M&A activity: challenges and opportunities
July 2021 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
July 2021 Issue
FW discusses the outlook for M&A activity with James Fletcher at Ashurst LLP, Jerry Dentinger at BDO, and Ani Kusheva at Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates.
FW: Could you provide an overview of some of the major factors currently driving M&A opportunities? How would you describe recent deal activity?
Kusheva: The flurry of deals that we saw toward the end of 2020 has certainly accelerated in 2021. We have seen a significant increase in corporates carrying out fast-tracked acquisitions and divestitures, either accelerating long-term strategies to gain scale and growth or reacting to distress. We also see mega deals – which may have been put on hold in 2020 – returning and driving current M&A activity. In the first quarter of 2021, we continued to see a rise of de-special purpose acquisition company (SPAC) deals with companies, including European targets, choosing to go public by merging into a SPAC blank cheque company. We also see private equity firms continuing to contribute to M&A volumes, deploying record amounts of available capital.
Dentinger: Today, a very active seller’s market exists with buyers eager to put capital to work. Volumes have accelerated for many reasons, not the least of which are pent-up demand and resilient valuations, even amid a global pandemic. Corporate balance sheets are flush with cash, and there is significant dry powder in private equity and family offices. This, combined with lenders that are also aggressively looking to put funds to work, all contribute to creating significant demand for quality assets in the marketplace. We continue to see family-owned businesses looking for liquidity events, unwilling to manage through the next crisis in the 21st century. On top of this, the significant growth of SPAC funding and uncertain tax policy around capital gains has added fuel to the already high sense of urgency to get deals done, quickly. The pipeline is nearing capacity.
Fletcher: The first month of the UK’s coronavirus (COVID-19) lockdown in the spring of 2020 saw only one UK takeover announced. Since then, UK public M&A deal activity has rebounded strongly and the market has been on something of a bull run, with 11 firm offers announced in Q3 2020, 17 in Q4 2020 and 13 in Q1 2021. The main driving force behind that deal activity is familiar – the amount of dry powder available to private investors. Given that, a significant number of the recent UK takeovers have been private equity-backed public to private (P2P) transactions, such as KKR and Equitix's £2bn bid for John Laing Group plc. The other emerging driving force is trade buyers that are coming out of the pandemic in reasonable shape and with significant cash balances to invest.
“The technology, media and telecom sector is still, by far, the most active one, which seems to be a natural consequence of an increasingly virtual world and abundance of available capital.”
FW: Which industries or sectors are experiencing higher transaction volumes? Have any recent, notable deals caught your eye?
Dentinger: SPACs are moving mainstream, with SPAC dollars raised in Q1 2021 having already exceeded all of 2020. Investors’ appetite for SPACs, or ‘SPACetite’, seems insatiable. However, most remain an empty shell in search of a target, meaning the importance of looking through to the underlying sponsor, management teams and infrastructure are fundamental to risk management. On the industry side, healthcare, technology and software as a service (SaaS)-based business models continue to garner high valuations, but this presents challenges to a buyer’s investment thesis and their ability to grow into the price being paid. We also see sellers doing add-ons during their own sale process in hopes of benefitting from multiple arbitrages.
Fletcher: There are certain sectors where there is, in some cases, a perceived dislocation between the value of the underlying assets of a target company and the price at which its shares are traded. That may be driving higher than usual deal volumes in those sectors. The level of deal activity in relation to listed real estate investment trusts (REITs) is a good example. There is also a continuing high level of deal activity in the tech sector, often driven either by a desire or need for existing investors to achieve an exit or by more traditional corporates looking to transform their business to be more digital in nature.
Kusheva: The technology, media and telecom sector is still, by far, the most active one, which seems to be a natural consequence of an increasingly virtual world and abundance of available capital. The sale by Dell Technologies of Boomi, a leading provider of cloud-based platform business, to private equity firms Francisco Partners and TPG Capital for $4bn is a fair representation of current M&A activity. We see several technology clients reshaping their portfolios, focusing on core infrastructure and expansion of select high priority areas, in particular in response to ‘work from anywhere, do from anywhere’, which is here to stay.
FW: How would you characterise the impact of the global pandemic on M&A activity? In what ways have buyers and sellers responded to these changes?
