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Up to 2020, the belief prevailed that M&A activity required certainty in climatic conditions in order to thrive. The pandemic upended that, as it did so many things. The concept of economic cycles was suspended as the world focused on a single effort to recover from that seismic shock. After a short pause in mid-2020, M&A roared back to life, producing a remarkable period of deal activity through the disruption. Strategics felt the imperative to reposition their businesses, using M&A to accelerate those efforts, while private capital firms proved determined to deploy their ample funds, supported by favourable debt markets, in economies supported by governmental stimuli. The significance and pace of change required by global macro themes, not least digitalisation, energy transition and ESG – and now rebalancing of global supply chains – has been the framing for this spate of frenetic deal activity.
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GAVIN DAVIES
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Trends in M&A
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Where the real problem lies
How effective is the growing shareholder voice in public M&A?
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= Competitive Advantage
ESG in every deal
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Portfolio realignment
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Global politics and operational repositioning
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National security or nationalist sentiment?
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Introduction
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Our annual M&A review looks at consequential legal themes in more detail, including how political considerations are playing out through national security regimes and how multi-nationals are approaching operational repositioning driven by geopolitical issues. Other notable trends we explore include how carve-outs are being used to accelerate portfolio realignment, the increasing manifestation of ESG in transactions, and how shareholders are making their voices heard in M&A. Yet despite challenging conditions, M&A markets are far from closed. There remain good reasons that transactions have proceeded amid a turbulent environment. Among the drivers of such resilient deal activity are balance sheet planning and the continued hunt for transformational deals by strategics, the deployment of more equity by funds and availability of private credit, and the opportunism on the part of well-positioned buyers, including through currency arbitrage and in distressed situations. Reason for optimism remained at the end of 2022, with a $50 billion 'Merger Monday' providing a mid-December bright spot. As the market digests tougher economic circumstances, will the slowdown be as short-lived as the pause in 2020? Or will the ominous outlook and fiscal picture in many major economies hobble M&A well into 2023? That is currently unclear. Headwinds and tailwinds have for some while been the metaphors of choice for global M&A. We now add to those a third weather condition – fog.
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Melanie Debenham Partner herbert Smith Freehills
If it is now evident the M&A market can cope with the unexpected, the question posed by 2022 is whether it can absorb our current perma-crisis state, with once-in-a-generation events now erupting with disturbing frequency.
The statistics have borne this out – the value of global M&A averaged around $1 trillion for eight consecutive quarters from Q3 2020 to Q2 2022, with 2021 seeing record deal values of over $4.2 trillion. But there was a marked deterioration in M&A conditions in the second half of 2022, with deal values of only $1.4 trillion across Q3 and Q4 combined, a 33% decline compared to the first half of the year. If it is now evident that the M&A market can cope with the unexpected, the question posed by 2022 is whether it can fully absorb our current perma-crisis state, with once-in-a-generation events now erupting with disturbing frequency. Geopolitical tensions reached new heights with Russia's invasion of Ukraine raising political, economic and energy security issues and providing international businesses with the salutary experience of needing to rapidly exit operations in a developed market. Inflationary pressures, meanwhile, are challenging asset valuations in deals, and in some cases testing business viability. Even the tech sector, that unrivalled growth engine of recent years, has seen valuations take a battering, and rising interest rates are forcing those operating with leverage to revisit their models. More than a decade of low inflation and interest rates mean that we need to rebuild experience of transacting within these more challenging conditions.
A key focus for deal lawyers remains the priority of reducing periods between signing and closing, and catering for any negative developments during that gap – at a time when merger control and foreign direct investment regulators have never been more numerous and proactive, blowing out deal timetables and increasing execution risk. M&A lawyers also face greater demands to gauge the context in which they advise. Every transaction will have ESG considerations. While the precise issues will vary between sectors and geographies, the direction of travel on ESG is clear – businesses are being held to higher standards of corporate responsibility by a diverse collection of stakeholders. 'Licence to operate', for example, may increasingly involve decisions of where to no longer operate.
