The state of the M&A market: down but not out

July 2023  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2023 Issue

M&A in 2022 and 2023 is somewhat unfairly pitched against the dealmaking boom the market saw immediately post-coronavirus (COVID-19) pandemic. The story of what was to come post-2021 was a much deliberated one and dealmakers predicted that the lull of activity in 2022 would creep into 2023.

As we have come to the end of Q1 2023 these predictions have proven correct. Rising inflation and interest rates, geopolitical tensions and increased regulatory scrutiny have compressed valuations and caused corporations and investors to keep their feet out of M&A waters, and instead to continue to focus on internal operations and running the best possible business in the current environment.

This slowdown in deal activity is seen across the board – the initial public offering (IPO) market remains unattractive, business to business (B2B) sales remain stagnant as a result of the large valuation gaps and unwillingness of buyers to deploy funds, and private equity (PE) activity remains slow compared to previous years.

The current market, which is underpinned by softening valuations, is not conducive to dealmaking, as the bid-ask spread between buyers and sellers is often too wide to even allow room for compromise. The relative weighting that investors are applying to growth versus profitability has shifted since 2021; for example, well established ‘profitable’ software companies have seen less of a valuation impact when compared to ‘unprofitable’ software companies.

Previously, high-growth companies typically traded at a significant premium to those companies characterised by lower growth and higher margins. Many sellers are finding it hard to let go of their assets at today’s price, knowing what they could have achieved 24 months previously. Similarly, corporations with healthier balance sheets and investors who are in no rush to exit are inclined to wait it out until exit opportunities become clearer.

In terms of the numbers, aggregate Europe, the Middle East and Africa (EMEA) deal volume and value declined by 12 and 37 percent respectively in 2022 compared to 2021. Europe was home to the most withdrawn M&A over the same period, with 43 percent of failed deals involving a European target. The story continues into this year, with the end of Q1 2023 showing a 27 percent drop to the levels of activity seen in Q4 2022 and a 48 percent drop compared to Q1 2022, undoubtedly aggravated by the collapse of Silicon Valley Bank and Signature Bank, the Credit Suisse wobble in Europe and the continued rumblings of a recession.

Weak leveraged finance markets and the players operating within

In attempts to tackle record levels of inflation, central banks in major economies have continued to increase interest rates, which has led to a significant increase to the cost of capital in 2022 and in Q1 2023, reducing financial sponsor activity. As yields rose sharply the syndicated loan market has dried up, with leveraged loans halving in volume in 2022 compared to the previous year.

The lack of cheap debt and the bid-ask discrepancies between PE sponsors and sellers has slowed activity by PE sponsors along with the rest of the market, although it remains more active than B2B M&A. The potential to acquire high quality assets at a lower value is a driver for those sponsors looking to deploy their capital this year. Of course, following record levels of capital deployment in 2021 many sponsors are still more selective and are facing increased investment committee scrutiny, therefore fewer deals are precipitating genuine bidding wars.

Looking forward, there is data that points to UK sponsor-backed enterprise software targets which are high-growth and produce high recurring revenue, as set to lead the way to increased UK sponsor exit activity in the latter half of 2023. Developments in artificial intelligence and machine learning as well as cyber and all things linked with data privacy also continue to pique investors’ interests and is a space worth watching.

An era of increased regulatory scrutiny

Antitrust and merger regulatory scrutiny has been on the rise across Europe and the US and has impacted deal volumes over the last 12 to 18 months by extending timelines, increasing deal costs and imposing enforcement actions. As regulators across the globe are progressively collaborating and exchanging information, those pursuing acquisitions involving targets with innovative disruptive technologies or transactions where the acquirer has an entrenched market position are coming under the microscope more often than before.

Equally, foreign direct investment regimes are more prevalent now than ever as political agendas in countries across Europe and beyond are placing national security concerns higher on their lists of priorities. More and more deals are falling within the remit of such screenings and regulators are not shying away from imposing sometimes difficult and in some cases even dealbreaking conditions. Transactions in the life sciences, health and technology spaces, which are outside of the more traditional national security industries, are now often being caught in the fire.

As these trends look likely to continue into the rest of 2023 and beyond, dealmakers must become accustomed to the new ‘regulatory scrutiny’ normal and be attuned to these considerations early in the deal process, factoring them into stakeholder expectations, timelines, due diligence and costs.

The time for ‘creativity’

The volatile economic environment has also been a catalyst for exploring new trends and pursuing less customary avenues to facilitate deals. For example, in the PE market, the last year has seen an increase in private credit funds as an alternative funding source to the syndicated loan market. The reset in public company valuations in 2022, particularly in the technology sector, led to an uptick in interest levels in take-private deals by PE sponsors, and this trend has continued in 2023 as PE firms seek to invest in high quality and high growth assets at compelling prices.

2022 also saw companies seek to strengthen their industry positions via bolt-on acquisitions or through divestment of non-core assets through carve-out deals, as companies want to focus their efforts and funds on key aspects of their businesses that do best and drive profitability. Strategic thinking around appropriate partnerships and collaborations took on a big role in global M&A deal planning, along with heightened diligence in identifying synergies.

Acquirers are nervous about using cash to fund acquisitions, so corporates are increasingly striking deals using stock as consideration. This might raise additional complications, such as sellers requesting mutuality of warranties and conducting a full due diligence exercise on the acquirer. These requests are understandable, as sellers that sell their companies without receiving cash in hand need an extra level of comfort that the acquiring corporation holds up. Reciprocal warranty and indemnity (W&I) insurance can also be an option to explore in these structures. Parties striking such deals should be aware that the additional considerations in such structures come with increased costs, and timelines which are often pushed out.

Another interesting pattern of behaviour has emerged as a result of the US IPO markets remaining largely closed. Foreign companies, particularly in the life sciences space, that are looking to access the US public market are doing so via ‘cross-border reverse mergers’, which involves a merging of a private or public foreign company with a US public company and the shareholders of the foreign company receiving stock in the US public company as transaction consideration. With the fixed valuation agreed at the time of announcement, pricing is less exposed to market fluctuations and absent any prolonged regulatory review, reverse mergers are offering an alternative creative route to IPOs. It is worth watching this space.

Looking onward: calm before the storm

What is driving some of the M&A activity in the current market is also what is hindering it. Large trade acquirers with firepower (meaning the capacity to conduct acquisitions based on balance sheet strength) are maintaining their appetite for strategically important M&A, and sponsors sitting on record levels of dry powder continue to look for the perfect bargain.

Bargains are plentiful at the moment, as those targets running out of cash are facing depressed venture funding activity, too long a path ahead to IPO and are faced with investor pressure. Such companies are turning to M&A as a solution to deliver liquidity, streamline costs and bridge funding gaps to try to continue to develop their products.

When inflation stabilises and credit markets reopen, we expect a return of M&A activity to rush through, fuelled by pent-up demand from sponsors and motivated trade buyers. It is a matter of waiting out the calm before the storm.

 

Stephen Rosen is a partner, Alex Mitrea is an associate and Mo Swart is a trainee at Cooley LLP. Mr Rosen can be contacted on +44 (0)20 7556 4352 or by email: srosen@cooley.com. Ms Mitrea can be contacted on +44 (0)20 7556 4219 or by email: amitrea@cooley.com.

© Financier Worldwide

BY

Stephen Rosen, Alex Mitrea and Mo Swart

Cooley LLP

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