Kusheva: We did have a pause of M&A activities at the beginning of the pandemic. However, the adjustment by all involved parties – buyers, sellers, advisers, finance providers and insurers – to carrying out virtual deals has been impressive and delivered a swift recovery and acceleration of M&A activities since the second half of 2020. The pandemic certainly accelerated capability-driven M&A. M&A deals are often not only viewed as key to growth but also as key to survival. This has hugely impacted the timing for completing acquisitions of strategic targets. We have completed transactions in weeks that would typically take months, without skipping any steps critical to a successful deal. Another significant consequence of the pandemic is with government intervention in M&A deals. Several jurisdictions introduced and expanded governments’ rights to screen, challenge and block foreign investments. While national security analysis used to be carried out for a very limited number of transactions, this is now becoming a common part of the standard due diligence process.
Fletcher: In general, there has been a flight to quality. That is not to say that investors have not sought opportunistic takeovers but, often, it has been challenging for bidders and target boards to reach an acceptable valuation in those situations because target boards have, rightly, been concerned to ensure that they do not recommend an offer that fails to recognise the long term, post-pandemic, value of the business. Where the target’s share price is not considered to be reflective of the long-term value of its underlying business, bidders and targets have often had to utilise different valuation benchmarks, beyond the traditional premium of an offer price to the current share price, to justify the offer. On occasion, that has led to a far higher premium than the traditional 30 percent and, conversely, a lower premium in other situations.
Dentinger: M&A came to a screeching halt when the COVID-19 pandemic hit the US in March 2020. However, the market started to see life as early as Memorial Day and gradually ramped up throughout the summer and autumn for companies that showed pandemic resistance or benefitted by virtue of their industry space. Now, M&A activity is robust due to pent-up demand, as we have seen in 2021 transaction volumes. Buyers have paid a premium for companies that have successfully weathered the interruption, and sellers are eager to convey their value proposition through a rebounding customer base or a successful pivot in their business models. Sellers are preparing – and buyers are studying – 2020 earnings before interest, taxes, depreciation, amortisation and coronavirus (EBITDAC) analyses very closely, something that has become essential to connect the past to today’s growth projections and bridge the lofty valuations.
FW: What shifts have you seen in price expectations and valuation multiples?
Kusheva: From the legal side of M&A deals, we see increasing valuations due to an abundance of available capital and increased competition for premium assets. The vaccine rollout is noticeably restoring investors’ confidence and creating expectations for strong valuation multiples. We also see opportunistic buyers seeking to acquire targets based on a lower 2020 earnings before interest, taxes, depreciation and amortisation (EBITDA) and sellers with leverage successfully resisting it. Further, we see that valuations of targets increasingly factor in non-financial measures reflecting investors’ and boards’ commitment to long-term value creation and, in particular, environmental, social and governance (ESG) and digital transformation.
Dentinger: Primarily due to the dynamics of supply and demand, many declines in valuation multiples resulting from the crisis have rebounded quickly and are now above pre-pandemic levels. However, our surveys have shown that over 90 percent of private equity fund managers expect valuations to continue to rise – with more than half anticipating a 10-25-plus percent increase in 2021 – up from already historic highs. COVID-19 exposed vulnerabilities in businesses across industries, and we expect more strategic divestitures in 2021 as companies focus on core business segments and restructure balance sheets. Opportunities may exist in distress and carve outs, but volumes have lagged expectations. After the initial shock of the pandemic, distressed M&A has been slow to ramp up, but we anticipate that more opportunities will surface as government stimulus payments end.
“Communication technologies have facilitated, but not necessarily accelerated, the execution of transactions, as in-person meetings are often still required.”
FW: To what extent have you seen a change in the way deals are executed in the current market? Have dealmakers become more reliant on technology to facilitate the deal process?
Dentinger: Sellers are using their leverage to pressure buyers into shorter deal timelines. If buyers are not adequately staffed internally, they may be in a difficult spot to move quickly due to the sheer volume of deals in the marketplace, which has caused service providers to be near capacity. Communication technologies have facilitated, but not necessarily accelerated, the execution of transactions, as in-person meetings are often still required. Data analytics are in use on both sides, a trend that was underway pre-pandemic and continues to accelerate.
Fletcher: The pandemic has fundamentally changed the way in which deals are executed. The most visible sign of that is that whole deals are being done over Zoom or Teams at the moment, but that is just the tip of the iceberg and will not necessarily be permanent. Pre-pandemic, companies were, rightly, already looking for more efficient and effective ways to collaborate and execute deals through the use of technology. Naturally, that has accelerated during the pandemic. Using electronic signature platforms is now the norm and a good example of that change. It has been shown to be a far more efficient way to have documents executed by people in different geographic locations.
