Recessions are not just about poor economic growth, they are often accompanied by other characteristics such as widespread job losses, fewer available jobs, and more Government relief. Investors may baulk, but stocks tend to bounce back rapidly making recessions a good time to invest. With all the turmoil in the UK political arena due to Brexit, Covid-19 and the energy crisis caused by the Ukraine war, one might ask if now is the time to carry out Mergers and Acquisitions (M&A) in the UK. The answer is yes as a strategic M&A transaction creates synergy and economies of scale which offset margin pressure and create shareholder value growth where organic growth is non-existent. In terms of funding for M&A transactions there remains a lot of ‘dry powder’ amongst the investor community allocated to support such deals.
Research has revealed how important small and medium-sized enterprises are for the British economy as businesses that employ between one and 249 employees contribute more than £2 trillion in turnover and employ 44% of the British workforce. A few of these companies are tomorrow’s future corporates and with the right strategy, they represent exceptional investment opportunities, particularly with limited yields in public markets and property assets.
M&A is one of the few ways to create positive disruption and growth in stagnant markets – although in previous recessions and in the face of rampant inflation, trade buyers typically favour investment in technology over M&A as technology facilitates increased margins and productivity. This is also of key importance to anyone preparing their business for sale as technology is increasingly influencing price-earnings multiples achieved on sale values.
We expect taxes to remain high and cannot see how the tax breaks on Capital Gains Tax can stay as generous as they are. Some UK trade buyers will baton down the hatches, but the trends seen in the last quarter show that international deals are more than ready to pick up the slack – we have seen an increase of 35% in international bids on our M&A projects during the year. However, companies that keep cash when inflation is rampant will find themselves going into reverse, thereby demonstrating the need to change their business model via M&A to create a competitive advantage. It may seem prudent to sit on your hands, but after so many recessionary shocks, CEOs may consider that attack is better than defence. These are some of the deal trends we have seen during 2022:
- M&A activity in the first half of 2022 reset to pre-pandemic levels of approximately 25,000 deals.
- Private equity deals accounted for nearly 50% of M&A.
- 30% of all transactions were in the tech space.
- The next two largest sectors in M&A were real estate at 13% and industrials at 11%.
- Deal makers in the Americas have been the most active traders, delivering almost half of the global deal value (48% versus 52% for all of 2021).
- Europe, the Middle East, and Africa’s share are up slightly, 28% versus 26%, as is Asia–Pacific’s share, 24% versus 22%.
- The ESG (Environmental, Social and Governance) agenda is becoming one of the top management objectives for global businesses and is forecasted to drive deal activity going forward.
Cross Border Transactions
Recent deals in the last quarter of 2022 include Johnson Control’s purchase of Vindex Security Systems, Ares Management Corporation’s purchase of Bovingdons Catering and Oak View’s investment in Era Fire. The strength of the US dollar has been a driving force but also with multiples historically lower than in the US, the UK represents value for money. Indian and Scandinavian buyers also seem very focused and another recent Avondale deal saw The Vintage Cosmetics Company acquired by the Canadian Group, Upper Canada Soap. This shows that cross-border transactions are now firmly on the table, even below the £10m bar. The Harvard Business Review estimates that small acquisitions typically generate additional annual shareholder value of between 8.2% and 9.3% over several years, compared with the 4.4% average of the so-called “big-bet” deals.
The Valuation Counterbalances
Borrowing costs are going up as interest rates rise both to offset inflation and also as we seek to ease our economies of addictive quantitative easing, which effectively increases the money supply and creates the near zero-base rates we have seen. There is no doubt that borrowing costs are putting pressure on valuations, but as we saw in the 2008-2009 ‘crash’, some companies that may have been ideal acquisition targets withdrew from the market, thereby reducing the stock of quality assets to acquire. This, in turn, drives multiples up for the remaining stock and creates a counterbalance. Rather than a drop in valuations, we predict that the earn-out deal will start to become more prevalent and deal structures may soften.
Most private companies have a price-earnings valuation of typically between 4-15 depending on the size of the company and the quality of the earnings. A business with a robust, long-term business model and recovering earnings is in a stronger position as too many buyers chase too few quality acquisition opportunities. Conversely, weaker companies with poor balance sheets and damaged business models will provide value play opportunities to the strong acquirers – those with cash and a robust position. Economies of scale and consolidation become more important with recessionary winds, but inflation will also need to be built into the valuation models and the ROI.
Disclosure & Due Diligence
We are also seeing a trend in transactions where the buyers have not accepted responses to due diligence enquiries which are deemed to be ‘disclosed’, hence providing the seller protection under the warranties.
This creates more work and cost, as it involves repeating much of the due diligence responses as part of the disclosure exercise – but is not a deal breaker. However, as the disclosure letter is one of the last parts of the process, to suddenly find that much of what the seller thought had been done needs to be repeated can be frustrating, particularly when they are already under pressure trying to get a deal across the line with the backdrop of tight timescales. If this is understood from the outset, the process can be managed more efficiently.
Buyers will often outsource due diligence to multiple teams to deal with different aspects – legal, financial, commercial, HR, environmental, IT, IP, etc. These teams will review different parts of the data room created by the sellers in response to due diligence enquiries, as is relevant to their own field of expertise. If, for example, the sellers put some information about intellectual property in the data room, it may be in response to a commercial enquiry and hence in that section of the data room. The development of that IP may have a corresponding R&D tax relief claim. The sellers feel they have disclosed that however the tax team acting for the buyers has not reviewed the commercial section of the data room as they are concentrating on taxation, the commercial team who have reviewed the relevant section might not understand the significance of it, therefore the tax credit has not been reported back to the buyers. Hence, why buyers often want specific disclosure against warranties to avoid such things being missed rather than simply having the entire data room deemed to be disclosed against the warranties.
Bingo – Employee Ownership sales hit a full house
There are now 1,000 employee-owned businesses in the UK, an increase of circa 200 in 2022. Our recent completions of Benbow Joinery (80 employees) Carlton Bingo (240 employees) and Ice Roofing & Cladding Ltd (50 employees) all show the preference for these sales in the emerging mid-market. Vendor-led, Employee Ownership sales enable a very soft exit, often at higher values than can be achieved in a trade deal, particularly where revenue is not contracted. Add 0% tax and they can present a highly effective exit strategy. Many owners are realising they are not as complex as they seem, although the strategy to hand over to management is as important as the financial, legal and change of control aspects of these transactions and succession planning is vital. The prospect of Capital Gains Tax and dividend taxes increasing make Employee Ownership sales a highly effective way to lock value in today and transition over time rather than the more often and immediate ‘now what?’ that trade sales often leave shareholders with.
Although M&A activity slowed in the first half of 2022, it is now back to pre-pandemic levels. The recessionary factors will further slow activity on the big-ticket sales, but it is unlikely to have a great impact on volumes in the sub £50m space – but time will tell. Whilst business valuations are currently holding, they may fall back and we will most likely see more highly structured deals as the economic uncertainty continues.
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