In most countries, the focus of FDI regulation remains on national security rather than wider national interest considerations. However, the scope of activities and technologies considered by policymakers to fall within the concept of national security has evolved to become extremely broad, often encompassing not just military and defence but also critical infrastructure, communications assets, advanced technology and data, healthcare and even matters such as food security. At the same time, we have seen increased political focus on the domestic impact of consolidation of global value chains where this is perceived to work against the interests of countries that have nurtured the targeted industries (in particular, in advanced manufacturing, research intensive and technology sectors). National security is rarely defined in FDI regimes and we have seen a number of cases that seem influenced more by national interest considerations. Inevitably, geopolitical tensions result in increased focus on investment from countries such as China and – more recently – Russia. However, it is also clear that many FDI regulators are broadening their focus: there are numerous examples of proposed acquisitions involving investors from countries such as, Canada, the US and the United Arab Emirates coming under scrutiny, and under the new UK investment screening regime we have even seen an example of conditions being imposed in relation to investment in a UK company by a UK investor. This means that it is now more important than ever before that deal parties and their advisers consider early in the transaction planning process what investment screening issues may arise, how these might be addressed, and whether they may ultimately threaten the viability of the transaction.
The global trend towards greater protectionism and stricter enforcement of FDI regulation remains an important consideration for deal planning
Foreign direct investment (FDI) flows have started to surge back above pre-pandemic levels, but many existing FDI screening regimes have been expanded recently and more new regimes have been adopted (particularly in the EU, in response to strong encouragement from the European Commission). Economic conditions and heightened geopolitical tensions have both undoubtedly accelerated this trend. Anticipating the potential for intervention in any transaction involving foreign investment is essential in the current climate.
Are regulatory regimes being misappropriated by politics?
Over 85% of acquisitions reviewed by the Committee on Foreign Investment in the US (CFIUS) in both 2020 and 2021 involved non-Chinese acquirers Six of the 14 transactions in which remedies were imposed under the new UK investment screening regime in 2022 involved non-Chinese acquirers (although all three prohibition decisions and one of the two divestment decisions did involve Chinese acquirers) The first publicly announced refusal of FDI authorisation in France in December 2020 involved the proposed acquisition of French company Photonis by US group Teledyne
The UK's National Security and Investment Act (NSI Act) entered into force in January 2022, introducing a new standalone UK regime for the review of qualifying transactions and investments on national security grounds. The government emphasised that the UK remains open to foreign investment and that it did not expect to require remedies in a significant number of cases. However, since the first final order was published in July 2022, we have seen nine conditional clearance decisions, three prohibitions and two divestment orders. While this remains a small number of transactions in absolute terms, it nonetheless represents a sea-change compared to the previous regime under the Enterprise Act 2002, where the government intervened in just 16 transactions between 2003 and 2021. High level summaries of prohibition or conditional clearance decisions under the NSI Act are made public. However, only very limited information will be included about the national security concerns identified and any conditions imposed. This can make it difficult for parties to rely on publicly available decisions as a guide when conducting a risk assessment for a proposed transaction. The government has issued general guidance on its intended approach, but this is no substitute for practical experience of the new regime in action. We have been involved in a number of the conditional clearance decisions issued to date and are advising on a number of other transactions currently under review by the Investment Security Unit (ISU). The types of conditions which we are seeing include:
restrictions on information flows; restrictions relating to the appointment of board members and key staff; the appointment of a government observer to the board; requirements relating to notification of future transfers of assets; and requirements relating to maintenance of R&D and manufacturing capabilities in the UK.
Upfront consideration of possible remedies is advisable for any qualifying transaction which could potentially be considered to give rise to national security concerns (broadly defined), alongside early engagement with the ISU.
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Brussels
Kyriakos Fountoukakos
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Matthew Fitzgerald
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Joseph Falcone
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Veronica Roberts
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These are not confined to challenges arising from the outbreak of war; the gradual retrenchment from globalisation and increasing political risk in several jurisdictions necessitate a detailed risk analysis and planning to mitigate financial loss in the event continued operation becomes untenable. Lessons can be taken from the experience of companies that exited Russia in the aftermath of Russia’s invasion of Ukraine. These include:
Political risk is a consistent theme in this report and the events in Ukraine have brought into sharp focus the risks faced by companies with global or international operations.
