Antony Walsh, Robin Johnson and Hannah Kaye discuss factors influencing
M&A activity in 2021 reached record highs after being briefly depressed as a result of the pandemic and, in 2022, we have seen continued high levels of activity, albeit with signs of some softening as a result of inflation and sadly the Ukraine conflict. Deals have not been aborting, rather processes are taking longer as the impact of inflation is diligenced. Whilst some of the key trends currently driving the M&A landscape may be predictable, for example deglobalisation of supply chains; push for technology; thirst for talent, others may not be what we would have expected 12 months ago such as the rapid exit from Russia; the highest sustained inflation for a decade, primarily due to the pick up of the economy after the pandemic. We expect these trends to continue to be drivers of the M&A landscape during 2022 with a subdued first half hopefully leading to a more positive second half and outlook for 2023 and 2024.
Supply chain security and optimisation
In recent times, the impact of the Covid-19 pandemic, the Brexit transition period coming to an end and, most recently, the conflict in Ukraine and the associated disruption to certain markets have all demonstrated the fragility of supply chains, as the ‘just in time’ manufacturing process proved challenging. ‘Factories of the future’ have suffered as the lack of one component can stop a whole process. The internet of things and 4D printing is yet to fully replace older style manufacturing primarily due to the need for approvals in procurement processes and fear of product validity. As a result, despite the increased globalisation of their customer base, organisations have adjusted their practices, and are having to look to secure multiple local suppliers to minimise the risk that a localised crisis or issue may cause disruptions to their supply chain. ‘Deglobalisation’ is too simple a term, what we are seeing is more nuanced. Globalisation of customer base remains a high-priority (with only limited evidence that corporates are doubling-down on their home markets). Deglobalisation of supply chain, though, is real as companies seek multiple supply locations to minimise the potential for disruption.
The internet of things and 4D printing is yet to fully replace older style manufacturing primarily due to the need for approvals in procurement processes and fear of product validity.
Such uncertainty has translated into a driver of M&A activity, as organisations are using M&A as one way to secure their supply chains via vertical integration to take direct control of suppliers at different stages of the production
or distribution process.
Security of supply is set against a backdrop where it is increasingly important for global organisations to ensure that they have understood and assessed the risks inherent in their global supply chains, to ensure that the organisation is not inadvertently supporting human rights abuses, forced labor or bribery and corruption in the supply chain. During the pandemic there had been a move towards third party review and accreditation of factory status permits and compliance. There has, however, been a dramatic reversal here in the last few months as the world has started to open up again with an insistence from, certainly global multinationals, doing their own factory reviews. Anecdotally, it would appear that some compliance issues have slipped during the pandemic. There does appear to be some discrepancy in approach between organisations that need to report ESG findings against those that don’t have the need for public reporting. The EU is moving to legislate in this area, and this will impact UK companies that access the EU single market. In acquisitions of this nature, it is therefore key that companies undertake full legal and commercial due diligence on the relevant distributor or producer and obtain appropriate contractual protections, in order to minimise the financial and reputational risks that can be incurred as a result of problems in the supply chain being brought closer to home.
Valuations: the impact of inflation
The impact of inflation in the wider economy is leaving businesses in all sectors grappling with increasing costs. This is particularly the case for manufacturing and retail businesses that incur high energy costs and those with high transportation costs. Automotive original equipment manufacturers (OEMs), for example, are suffering a second blow, only just recovering from the semi-conductor shortage they are straight into sharp rises in energy and shipping costs.
Deals are not necessarily aborting due to rising inflation, rather those deals are taking longer to sign as the diligence burden increases. Buyers are finding that certain financial information set out in the information memorandum provided by the seller may not stand up to scrutiny in the light of rising costs. Such variances can add uncertainty to the valuation process and may ultimately depress the purchase price that buyers are willing to pay. Simply put, if deals are valued on an earnings before interest, taxes, depreciation, and amortisation (EBITDA) multiple basis and costs are rising at pace, how sure can a buyer be that the forecast EBITDA is going to survive the next 12 months, let alone the next few years? EBITDA multiples are predicated on a buyer recouping its investment over time and that fundamental may not be possible if inflation is eating into net earnings, particularly in sectors which are susceptible to the impact of price-rises on consumers.
Deals are also taking longer to close though, anecdotally, such delays are for other reasons such as increased anti-trust scrutiny and the impact of foreign direct investment regimes (discussed later in this article). That said, inflationary fears are causing buyers to scrutinise termination rights because a multiple month gap in an environment of rapid inflation may materially impact the target business.
Talent: the people factor
It is recognised that there is a global shortage of talent, with many businesses struggling to find the right people in the right location. Historically, global businesses relied on senior management to travel on a regular basis. Travel restrictions during the pandemic brought this to an end. This resulted in greater reliance being placed on local management teams, which has led to gaps in talent emerging.
Arguably the biggest impact of the pandemic, in terms of workforce at least, is the global nature of recruitment. Anyone, anywhere in the world can now work for any company which has embraced remote working. We are seeing a fight for talent with companies being squeezed on pay for fear of risking losing key employees who can now be poached by any organisation in the world – no-one needs to move cities or even continents now to take on a more lucrative role, they simply log-in to a different portal.
It is recognised that there is a global shortage of talent, with many businesses struggling to find the right people in the right location.
