With inflation at a 40-year high, interest rates climbing, and the geo-political environment denting confidence, what impact is this having on the UK M&A market and the way deals are being structured? Our latest ‘5 minutes with Corporate Finance’ article explores how the current economic climate is affecting dealmaking.
2021 proved to be a record-breaking year for M&A activity in the UK, with a surge in deal-making reported during the second half of the year. Although the early months of 2022 showed signs of further economic recovery, the effects of our unstable macroeconomic and geopolitical environment are now becoming increasingly apparent.
The current environment
Before looking at the impact on deal-making, it is worth reviewing what has caused the climate in which deals are now being done. Perhaps the biggest change was caused by the global supply chain issues that developed during the COVID-19 pandemic, and which continue in its aftermath. Suppliers of products such as construction materials, some minerals and processor chips are struggling to keep up with rising levels of demand.
Just as these issues were beginning to get resolved, the issue became much more acute due to the Russian-Ukrainian war. The conflict has caused global disruption due to the Black Sea ports being blockaded and the West purposely diverting its demand away from Russian supplies on moral grounds. Russia is a leading exporter of some of the world’s most important commodities including gas, coal and crude oil for diesel. In addition, the Ukraine and Russia together account for a large proportion of the global supply of fertilisers and basic foodstuffs such as wheat, sunflower oil and barley.
All of this has caused shortages in supply, which fuels higher inflation and, in response, rising interest rates. The shortages have also resulted in reduced international trade, dented confidence and stock markets, and the risk of global food shortages – particularly in less developed parts of the World.
Uncertainty, never a helpful factor in business, has returned and some of the impacts on deal-making follow.
Deal volume has lowered in some parts of the market
Hesitancy, or at least heightened caution, among deal makers is increasingly evident; unsurprisingly, this is the result of economic uncertainty making deal makers and funders more reluctant to take risks. This risk aversion resulted in lower deal volumes during the first quarter of 2022, most notably in the higher value category.
However, the impact is size and sector dependant and we are pleased to report that buyer hesitancy does not appear to have reduced the appetite for M&A activity within our SME marketplace – there has been no reduction in enquiries or in the PKFSC corporate finance team’s pipeline of transactions.
More frequent use of earn-outs
As buyers look to reduce the risk surrounding acquisitions, we have witnessed an increase in the use of some form of earn-out in deal structures. Earn-outs involve deferring payment of part of the consideration, and making the deferred element contingent on continued performance. So, the buyer pays a partial sum at completion and is only liable to pay more if the target’s performance remains strong.
Increasingly tough due diligence
More stringent due diligence was on trend long before the current environment developed, but quite understandably the level of detail has increased still further, especially in regard to future performance. Future performance is affected by customer demand, supply-side inflation, interest rates and other factors. Funders and buyers are being increasingly rigorous when checking the robustness of a target by looking at ‘what if’ scenarios, ‘sensitising’ forecasts to show the outcome of a number of pessimistic assumptions.
In our recent experience, a few areas that have attracted more scrutiny from buyers and their funders are:
- Customers’ price elasticity – product prices have to rise in most cases, so buyers and funders favour products that consumers will continue to need despite shrinking buying power.
- Supply chain – as already referenced, many industries are experiencing severe supply chain issues and cost inflation, so it’s important to evaluate the resilience of a business’ supply chains, and the availability of alternative sources of supply.
- Utility contracts – power costs can be a significant cost element in many businesses. The end of the Ukraine situation, which is pushing inflation, is uncertain so buyers need to look closely at the utility contracts. We have seen some cases where fixed price contracts have expired and costs have doubled or more overnight.
Careful examination of the sustainable profit assumed for bidding
Determining the sustainable profit on which to value a business is far less easy than it used to be. For many, lower profitability looks ‘baked-in’ for the foreseeable future but that’s not always the case; some businesses have opted to delay price rises to customers, for fear that customers will seek out cheaper rates from competitors, or that a price rise will lower transaction volumes. This has markedly reduced the current profitability to a level which, potentially, may not endure.
In a few cases in strong sectors, where it is known that price rises will definitely be implemented later with minimal risk of diminished volumes, we have seen ‘sustainable profit’ adjusted upwards to reflect that the target business’ current profits are not representative of the medium-term level of profit. In effect, those businesses have been valued on the basis of the higher profit that is expected to be delivered when the current ‘perfect storm’ of headwinds passes and the economy has become more stable.
Sector valuation variance
The current environment has, as always, created some winners and some losers. To some extent it is dependent on how much the current global issues affect a particular sector. It’s hard to generalise but, at a macro-level, it’s clear that the ‘overheated’ somewhat speculative stock market valuations of businesses in hi-tech sector are out of favour and have reduced dramatically. Whilst these so called ‘growth stocks’ (characteristic of the US markets) have fallen, so-called ‘value stocks’ (more typical of the UK London Stock Exchange) have increased in value; this is because, despite being more staid, they are underpinned by more robust assets. ‘Value stocks’ include companies in mining, banks and natural resources.
What does this mean for deal-making in the UK?
If we look at the UK as a whole, deal volumes are down and caution is raised. However, the detail is more complex and the effects of the current environment vary widely according to deal size and sector.
Within our marketplace, we had a record year up to March 2022 and continue to experience very strong current M&A activity levels, with no reduction in our pipeline of transactions.
Whilst the current economic climate may not seem conducive to lucrative deal-making at the outset, we believe there are opportunities to be taken advantage of – but the need for support and guidance from expert corporate finance advisors has never been more important in getting it right. We can help you navigate the market and take advantage of opportunities.
If you would like to arrange an initial consultation with one of our team, please get in touch with us today. Subscribe to our insights to receive future articles directly to your inbox.