Geopolitical tensions are driving decisions on where to invest and operate, and when to exit
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Sydney
Rebecca Maslen-Stannage
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Shanghai (Kewei)
Gavin Guo
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LONDON
Mike Flockhart
Not all companies must act at the same pace: some will be compelled to act quickly because of the nature of their business or products, their profile, relationship with governments or customer base. Others will have more time to formulate a plan. However, in either case understanding potential exit strategies in advance is crucial to preserving value. The options available to each company will differ. Contrast the experience of McDonald’s, which was able to close its Russian restaurants swiftly, with that of Burger King, which was unable under the terms of its joint venture and franchise arrangements to procure the immediate cessation of operations. Some companies had no choice but to cease operation because their Russian business was dependent on intellectual property that could not be transferred or licensed without negating the purpose of exiting and exposing the company to unacceptable risk of replication and competition. Some companies may be better served by not taking proactive measures, but instead allowing assets to be nationalised or otherwise appropriated and then falling back on international law rights and remedies; a high risk strategy but one that needs to be considered.
M&A can be a useful tool for a company looking to exit a jurisdiction, along with 'warehousing' the business (that is, transferring it to an independent party as a temporary measure) which can be an attractive option, particularly if there is a realistic prospect of the situation normalising within a short period.
Inevitably, there will be challenges that will have to be considered on such transactions. These include:
Each crisis has its own characteristics and the next will differ from the last, but companies would be well advised to consider the consequences of geopolitical risk and the role M&A might play in preserving value in the event of an enforced exit
Tax and regulatory issues – These will be key on any transaction. Where a warehousing structure is being used, it will also be important to understand the risks impacting a future retransfer of the business. The Russian government took active measures to encourage warehousing and other transactions to transfer businesses to local management, including changing the tax code to exempt Russian citizens from tax on gains from such transfers. Whether the Russian government will be so supportive of retransfers of businesses back to western owners in the future or to western sellers benefitting from anti-embarrassment or similar provisions remains to be seen. Employees – Companies must consider the impact of their actions on employees 'in country'; while selling or closing a business may be justified by the economic circumstances, companies must be wary of exposing employees to other risks. Russia introduced laws that exposed local managers to criminal liability for making redundancies in certain circumstances. The risks for citizens of western countries were exacerbated and there was therefore an imperative to repatriate them quickly.
Funds repatriation – Companies will have to establish how they can get the proceeds of any sale out of a jurisdiction, whether that be by way of dividend, intra group loan or royalty/service fees.
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JAMES PALMER
gEOPOLITICS AND BUSINESS INSIGHTS
While we saw carve-out activity soften in the second half of 2022, in line with M&A more generally, we expect these types of transformative deals to remain a firm feature of the M&A landscape in 2023 for a variety of reasons:
Carve-out transactions, whether structured as private sales, public spin-offs or break-up bids, are a key M&A tool for large corporates in reshaping their portfolios, shoring-up balance sheets and delivering value to shareholders.
The pace of repositioning by large corporates continues to drive carve-outs
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Paris
Frédéric Bouvet
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Melbourne
Raji Azzam
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Laura Ackroyd
While the subject matter of carve-out transactions can vary significantly, from specific business divisions or units, brands or geographies, a unifying feature is the high level of integration or interdependence between the target business and the parent organisation. This means that significantly more work is required in defining, separating and setting up the target business for a deal than is customary for most M&A. In all forms of carve-out transaction, detailed preparation is critical to successful implementation and protection of value. This includes:
Each crisis has its own characteristics and the next will differ from the last, but companies would be well advised to wargame the consequences of geopolitical risk and consider the role M&A might play in preserving value in the event of an enforced exit
Firstly, difficult market conditions can stunt business growth and drive tougher competition for capex within organisations. In response to this, large corporates could seek to generate value through divestments and shed non-core assets in order to optimise their portfolios, rationalise cost centres and reduce leverage.
Secondly, corporates will need to continue to respond to sector-specific trends, such as energy transition. This will continue to drive targeted refocusing of business goals, and can often lead to associated transformative M&A. Thirdly, we expect competition for high-quality assets to remain buoyant, with financial buyers and strategics often open to exploring more complex transactions in order to access good M&A targets. As we saw in 2022, this may include pairing-up on public bids, with a view to breaking-up the listed company's business on completion.