Kusheva: The speed of dealmaking, from the initial approach to signing, has significantly increased due to fierce competition for premium assets. All M&A deal participants, led by financial and legal advisers, finance providers and warranty & indemnity (W&I) insurers, have adapted to the new rhythm without compromising standards of services. M&A dealmakers had successfully adopted technology-based solutions before the pandemic, with entirely virtual legal and financial due diligence, virtual signing processes and virtual or hybrid management presentations. Although we saw attempts for site visits to be carried out by drones, physical inspection of a target’s assets seems to be the only diligence-related workstream that cannot, and should not, be virtualised. With respect to deal negotiations, technology has significantly optimised the process and is a perfect solution for a significant part of the deal documentation. However, it is also apparent that in-person negotiation remains the most efficient, and often the only, way to resolve critical deal points.
FW: Have acquirers enhanced their approach to risk management and due diligence? Are you seeing a growing appetite for M&A insurance, to help manage risks and see deals through to completion?
Kusheva: Despite the increased volume and size of M&A deals, we see a continuing disciplined approach to risk management and due diligence. Where we see a change is with covenants in purchase agreements relating to targets’ operations between signing and closing regulating COVID-19-driven actions, with the scope and allocation of risk relating to such covenants being highly negotiated. We have not noticed a growing appetite for M&A insurance, probably because it had already been fully integrated in the M&A deals process prior to the pandemic. However, we have noticed that COVID-19 exclusions in W&I insurance policies, which were initially too broadly-drawn, are now narrower, maintaining the attractiveness of that product.
Fletcher: While it varies of course depending on the sector and specific business, more than ever, there is a significant focus in due diligence on governance, compliance and issues that could cause reputational damage or regulatory issues. While some of those fall into ‘legal’ due diligence, some are softer commercial and cultural issues, that have implications for the risk profile of a business. Where and with whom does the target do business and does that fit with the risk appetite of the buyer? What is the culture of the target regarding governance and business risk and, again, does that fit with the buyer’s? While formal policies and procedures can be enhanced post-completion, changing an ingrained culture can be challenging. Naturally, there is also now enhanced due diligence on the implications, if any, for the target business of Brexit. The pandemic has also shone a light on the robustness, or otherwise, of supply lines. While M&A insurance is commonplace in private M&A transactions, there are challenges regarding the use of it on UK takeovers and I am not aware of it being used successfully on one to date. For example, a target company itself cannot give warranties on a UK takeover, and finding anyone else prepared to do so, or persuading an insurer to provide a wholly synthetic warranty package, can be difficult. Another challenge is the ability to conduct due diligence and a disclosure exercise to a standard required by the insurer given that, traditionally, due diligence on a UK takeover is more limited because the target’s shares are publicly traded, so all information needed to price those shares should already be available publicly.
Dentinger: Risk management has increased, with strong emphasis on connecting the dots from the past to the present and significantly more granularity around the analysis of customers, cost structures, margins and contracts. Representations and warranties insurance (R&WI) use had been ramping for years prior to the pandemic, and seller leverage today continues to drive its use to both accelerate close and transfer risk to buyers.
“Given the amount of dry powder available to private investors, I am optimistic that the UK public M&A market will remain buoyant for the remainder of 2021.”
FW: What general advice would you offer to parties on planning, negotiating, structuring, financing and closing successful deals in today’s market? What key issues need to be considered?
Fletcher: On a takeover, plan your approach carefully to maximise your chances of being granted due diligence access and a recommendation by the target board. That includes the following. First, do what outside-in due diligence you sensibly can do to help demonstrate that you will take a proportionate and considered approach to due diligence and that your offer does not face material regulatory hurdles. Second, line up financing in principle on a certain funds basis, as required by the UK Takeover Code. Third, have a detailed rationale and justification for your valuation, including by reference to alternate valuation metrics if necessary. That means involving advisers early in the process and being willing to commit a sensible level of resource. If granted due diligence access, you should be prepared to move quickly to announce your offer. Given volatility in share prices, if your healthy premium is swallowed up by an increase in the target’s share price during the due diligence process, that could threaten the target board’s willingness to recommend your offer.
Dentinger: Start early, plan accordingly, and anticipate running parallel diligence workstreams that previously may have been sequential. This can be a costly investment for buyers participating in a dynamic auction process where multiple bidders are involved. Given the compressed timelines, some buyers have made strategic decisions to forgo certain diligence workstreams and instead focus on confirming value propositions and identifying negative synergies that may be inherited. With accelerating speed to close a priority, something has to give during the diligence process, and it usually is synergy capture and integration taking a back seat. At a time of high multiples, this increases the challenge and extends the time frame for value creation post-close.