Such hunger for talent has led to companies using M&A as a way of resolving staffing issues in a way that is similar to securing the supply chain. We are seeing, for example, that organisations looking to establish a local supply base for a particular geographical area may choose to do this via acquisition where it would be difficult to set up their own establishment and recruit in the particular location. Companies are also using acquisitions as a route to fill talent gaps at a more strategic and senior level. We are seeing deals being done whereby, relatively speaking, the buyer does not truly care about the fundamentals of the underlying business. Rather, what they are buying into is a successful management team who, on the buyer’s platform, will be able to add further value.
Some locations which had seemed to be attractive from a cost point of view pre pandemic have now the most acute labour shortages. Even outside of the M&A process a number of multinationals are having to revisit their own internal retention policies. Retention and sign on arrangements
are becoming equally important in deals as historic option structures.
Regulatory scrutiny and foreign direct investment
The regulatory environment for M&A is increasing in many jurisdictions. In recent years, jurisdictions worldwide have introduced new foreign direct investment (FDI) screening regimes or expanded existing regimes to enable governmental control of inbound investments into certain sectors. In some jurisdictions, this has been driven by an increased desire to protect domestic assets from what has been seen as opportunistic foreign acquisitions. However, security of the supply chain is also a relevant factor. These foreign investment regimes no longer focus solely on the military and defence sectors, impacting for example the wider TMT (technology, media and telecoms) sector. Governments and corporations alike were exposed by the pandemic as it became clear that the world’s supply of PPE, for example, was manufactured in China. Similarly, many countries lacked the ability to quickly manufacture vaccines. Governments are keen to close such gaps and are utilising their regulatory powers to make their influence felt.
In the UK, by way of example, the new national security and investment (NSI) screening regime came into force in January 2022. This means that a wide range of transactions will be required to make a mandatory notification and obtain clearance before the deal can close. Similarly, the EU also has introduced a new EU-wide regime that encourages cooperation between EU countries and the European Commission in relation to foreign investment screening. Twenty-four of the 27 EU countries have or are in the process of implementing such regimes. We have already seen the French government make use of their powers to prevent certain deals closing.
We are also seeing competition regulators across the globe heavily scrutinising deals involving potential competitors. This is particularly true in the technology sector. We have also seen significant investigations in retail and energy.
It is early days so far to determine whether these regimes will dampen interest in M&A in relevant sectors. However, the new UK FDI screening regime has resulted in an increased regulatory burden for businesses and could impact their M&A processes, as a filing would extend the deal timeline and would introduce the additional complexity inherent in a split exchange and completion. It is wrong however to simply see FDI as a new UK shiny toy. FDI regimes need to be looked at now across all jurisdictions and a clearance of FDI in one jurisdiction does not necessarily mean a clearance in another. Unlike anti-trust where you could go to Brussels for an EU filing, this is not the case with FDI. Failure to abide by the new rules could also lead to significant penalties. Given that the UK regime can also apply to transactions completed since 12 November 2020, we are seeing that historic acquisitions undertaken by the target that may be affected also need to be diligenced. Organisations will need to have regard to both competition and FDI regulators in relation to pre-closing conditions in SPAs, and how the parties share these risks will have to be agreed.
Arguably a number of the above key M&A trends are most acutely felt in the TMT sector. TMT deals set a high-bar in that pricing for such transactions has been soaring for many years and TMT was one of the few sectors largely unaffected by the pandemic (and, if anything, multiples increased post March 2020 as the need for technology in a home-working enabled environment became clear).
The new UK FDI screening regime has resulted in an increased regulatory burden for businesses and could impact their M&A processes, as a filing would extend the deal timeline and would introduce the additional complexity inherent in a split exchange and completion.
Tech deals have again been fuelled by many of the identified key M&A trends. Certainly the industrial supply chain push has led to a desire for smart supply chains and therefore utilising the latest technology to maximise efficiency. Similarly the large macro trends of ESG and the move away from fossil fuels (due to environmental and inflation concerns) is benefiting the TMT sector because suddenly every company is a tech company, even 100 year old automotive OEMs are tech companies as they push their electric vehicle agendas. All of these factors add fuel to the flames of TMT business valuations.
TMT is also at the sharp-end of the fight for talent. Valuations in this sector continue to be supported by the intangible benefit to the acquirer of scooping-up a dynamic new team. On the flip-side, TMT sector businesses are feeling the pinch in terms of wage inflation, particularly because many of their teams can work fully remotely and therefore anywhere in the world such that all technology businesses are now competing with the West Coast for talent and pay. We are not seeing such wage inflation impact valuations which suggests that, one way or another, such increased costs are being passed on.
One head-wind that is impacting the TMT sector is government oversight through FDI regimes as noted above. Cyber security is paramount and governments have been guilty in the past of not protecting national interests
through protecting their prized technology assets against overseas acquirers.
2022 is likely to be a game of two-halves. The fundamentals of the economy remain strong (with individuals, corporates and private equity and similar institutions sitting on record levels of savings and cash). Up until the end of quarter four of 2021 M&A was seen as a key driver for growth amongst boards. While there is now more caution we believe that the need for the financial sponsors to drive deals will inevitably result in significant deal activity in 2022. However, we also believe there are some lessons to be learnt in terms of the new style due diligence which needs to be carried out in areas like trade, supply contracts, ESG, regulatory compliance and talent identification. The inflationary head-wind is here now and will be present through much of the year but one assumes that, by H2, such costs will have been priced-in such that deal flow will ease. Certainly that is our sense talking to clients and intermediaries, namely that interest in M&A is piqued again after a quiet Q1.