PRIVATE SALES Where a large corporate disposes of a non-core business via a private sale process. Typically structured as an auction, with the seller undertaking considerable vendor due diligence and reorganisation planning work pre-launch. Early stage planning by the seller is critical in keeping transaction timelines tight in the sales process and in protecting value in the target business.
PUBLIC SPIN-OFFS Where a large corporate separates part of its business operations into a standalone listed entity, and distributes the shares in that entity to its current shareholders, or sells the shares to new investors, or both. Significant work is required to separate the target business from the parent organisation and replicate or replace parent organisation functions, in order to minimise ongoing transitional support.
BREAK-UP BIDS Where bidders team up to acquire a listed entity and break up its assets on completion, with each bidder taking a different portion of the business. Bidders will conduct thorough outside-in diligence pre-approach to assess the feasibility of a break-up bid. However, limited information access usually necessitates some use of assumptions and flexibility in consortium documents as to how the separation will be executed. More detailed planning can be undertaken, with co-operation from the target, as the bid progresses.
Determining the perimeter: identifying at an early stage what assets and which personnel will be the subject of the carve-out transaction, where they are currently located (within the parent organisation's legal structure) and how they overlap with the retained business. Use of clear separation principles to determine the perimeter and the target operating model accelerates the process and, in the context of a private sale, reduces the risk of cherry picking by a buyer. A well-defined perimeter is also critical to efficient preparation of carve-out financials and vendor due diligence reports – with late changes having significant knock-on impacts to numerous workstreams.
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Mapping the reorganisation: the next critical step is detailing the reorganisation required to legally separate the identified assets and personnel from the parent organisation and ensuring this is done in a tax efficient way. Timing of the reorganisation will differ depending on the type of deal. For public spin-offs, the reorganisation will need to occur pre-launch. For break-up bids, bidders will want the reorganisation to occur on or as soon as possible after completion. For private sales, the reorganisation typically occurs between signing and completion – so having a detailed plan in place pre-signing is helpful in instilling confidence in potential buyers, minimising execution risk and keeping transaction timelines tight. Break-up bidders may however be hampered by incomplete advance diligence given the public nature of the bid.
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Planning for transition: inevitably, the carve-out business may not be able to operate entirely independently on Day 1. Therefore, to minimise business disruption, a degree of ongoing transitional, or indeed reverse-transitional, support will be required from/to the parent organisation. Transitional periods can be long and very involved and, on private processes, can require significant co-operation between the seller and buyer post-completion. We have sometimes seen this lead to financial buyers being preferred over competitors or strategics in auction processes.
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Identifying the pressure points: hot spots vary from deal to deal but can include operational complexities (such as difficult systems or data separation), workforce management (including consultation and consent processes with employees and addressing pension risks), stakeholder engagement (such as complex contract migration exercises), tricky regulatory clearances (noting that the reorganisation, as well as the ultimate transaction, may require various approvals) and large Day 1 costs (for example if there are material assets which are excluded from the perimeter but which are required for the ongoing operation of the target business). Identifying these complexities at the outset and planning effectively for them will help limit the potential for value destruction through the time consuming carve-out process.
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All of the above means there is generally quite a long lead time on a successful carve-out transaction, and many of the opportunities we see come to market in 2023 will already be deep in the planning phase.
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Gavin Williams
OUR M&a SERVICES
Environmental, social and governance (ESG) issues have become key considerations in M&A transactions in recent years. Businesses operating within, or with links to, developed economies have long been regulated in areas such as anti-bribery and corruption, environmental protection, and health and safety. These obligations are now increasingly accompanied by disclosure requirements whether under national laws, stock exchange rules, or voluntary instruments. As it becomes easier to scrutinise corporate behaviour, disclosure and reporting requirements are facilitating greater levels of activism and litigation risk, with an increasing spotlight on allegations of greenwashing in particular. Lenders are likewise increasingly incorporating ESG metrics into their credit analysis and borrower evaluation. This can impact both the availability of acquisition financing and the ongoing financing for the combined business post-closing.
