M&A in 2023: A time of opportunity
It is generally understood that confidence underpins M&A activity. Facing into current macroeconomic turbulence in the context of persistently high inflation, all while navigating the aftermath of a handful of extreme climate events and a general election on the horizon, business confidence appears to have well and truly dissipated. As confidence plummets, you would be forgiven for assuming that M&A activity will plummet with it. Not so.
Real leaders are forged in a crisis and times of challenge can be transformational. So, while the current environment may force some corporates and private equity funds to divest assets or businesses, prospective buyers gain the chance to make smart acquisitions. For sophisticated buyers with an eye for strategic gains, transforming enterprises and a healthy appetite for calculated risk, the ground has never been more fertile. Corporates with robust balance sheets and 50/50 vision will see subdued business confidence for what it really is – a window of opportunity to use M&A to strengthen in targeted growth areas. Contrary to industry depression, M&A deal makers could well be feeling cautiously optimistic.
As recently observed by PwC in their report on Global M&A Industry Trends for 2023, "now is not the time to fall out of love with M&A". We're picking 2023 to be a year of managing inflationary and pricing challenges; a year of some distressed M&A activity and a year of strategic takeovers. We expect to see those with access to capital and healthy reserves to look at refining their M&A strategy and position themselves to capitalise on appetising targets.
Admittedly it’s a turbulent market. Ultimately, however, our pick is that 2023 will be a year of more resilience in M&A than you might think.
We explore below some strategic considerations, alternative structures and shifting norms around key provisions that are likely to feature in M&A activity in 2023 and beyond.
Evolving due diligence
Due diligence will continue to evolve as buyers zero in on the security and resilience of a target's supply chain and customer contracts. We expect to see a renewed focus on change of control consents in particular. In recent years an obligation to obtain formal third-party consent to a target's change of control may not have given rise to too much concern. In this inflationary environment, however, attitudes may shift. Contract counterparties might look at leveraging consent requests to re-price or otherwise improve terms.
Where time is of the essence, as with most distressed deals and accelerated M&A, the US and Europe have already seen that the use of legal technology can and will help dealmakers achieve compressed timeframes. The use of A.I. in document review is on the upswing and it's only a matter of time before it reaches AsiaPac. Where there is amplified risk, we can expect the use of technology to counter it.
ESG's rise to prominence
As one of the most critical developments to face mankind since the industrial revolution, ESG will continue to gain momentum. Climate change, biodiversity and sustainability will come to be recognised as an economic issue as much as a moral imperative, so be prepared. If they haven't already, sophisticated buyers will start taking a deep dive into the maturity of a target's ESG journey and the impact its operations have on the environment. Emissions controls and an increase in reporting obligations will play a part, which in turn will become directly connected with an organisation's ability to finance, social licence to operate and its ability to attract (and retain) talent. To satisfy this growing demand, DLA Piper has partnered with ESG risk-management platform Datamaran to offer an innovative integrated ESG due-diligence product that sits alongside and complements the traditional due diligence process.
In Europe, ESG is starting to be seen less through the lens of risks to be identified and mitigated and more of an opportunity to create value through the right acquisitions. Investors from a variety of pools of capital, in particular private equity and pension funds, are increasingly looking towards M&A as a means of improving their sustainability credentials and have already incorporated ESG-related metrics into their valuation models. This means that a solid ESG performance in the target company can be what seals the deal, as companies seek out a sustainability dividend as part of the transaction. A recently published global survey carried out by KPMG found that more than two-thirds of organisations would be willing to pay a premium for a target that demonstrates a high level of ESG maturity – almost one-in-five said they would pay a premium of 5 per cent or more and half were willing to pay between 1 per cent and 5 per cent.
A greater variety of deal structures
From a seller’s perspective, tax is one of the key reasons to adopt a share sale structure, but this is often much less of a factor in a distressed environment where valuations are subdued and gains are less likely. In this environment, a combination of distressed sales and buyers looking to carve out unwanted liabilities or cherry pick desirable assets will result in a greater number of asset purchases and pre-closing restructurings.
Price adjustments and deferred price structures
Completion accounts adjustment mechanisms are likely to retain their primacy in M&A deals given they enable buyers to correct short term trading impacts. We expect this to cause tension; completion accounts are rarely attractive to sellers in a distressed sale because of the inherent uncertainty in final consideration and the potential for disputes. Carefully crafted earn-out provisions and the use of escrow mechanisms will offer creative solutions to navigate risk (whether actual or perceived in the eyes of the buyer) and bridge valuation gaps in what will most certainly be a buyer-friendly environment.
Increasing conditionality & the return of the MACWhere there is a gap between signing and closing in a volatile market, we expect to see buyers seeking walk-away rights. Dealmakers can expect more buy-side demands for material adverse change (MAC) clauses, the terms of which will vary between them to capture or exclude macroeconomic and microeconomic events and/or breaches of certain warranties in the interim period between signing and closing.
Separately, the force and frequency of extreme weather events in New Zealand has emerged as a topical issue for negotiation. Transacting parties ought to pay closer attention than ever before to provisions dealing with insurances, purchase price reduction and cancellation rights.
Where a target in accelerated M&A is in serious financial distress, the likely state of competition in the factual of the successful acquisition may look very different from the counterfactual of continued ownership and operation by target. With this in mind, the Commerce Commission (ComCom) may be asked to clear an acquisition on the basis that it involves a target which is a "failing firm". The ComCom would need to be satisfied that, absent the acquisition, the relevant assets would leave the market. Compelling evidence will be needed to support such a clearance application. For this reason, these applications are uncommon. However, this is definitely one to watch.
Use of W&I to facilitate distressed deals
W&I underwriters have long touted the potential for W&I insurance to be used in distressed M&A transactions, including sales by receivers and managers. However, we haven't seen many examples of W&I insurance actually being used in those circumstances. Many underwriters are cautious of the material increased risks arising in distressed M&A, such as the likelihood of limited sell-side disclosure and the potentially accelerated due diligence process undertaken on the buy-side. We will be interested to see whether W&I insurance will start to gain momentum in distressed or insolvent M&A.
Cash is king
In a contracted market, cash is king. Certainty of financing will be a key feature in the M&A market in 2023. The reservoir of new debt finance will be somewhat depleted, and what's left will be earmarked for deals in those few sectors where there has been less impact on valuations and cashflow. The terms of new financings are expected to be much less flexible given market conditions with baskets likely to be substantially reduced and future acquisition lines heavily conditioned. The due diligence threshold for "bankability" will remain high and borrowers will need to be well prepared. That said, with the recent transformation of New Zealand's lending market to include alternative financing providers, new deals will still be done, and capital refinanced, but it will remain tough. Borrowers will also need to consider hedging instruments to mitigate high interest rate risk.