Sponsored briefing: Financing growth in uncertain times

Chris Hastings, Ceri-Ann McGraa and Ian Tetsill discuss the current M&A market trends and the market predictions for the future

Introduction

At the end of 2022, few would have predicted that the Collins dictionary would name ‘permacrisis’ their word of the year. But in light of the pandemic, political instability, war, inflation, higher cost of living and climate change, it’s hard to argue with the choice.

Many commentators had predicted a strong M&A market in 2022, with economies returning to pre-pandemic levels, and borrowers anticipating that their lenders would freely deploy funds in support of growth. Sadly, those predictions didn’t hold true. Whilst 2022 M&A deal volumes were well ahead of 2019/2020, after a positive start, Q3/4 was much quieter than anticipated.
Early 2023 showed signs of recovery, supported by improved market conditions. As we write this piece at the start of May, we are reminded that only eight weeks ago there were a number of articles betting on a strong rebound in M&A and predicting that over 90% of the FTSE 250 would be making acquisitions in 2023. These predictions may yet come true, but recent events in relation to the banking sector have provided a stark reminder of the destabilising effect of inflation and interest rate increases, especially when combined with investor and shareholder nervousness.

In spite of such volatility and changing sentiment, we believe there are reasons to be positive, with opportunities for successful, organic or M&A fuelled growth.

M&A trends

M&A markets experienced a subdued 2022. Having said that, bolt on M&A activity remained steady and there have been and will be deals to be done, albeit cautiously and with more issues to grapple with than previously.

Whether approaching M&A during the remainder of 2023 from a cautious (bolt on) or bullish (new platform) approach, those evaluating acquisitions need to consider their approach to valuation, particularly given the heightened diligence and interrogation undertaken by funders. In particular, given the difficulties in normalising financial results (accounting for price rises and increases in cost base) there has been and is likely to continue to be a shift away from locked box pricing mechanisms, towards hybrid locked box or full completion accounts mechanisms. This inevitably has an impact on transaction timetables from a diligence perspective, in reviewing the underlying financials, and a documentation perspective to ensure appropriate metrics and accounting policies are clearly reflected and leave no room for subsequent dispute.

Earn outs and other contingent consideration mechanics have become increasingly popular as a means to hedge against valuation uncertainty, with earn out periods becoming longer to ensure stability of financial results. These mechanisms can also impact on transaction timetables, as earn out hurdles must be negotiated and appropriate vendor protections considered.

After surmounting the valuation hurdle, there are a number of increasingly popular financing options to be considered before turning to external lenders. At the most simplistic end of the spectrum, and in the right circumstances, investors are still willing to equity underwrite transactions where their funds can support the up-front commitment and where competitive bidding processes drive tight timetables. However, buyers must be mindful that their ability to refinance equity cheques may be less certain than previously.

Deferred consideration mechanisms are now a common feature of acquisitions, and whilst this does enable acquisition costs to be spread, vendors are understandably alive to creditworthiness concerns, leading to more discussions around security and parent company guarantees. Vendor loan structures are another option and can provide an attractive funding solution, both from an acquirer and vendor perspective, albeit vendors are increasingly seeking variable interest rates, governance rights, or even performance-based redemption conditions for such vendor loans.

In each case, these mechanisms will need to be factored into structuring discussions with external lenders, but it is those acquirers that are most creative in their approach to using pricing and financing tools effectively that are most likely to maximise the success of their M&A activities.

Financing themes

Despite recent events, banks and alternative capital providers are very much open for business. Unlike 2008, liquidity is relatively plentiful and credit is available, however, there is evidence of a change in approach. In the context of M&A and leveraged buy-outs, focus is on certainty of funding. Lender due diligence requirements are increasingly robust, vendors are seeking low levels of financing conditionality and/or investor credit support, and buyers are looking to secure deals with a financing package that is fit for purpose, whilst navigating a competitive market.

These dynamics mean that speed and certainty of execution are of the essence. This is not necessarily new, however increasingly transactions are being paused in order for diligence or credit committee processes to run their course. Historically sellers (and to some extent buyers) may have pushed harder to hit existing timetables rather than exercising, and embracing, a level of extra caution.

Lenders are undoubtedly setting the bar higher than previously. Question marks relating to sustainability of earnings have led to a ‘flight to quality’, with increased demand for lending into financial services, tech and healthcare sectors where earnings are viewed as resilient and/or recurring. Some of the less-favoured sectors: consumer, retail and lower value industrials, are finding it increasingly challenging to gain support at the levels required. Funding decisions are becoming more binary, with lenders deciding more quickly when a particular credit is not for them.

For resilient businesses, competition amongst lenders remains healthy. Given appetite to deploy capital, for the right deals lenders will be creative to offer solutions that work in the current interest rate environment – the return of ‘PIK toggles’ (an ability to capitalise a portion of interest payable, at a slight premium), for example. The quid pro quo for this greater flexibility is that some lenders are imposing additional requirements, such as the need for a robust hedging strategy.

In the current somewhat muted M&A environment, vendors are rightly choosing their moment to go to market, and want their advisors to implement a tight process that can move quickly. As such, deal preparation is paramount, to ensure that detailed questions and due diligence requests from funders can be swiftly and effectively dealt with. In order to avoid unexpected negative publicity for their clients, some debt advisors are taking to cautiously testing terms with preferred lenders before taking deals to market. Equally there are steps that vendors can take: in addition to vendor financing and deferred consideration options above, there has been a marked return of stapled funding solutions.

By contrast to the more volatile M&A market, refinancing has held up well, with borrowers dealing with forthcoming maturities increasingly early to flush out lender appetite and lock down their liquidity. The re-emergence of forward start facilities, allowing CFOs to hard-wire refinancing packages several months ahead of their existing maturities, is indicative of the times we are operating in. However, borrowers are increasingly likely to have to concede some of the more aggressive (pre-2022) documentation terms they may have grown accustomed to – only the strongest credits are likely to maintain loose single financial covenants with lots of headroom, and other more borrower-friendly provisions are increasingly being negotiated out of term sheets.

Looking forward

Market predictions are always challenging, and never more so than today, however, there is a sense optimism about M&A activities and strategies. Despite a challenging few months for fund-raising, investors and lenders generally have capital to deploy, and there is a recognition that the weaknesses that were exposed in the banking sector should not dampen the mood.

As is always the case, resilient businesses in certain sectors will remain preferred targets for acquisitions and/or financing, and those in more challenging sectors will face tougher times. However, there appears to be no shortage of versatility and creativity on display from market participants and the additional layer of caution and diligence should be positively embraced by those who wish to remain highly active this year.

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