2022 was a year of two halves for M and A, 2023 looks to be similar and deal terms trends are following the same pattern
The first half of 2022 saw a continued boom in M&A, following a record year in 2021.
But the uncertainty and volatility caused by the polycrisis of the war in Ukraine, a hostile China still struggling with the Covid-19 pandemic, political instability in the UK and across the globe, inflation and interest rates spiralling, a cost-of-living crisis, public sector strikes, weak consumer demand, the climate emergency, recruitment and supply chain issues, regulatory constraints on foreign direct investments and digital businesses, and ultimately businesses "firefighting" these multiple issues simultaneously began to drag on dealmaking in the second half of the year, and debt financing for deals collapsed.
Global M&A fell a third year-on-year to December 2022 – a record percentage fall – and the UK followed this downward trajectory. However, 2022 remained one of the best years for M&A on record, despite there being no usual year end boost in activity, with private equity particularly losing momentum.
We have analysed a sample of M&A deals that Osborne Clarke UK's corporate team advised on in 2022 in this context and compared them to our analysis in previous years to identify recent M&A deal terms trends, and to predict deal characteristics and activity in 2023. (See our infographic on M&A deals advised on by Osborne Clarke.)
Deal values static
Deal values remained static with our sample of more than 50 deals in 2021 having an aggregate deal value of £1.9bn and our sample of 40-plus deals in 2022 having an aggregate deal value of £1.3bn, though a larger proportion in 2022 related to deals completed earlier in 2022 before the market contraction.
Cross-border work more challenging
2022 was a more challenging year for cross-border work, with the normally globally acquisitive US buyers impacted by increasing borrowing, Chinese overseas investment declining, confidence in UK and other foreign assets dented due to geopolitical and financial turmoil, and a focus on deglobalisation and domestic energy security.
43% of Osborne Clarke's deals were cross-border in 2022, down from 63% in 2021, but still remaining higher than previous years (30% in 2019 and 40% in 2020), as foreign acquirers with readily available cash took advantage of the weak British pound to acquire cheaply, and acquirers still view cross-border M&A the quickest route in to a local market.
Tech M&A the leading sector
Globally, tech M&A has been a strong sector for a number of years, and we saw an increase in the percentage of our deals in this category in 2022. Tech M&A accounted for 35% of our deals (30% in 2021). M&A of financial services targets also came to the fore.
The urgent need for businesses to digitalise or adopt technological solutions by acquiring relevant assets to keep pace with the changing world and competitors drives the strong performance of tech M&A. In 2022, tech targets' valuations held up relatively well and there was a decent flow of start-ups for acquirers to approach. Private equity sponsors, which often favour tech businesses, were keen to spend some of their built-up "dry powder" in the sector.
'Locked box' back in fashion
There has been a slight uptick in the use of "locked box" mechanisms in transactions in 2022 from 35% to 38% of deals. In 2021 we had seen purchasers preferring the deeper dive of completion accounts amid the economic uncertainty of the pandemic. The reversal of this trend in 2022, to rely on the simpler locked box mechanism, reflects the improved confidence in financial data, at least in the first half of the year.
'Earn-outs' ever more popular
We continue to see the reliance on earn-outs to bridge valuation gaps; with a declining M&A market, purchasers are wary of over-paying, but some sellers' expectations are yet to adjust to the lower realistic valuations the downturn has brought.
In uncertain economic times, an earn-out can persuade a seller to sell, in the hope that their higher valuation is achieved. But it also gives a purchaser comfort at the outset that they are paying the right price for the market conditions and can hold back cash needed to cover increased costs, like debt servicing, unless and until the earn-out is achieved.
Earn-outs are also prevalent in the sale of tech and other new businesses, which may not benefit from years of tested financial data or revenue.
A quarter of our deals used earn-outs in 2022, a solid increase on a fifth in 2021.
With valuations and financial due diligence proving challenging, agreeing on appropriate metrics for any earn-out has been problematic.
Fewer escrow accounts
With law firms no longer holding escrow accounts, deal parties' only option is to engage a third party escrow agent. An agent's services come at a price, and for many clients this is a deterrent, particularly when finances are tight.
There has been a distinct decrease in escrows in our deals from 27% in 2021 (37% in 2020) to 21% in 2022. Fewer escrows may also have resulted from purchasers' improved confidence of sellers' ability to settle claims and reliance on alternatives, such as price holdbacks and warranty and indemnity insurance.
W&I cover back to normal market levels
In 2021, there was warranty and indemnity (W&I) insurance on nearly half of our deals. In 2022, 33% of deals involved W&I insurance. This is comparable to the percentage in 2020.
While we expect the trend favouring the use of W&I insurance to continue as the transaction insurance market continues to expand and mature, the decrease we have seen may be due to a lesser percentage of our private equity transactions (where W&I is heavily used) being included in our deal sample (private equity slowing in the second half of 2022), or a larger number of smaller deals, or those where W&I insurance is less often used (such as real estate or infrastructure) being included in the sample.
Access to W&I insurance, which with a booming M&A market in 2021 was difficult, eased in 2022.