Kusheva: My advice would be to start planning as soon as possible and be prepared for an accelerated negotiation, structuring and financing. All issues with the potential to impact on the timing of a transaction have to be identified in advance, realistic ‘long-stop dates’ need to be agreed and action plans put in place to minimise execution risks. It is now even more important to identify all regulatory clearances, including any national security notifications, and prepare relevant applications as early as possible. Timelines of the transaction should also factor in regulators currently taking the full period of time allowed to review applications and often seeking to extend that period of time. In contrast, filing requirements – such as original documents, notarisations and apostille – have not been relaxed, which in certain jurisdictions could delay the process by several weeks.
FW: How buoyant do you expect M&A activity to be through the remainder of 2021, and beyond? Will acquirers need to continue to adapt their M&A strategies to navigate challenges and take advantage of opportunities?
Dentinger: In 2021, M&A activity should remain strong. However, as the year progresses, economic uncertainty will affect whether this momentum continues into 2022. The primary headwinds are tax policy and inflation, with both being major external factors contributing to urgency to close. Today’s supply chain shortages reflect the global economy returning to growth, but the trifecta of pent-up consumer demand facilitated by accommodative monetary policy to fund historic government spending foreshadows more permanent than transitory inflation. The inflation question is significant given the impact on margins and whether sellers have the pricing power to pass along cost increases. When buyers need to justify paying record multiples, the impact on valuations could be significant. Add in expected capital gains tax increases and likely other increased operating taxes, and valuations will be further tested.
Kusheva: The transformation driven by COVID-19 is expected to continue, with companies using M&A activities to thrive in the post-pandemic phase. Even if the SPAC boom is now beginning to slow, a significant number of SPACs – nearly 500 with more than $140bn in assets raised, according to Refinitiv data – are under time pressure to find a target which will impact M&A activities. This trend would only be accelerated with regulating authorities announcing stimulus and infrastructure spending. In light of an increased number of opportunities, acquirers will certainly have challenges to navigate. Downsides of the pandemic will continue to crystallise as governments wind down COVID-19 support packages. We also expect to see an increased litigation risk, which corporates need to anticipate and mitigate. In this context, a review and update of directors’ protection – under D&O insurance but also, and especially, under indemnity arrangements with companies – is highly recommended.
Fletcher: Given the amount of dry powder available to private investors, I am optimistic that the UK public M&A market will remain buoyant for the remainder of 2021. Beyond that, the fundamental drivers of M&A activity still hold true but, clearly, the world is an uncertain place and a resurgence of the pandemic in Europe or the US or other macro events, such as an elevation in trade tensions between the US and China, could threaten that. In addition, the UK’s new national security and investment regime is indicative of a general legislative trend toward protectionism and enhanced national security laws, but, generally, I see that shift more as creating additional hoops to jump through in order to close transactions rather than presenting a fundamental threat to M&A activity. While bidders will have to continue to adapt their strategies, including to take account of the forthcoming changes to the UK Takeover Code, the key points bidders will have to persuade target boards of will continue to be that the offer price reflects a fair valuation of the target’s business and is attached to a deliverable deal.
James Fletcher is a senior partner in the public company team of Ashurst’s corporate transactions department, specialising in advising corporates and investment banks on public and private M&A transactions, ECM transactions and corporate advisory work. Representative clients include Oxford Instruments plc, Dialight plc, AVEVA Group plc, Rothschild & Co, Numis and Eastdil Secured. He can be contacted on +44 (0)20 7859 3156 or by email: james.fletcher@ashurst.com.
Jerry Dentinger is one of the founding partners of BDO’s transaction advisory services practice, responsible for originating client engagements, overseeing project execution teams and leading the overall strategic direction of the practice. He has more than 25 years of experience providing corporate finance advice to senior executives of middle market and Fortune 1000 companies. He is focused on financial due diligence for private equity investors, strategic acquirers and debt capital providers. He can be contacted on +1 (312) 239 9191 or by email: jdentinger@bdo.com.
Ani Kusheva is a partner in Skadden’s London M&A group and focuses her practice on corporate matters, including cross-border mergers and acquisitions, public company takeovers, joint ventures and private equity transactions. Ms Kusheva’s recent transaction highlights include representing clients such as Silver Lake Partners, International Paper Company, R.R. Donnelley & Sons Company, Armstrong World Industries, Inc. and Globalworth Real Estate Investments Limited. She can be contacted on +44 (0)20 7519 7233 or by email: ani.kusheva@skadden.com.
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Ashurst LLP
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