The immediate impact of Covid-19 on UK M&A manifested in April, with the month seeing the lowest level of activity since September 1985. Yet, even amidst uncertainty, it would be unwise to give up on M&A in 2020. Partner James Worrall puts forward his predictions for the markets.
Reported deal value in April totalled £49.1m from 35 transactions with March to April aggregate deal value down 99% and April's aggregate value down 92% compared with April 2019. On a global level M&A reported a 72% month on month aggregate value reduction, dropping to the lowest level since September 2002.
Uncertainty reigns
It's beyond doubt that the UK faces a deep recession in consequence of the Covid-19 pandemic and the restrictions placed on all of our lives. Unlike previous recessions in the modern era, there is no precedent for what the recovery will look like. With Government borrowing for 2020 forecast to be £299bn, a post-war record, how the Government responds in the medium term with tax and public spending decisions remains to be seen. Against this backdrop, to say that the expected mentality of the business community in this uncertainty will be cautious is likely to be something of an understatement.
Transaction volume and structures
It will take time for M&A to recover from the crisis. In the medium term businesses will emerge from the crisis in different positions. Those who emerge strongly and more quickly may well find opportunities to acquire businesses that have emerged with pipeline or cash flow difficulties or generally weaker. These could take the form of distressed transactions, involving administration and liquidation processes or non-distressed transactions following a usual sale process. With a lot of private equity firms focusing on their existing portfolios and supporting incumbent management teams, they'll likely be reduction in PE transactions.
A significant proportion of transactions that were underway in February were paused in March as the pandemic's effects took hold. It remains to be seen how many of these transactions will return and many are likely to be restructured to account for the new economic circumstances in which we find ourselves.
Transactions that do happen are likely to see processes with increased focus on certain areas during due diligence, with buyers looking closely at matters including:
- the target's IT systems and capabilities for remote working and the general resilience of these systems
- the impact of the pandemic on the target's customers and project pipeline
- book debts and recovery risk, and
- the target's take up of Government support such as the furlough scheme and its compliance with the terms of this.
It seems certain that there will be a rise in the use of contingent consideration such as earn-outs to apportion risk between buyers and sellers and, with less debt finance being available, to reduce the up front transaction cost for buyers. Notwithstanding the challenges that earn-out models represent, this will be particularly useful where a seller is bullish about the target's prospects and a buyer more cautious. We will also likely see transactions whereby sellers retain equity with put and call option structures negotiated to provide for a full exit for the seller in the future. Private equity will no doubt re-emerge with significant capital at its disposal to commit, but not until the timing is right and opportunities are presenting themselves once again.
Deal challenges
As to the challenging facing parties considering M&A activity, there are a number of unique obstacles facing the markets including:
Valuation challenges
A challenge for businesses looking at M&A activity will be how valuation matrixes will need to adapt. With so much uncertain regarding not just the economic recovery, but also what changes to consumer habits and working practices are permanent, valuing businesses, and the long-term prospects of their models, will be difficult.
In-person meetings
Much of an M&A process can be dealt with remotely with video calls bringing parties together where required. There are, however, points in a transaction where face-to-face meetings are crucial, particularly at the outset of a transaction as the parties size each other up. Buyers will often want to get a feel for the target's management team, something best done in person where chemistry can be established.
Management capacity
Management teams of all businesses have been in firefighting mode since the start of the Covid-19 pandemic. Dealing with the consequences, with frequent board meetings and crucial decisions needing to be taken with regularity, is likely absorbing the majority of management time. For the boards of potential buyers, taking on a transaction process and finding sufficient time to dedicate to it is likely to be difficult.
Predictions
1. It's safe to say we will be in a buyer's market for the foreseeable future, giving buyers the opportunity to be more assertive in the terms demanded and presenting businesses emerging strongly from the crisis with the opportunity to take advantage of this and acquire businesses at reduced valuations.
2. There will be circumstances where the requirements of buyers in terms of contractual protection and what sellers are willing to provide in this regard will not be aligned. Warranty & indemnity insurance cover may well become more prominent as a way to bridge this gap.
3. In the immediate term, the scale of private equity investment will likely be significantly reduced although we do expect to see some bolt-on acquisitions to existing portfolio companies where opportunities are too good to miss. There will be a tipping point however, potentially in late 2020, when investors look to re-engage with the market and use the war chests at their disposal.
4. Not all sectors will be impacted equally, we expect to see continued activity in sectors less impacted by the pandemic (and those for which it presents opportunities) such as health & social care, life sciences and technology & innovation.
It is going to be a challenging year for UK M&A but, with lockdown now being eased, and businesses adjusting to the new normal there will be plenty of opportunities for bold businesses.
Looming on the horizon is the expiry of the UK's transition period following its exit from the European Union. With talks in relation to a future trading relationship seemingly going nowhere fast and the prospect of 'no deal' as real as ever, it's safe to say that the only certainty for 2020 is uncertainty.
Originally published 5 June 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