Other trends include:
- Increase in conditional deals and asset deals: to accommodate notifications under the National Security and Investment Act or to come outside of the mandatory notification rules in the Act, and tough negotiations of material adverse change (MAC) clauses in light of political and economic uncertainty.
- Deeper due diligence: thorough due diligence (DD) back in vogue after being squeezed in the bull market and following some high-profile company failures cited to be due to lack of comprehensive investigations, and DD and warranty scope widening with increased focus on ESG (environmental, social and governance) matters, sanctions and export controls, cybersecurity and supply chains, and more scrutiny by W&I insurers.
- Longer deal timetables, more challenging negotiations: a longer initial period to "court" reluctant sellers unpersuaded as to the valuation of their business, more stop-start deals, price renegotiations and aborted transactions, where valuations are declining, diligence more rigorous, parties more wary of risks and financing harder to come by.
- More distressed deals: meaning limited warranties, and shorter timetables, and non-conventional W&I products, with higher premiums and narrower cover.
- Non-traditional financing sources: such as private debt and joint ventures.
- Limitations periods for claims shortening: during 2020 and 2021, these had lengthened to allow for claims to show up in volatile accounting figures.
- Increase in M&A disputes: more focus on liability terms.
- Complexity: transactions became increasingly complex.
See also our summarised deal trends in Europe in 2022.
Outlook for 2023
M&A in 2023 is expected to be subdued, with recession likely in the UK and possibly in the US, until the third quarter, when analysts expect the market to slowly recover.
The highs of 2021 and early 2022 are not expected to be replicated any time soon, as the polycrisis of 2022 looks set to continue for the foreseeable future.
Some sellers will hold fire until the market is less depressed or while they focus on internal business challenges. Some acquirers will also wait until the market bottoms out. This is likely to lead to a shortage of supply and demand of acquisition targets.
Opportunities in 2023 and predictions for deal terms
We anticipate that trends that arose as the market weakened in the latter half of 2022 will continue through 2023, and we expect completion accounts and longer limitation periods to be more common in 2023, though these trends may reverse as the market bounces back towards the latter end of the year and into 2024.
Despite the headwinds, many opportunities remain:
- Transformative M&A: to urgently address changes to the world of work and our lives more generally, including digitalisation and decarbonisation.
- Distressed sales: of businesses that struggle in the current economic climate. Timetables will be short, and warranties limited. We will see an increase in group reorganisations and carve-out transactions.
- Pent-up demand in private equity: of sponsors with plenty of "dry powder" which needs to be spent. We expect to see smaller non-leveraged PE deals with more scrutiny at investment committee. Sales and secondary transactions by sponsors and bolt-on programs (with streamlined processes) or complementary acquisitions will be popular, and structures to limit third party financing (for example, acquisitions of a minority interest, joint ventures with strategics, consortium acquisitions or other tie-ups with third parties).
- Domestic transactions: near-shoring, onshoring and establishment of in-house or local supply chains through acquisition.
- Keen individual sellers: manager-owner burnout following several years of out of the ordinary challenges, meaning many are preferring to sell out than rise to the next challenge, and pressure to sell in advance of changes to capital gains tax (the cut in the tax-free threshold and the tax-free allowance). Purchaser-friendly deals terms will likely follow, and accelerated timetables.
- Weak sterling: making UK targets attractive to overseas buyers.
- Cash-rich strategics: acquirers with readily available cash will take advantage of low valuations to enter into synergistic deals.
- Consolidation: in certain sectors (such as retail, leisure, wealth management), particularly those that are very fragmented or have struggled in the pandemic or with high energy costs or heavily impacted by the changing world.
- Sales to employee ownership structures: where sellers are keen to sell, but there is no obvious third party purchaser, and where the business wants to democratise and improve ESG credentials.
- Some valuations holding up: with less supply of potential targets, those willing to sell a quality asset may achieve a good price, despite the general M&A market, for lack of alternative targets, and be able to deal on seller-friendly terms and through more competitive sale processes.
- Disputes advice: a volatile climate often leads to more claims. With more earn-outs, or if the price adjustment trend reverses in favour of purchaser-friendly completion accounts to mitigate the risk of uncertain financial data, we anticipate an increase in disputes over calculations. W&I insurers will also see an increase in claims.
We predict the following sectors will see a strong M&A performance in 2023:
- Tech (particularly metaverse, Web3, cloud, fintech, telehealth, med and biotech, digital payments and digital assets, edtech, climate tech, tech-enabled services – for instance, HR and legal – and cybersecurity). For more about tech trends (including M&A in the sector), see our TMC Annual Review.
- Energy, renewables and infrastructure.
- Life sciences and healthcare.
- Mining and raw materials.
- ESG businesses, net zero businesses (such as recycling).
- Targets with longer term certain revenue streams, for example, infrastructure, professional fund or trust administration services.
M&A to rebound later this year
Notwithstanding the many obstacles, transactions will continue to be closed in the coming months, with the outlook improving after the summer, albeit more slowly, with increased scrutiny, more creative structures, non-traditional financing and on more purchaser-friendly terms.