What is now market norm, and what is best practice?
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Rebecca Perlman
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Silke Goldberg
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Timothy Stutt
Heightened focus on ESG is leading companies to dispose of poor ESG-performing businesses. In 2022, significant deals included the sale by Dutch chemical firm DSM of its Engineering Materials business for €3.5 billion and the bids by Brookfield Asset Management and EIG Global Energy Partners for Origin Energy, which was valued at $12 billion. The latter deal saw the bidders aim to split Origin into its extractive gas operations and retail energy supply businesses. M&A transactions also aim to take account of ESG-related upside, with strong ESG performers commanding a premium. In 2022, Goldman Sachs found that EU-Taxonomy aligned companies trade at a 37% price-to-earnings and enterprise-value-to-EBITDA sector-relative premium.
1. PRIVATE SALES Where a large corporate disposes of a non-core business via a private sale process. These are typically structured as an auction, with the seller undertaking considerable vendor due diligence and reorganisation planning work pre-launch. Early stage planning by the seller is critical in keeping transaction timelines tight in the sales process and in protecting value in the target business.
2. PUBLIC SPIN-OFFS Where a large corporate separates part of its business operations into a standalone listed entity, and distributes the shares in that entity to its current shareholders, or sells the shares to new investors, or both. Significant work is required to separate the target business from the parent organisation, to replicate or replace parent organisation functions and minimise ongoing transitional support
3. BREAK-UP BIDS Where bidders team up to acquire a listed entity and break up its assets on completion, with each bidder taking a different portion of the business. Bidders will conduct thorough outside-in diligence pre-approach to assess the feasibility of a break-up bid; however, limited information access usually necessitates some use of assumptions and flexibility in consortium documents as to how the separation will be executed. More detailed planning can be undertaken, with co-operation from the target, as the bid progresses.
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Hong Kong
Antony Crockett
Traditional due diligence, focusing on purely legal issues, is often insufficient to identify pervasive ESG risks, which commonly extend into areas of reputation and stakeholder risk. Indeed, many of the large ESG failings globally over recent years have not involved breaches of black letter law but failures to comply with the law's spirit. These include instances where businesses failed to meet community expectations or manage reputational risk exposures. Buyers are therefore incorporating broader, forward-looking assessments of ESG risks, and looking beyond the target to consider the wider business, its supply chains and associated reputational concerns, into their due diligence processes.
While it is market norm for buyers to be conscious of ESG risk, those that follow international best practices actively consider ESG issues as part of comprehensive due diligence processes. This is in line with the requirements which will be imposed on larger companies under the EU's proposed Corporate Sustainability Due Diligence Directive and which are currently stipulated under domestic law such as the German Supply Chain Act (LkSG) or Corporate Duty of Vigilance Law. A comprehensive approach can help identify regulatory or litigation risk further down the road. Where risks are identified as part of the diligence process, acquirers may seek contractual protection, including specific ESG-focused warranties and indemnities. Such provisions must be drafted carefully to ensure a breach or trigger event can be identified and resulting losses demonstrated. Post-completion, companies should remain focused on ESG considerations. Any integration plan must address ESG risks, implement remedial efforts and develop compliance measures to ensure ESG risks that persist beyond completion do not snowball into live legal implications. Likewise, sellers may look to negotiate a 'responsible' exit to get assurance that the buyer will run the business with integrity. Sellers which adopt international best practices are employing vendor ESG due diligence to help identify issues, corresponding rectification actions and appropriate disclosures to mitigate liability. Other common measures include carrying out due diligence on prospective buyers to check they do not have a history of conducting operations in an irresponsible manner. We also continue to see enhanced post-completion undertakings being sought from buyers – however, careful consideration must be given to contractual obligations that involve an ongoing relationship with the buyer.
Even where ESG factors are not the driving force behind a deal, they are now commonly integrated into most transaction processes
At the initial proposal stage, conduct early reviews to identify any ESG-related 'fatal flaws'
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Specialist due diligence undertaken to assess material ESG risks and opportunities
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Where material risks are identified in due diligence, seek ESG-focused warranties and covenants in deal documents
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During the integration stage or asset management phase, address ESG due diligence findings
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At exit, sellers may consider a responsible exit approach by ensuring, to the extent possible, that good ESG practices remain in place following the sale
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ESG TRANSFORMATION iNSIGHTS
However, the uncertainty these factors (and the emergence from the pandemic) created led to greater investor/shareholder opposition to some of the M&A deals or deal terms proposed in 2022, illustrating again that intervention in M&A is no longer limited to formal activist campaigns pressuring companies to generate value by disposing of business units via spin-offs and carve-outs, or by engaging in change of control transactions. A number of deals saw investors making their views heard after announcement, either to encourage a sweetened offer or to argue that the deal should not be pursued. Such tactics are no longer limited to the traditional cast of activist shareholders – minority shareholders, even those who have long been supportive of the board, have found their voice and will not hesitate to publicly challenge a transaction and board's recommendation or put forward M&A proposals of their own. It is fair to say that there is no guarantee that minority shareholders will follow a board recommendation.
We saw a slowdown in deal activity in the second half of 2022 as the global markets felt the impact of the continuing conflict in Ukraine, the onset of macro-economic headwinds and more challenging debt markets. We also saw fewer of the more traditional activist M&A campaigns in 2022 as compared to recent years.
Boards should not assume that shareholders will follow their recommendations
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Philippa Stone
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Hubert Segain
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Caroline Rae
Schneider Electric's £9.5 billion offer for UK software developer Aveva, which was the largest UK deal of 2022, was met with strong opposition from Aveva's shareholders who voiced their disappointment that the board had recommended an "opportunistic bid" to investors. The French group, which already owned nearly 60% of Aveva, subsequently announced an increased final offer of just under £10 billion in an attempt to win over investors, which was approved by shareholders.
In May 2022, AGL Energy, an Australian listed company, terminated its demerger plans following lobbying by Mike Cannon-Brookes, the billionaire co-founder of Atlassian who became the largest single shareholder in AGL Energy with his purchase of 11.28% via Grok Ventures. Cannon-Brookes subsequently succeeded in his attempts to install four directors to the board at AGL Energy's AGM in November 2022. Retail investors in Hong Kong are lending support to a campaign for HSBC Holdings to spin off its Asia operations put forward by one of its largest shareholders, Ping An Insurance Group. HSBC management held an informal meeting of Hong Kong shareholders in August 2022 seeking to engage with investors and set out the board's objectives. In France, the government is looking to buy out the 16% of Electricité de France (EDF) that it does not already own. EDF minority shareholders are forcefully challenging the proposed transaction. The €12 share price offered is much lower than the €32 per share of EDF's IPO in 2005. After a vain attempt to challenge the EDF board decision which issued the reasoned opinion (avis motivé) recommending the public tender offer to the shareholders and bondholders, a group of shareholders has filed another claim before the Paris Court of Appeal to challenge the French Financial Market Authority (AMF)'s decision to approve the public tender offer. Consequently, on 7 December 2022, the AMF extended the offer (which initially should have closed on 22 December 2022) pending the Paris Court of Appeal's decision, which is required to be given within five months.
Capricorn Energy abandoned its proposed £1.4 billion all-share merger with Africa-focused Tullow Oil following strong public opposition from over one-third of its shareholders with large investors calling for a strategic review of the business. In response, Capricorn announced a proposed combination with Israel's NewMed Energy LP, to create one of the largest independent upstream energy producers listed in London. At the time of writing, that combination is also facing mounting opposition from shareholders, including Palliser Capital who believe the deal undervalues Capricorn and has requisitioned a shareholder meeting seeking changes to the Capricorn board of directors.
Dealmakers may be facing the most challenging environment for M&A since the financial crisis of 2008/2009. Minority shareholders are well aware that these volatile conditions may lead to opportunistic bids and are ready and willing to speak out and use the full spectrum of tools at their disposal to oppose deal terms or indeed the transaction as a whole.
Now, more than ever, it is critical that bidders and target boards have a proactive and effective strategy to convince shareholders of the merits of the transaction, not only to secure the requisite voting majority but also to avoid a public dressing down from shareholders
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Tommy Tong
Public M&A UK - The podcast series
SHAREHOLDER ACTIVISM INSIGHTS
2022 was a tale of two halves for M&A activity. The year started strongly before war, inflation, interest rate rises and political uncertainty slowed the relentless pace of dealmaking we saw from the middle of 2020 onwards. See our regional insights for further reviews of M&A activity in 2022 by jurisdiction. As we enter 2023, we see a number of themes continuing to impact and influence M&A transactions and their terms.
What are the main themes we are seeing in transactions and their terms?
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Malika Chandrasegaran
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Greg Mulley
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Düsseldorf
Christoph Nawroth
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Charles Steward
Over the last year, interest rates have increased dramatically across a number of key jurisdictions – central bank interest rates increased from 0.25% to 4.5% in the US, 0.25% to 3.5% in the UK and 0% to 2.5% in the Eurozone, in each case the highest they have been in more than a decade. A more challenging financing environment means that in 2023 we expect to see buyers, in particular private equity sponsors, being more selective and needing to put more equity into deals. This may see valuations adjust as lower leverage and higher cost of financing make internal rate of return targets more challenging to achieve.
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BACK HOME
With the increasing dominance of private equity buyers in the M&A market, 2022 saw a noticeable shift in deal terms that affected all participants in the market in certain situations. Private equity sponsors, particularly in competitive auction processes, were increasingly willing to rely on their due diligence and seek less protection from sellers to make their bids more attractive. This has led to sellers demanding fully 'no recourse' terms and pushing to delete warranties that have traditionally been accepted by sellers. This shift made life difficult for strategic buyers, particularly listed companies, who wanted to participate in auction processes but may have a more risk averse approach to M&A. As we move into 2023, a more difficult M&A market may reverse this trend.
The Covid-19 pandemic and government actions to mitigate it led to buyers needing to take a hard look at their gap covenants during 2020, and they came under further scrutiny during 2021 and 2022 as enforcement actions for 'gun-jumping' appeared to be a priority for the European Commission. A number of the trends highlighted in this report point to gap covenants continuing to be a focus for both buyers and sellers: lengthening timelines between signing and closing due to increased regulatory, FDI and antitrust scrutiny; reputational concerns around ESG matters; and the need for targets to protect their businesses in a volatile geopolitical environment. As with other deal terms, the competitive M&A landscape has left buyers often needing to accept less protection on gap covenants than they would wish for. If buyers find themselves with increased bargaining power over the coming year, it is likely they will capitalise on that by asking for terms that give them increased confidence in the operation of the target business between signing and completion. In addition to more granular covenants, buyers may look for greater rights of consultation and involvement in decision-making with respect to the target business, but with no voting control or board voting rights to ensure they stay on the right side of antitrust authorities.
Inevitably in any downturn marginal businesses will be vulnerable to the combination of a slowdown in consumer spending and higher borrowing costs. We saw some high-profile insolvencies in the second half of 2022 and we expect that trend to continue in 2023. These situations present opportunities for well-funded buyers to capitalise on the availability of businesses that may be fundamentally good in the long–term at significantly reduced valuations. With private equity funds, special purpose acquisition companies (SPACs) and certain strategic buyers still flush with cash, we expect them to look to deploy this by taking advantage of distressed or special situations, whether by participating in full acquisitions or providing more creative funding solutions to distressed businesses.
Even with multiple US, and a more limited number of European, SPACs looking for targets, 2022 was nevertheless a challenging year to complete de-SPAC transactions following the boom of 2021. Fewer than half the number of de-SPAC transactions that were announced in 2022 were completed. Market conditions and other developments affected this trend, most notably: post de-SPAC performance for many deals that did get done; the difficulty in finding funding through the private investment in public equity (PIPE) market, particularly to fund high levels of investor redemptions; the market impact of proposed regulatory reform in the US; and a general re-examination of the de-SPAC product as a route to the public markets in light of all of the above and the perceived costs of sponsor participation. Notwithstanding this, we expect de-SPACs to continue to complete in 2023 albeit in diminished numbers, especially since so many SPACs have approaching deadlines to deploy their capital. Transaction structuring in the expected ongoing absence of a robust PIPE market will be paramount, with high levels of investor redemptions expected to continue, particularly in the US.
