With (pandemic) heyday levels well behind, deal making activity and volume have continued to slow down in Q1 2023 under the pressure of macroeconomic factors and “everything everywhere all at once” uncertainty.
The M&A market – currently shaped by increased caution on both sell and buy sides and difficult access to traditional financing – is making way to distressed buyout and private credit opportunities. Deal-structuring features which prevailed during the cheap money era are also challenged by changing market conditions and (slightly) more purchaser-friendly deal dynamics.
1. More distressed deals
Rising inflation, decreased consumer demand and increasing interest rates are barriers in the path to liquidity and viable refinancing options. The liquidity crunch is forcing assets, some of which have longer-term positive outlooks, to come to market.
While the access to effective enforcement tools (such as security over shares of a Luxembourg holding company via a double-Luxco structure) are key for deal tactics, transactions often change route mid-process to become consensual restructurings. Faced with the threat of enforcement of security, borrowers are often getting on board with a less confrontational handover of keys to the business in order to mitigate reputational risk and transaction costs, as well as potential loss of business in an enforcement process.
Against this backdrop and a typically tense transaction dynamic, distressed deals are executed on very short timelines, with the acquirer having the benefit of very limited representations & warranties and related protections.
Board liability is also a hot topic and portfolio company managers are advised to carefully consider the duties towards the company in a distressed scenario, including their potential obligations to file (though not prematurely) for bankruptcy in Luxembourg in circumstances where the company has ceased payments and lost its creditworthiness.
2. Finding a bright spot in mid-market deals
As purchasers approach deal-making with more prudence and tightening credit conditions require higher percentages in terms of equity allocations, the appetite for big-ticket exposures seems to be dropping. As a result, pent-up dry powder is finding an escape valve in smaller-size deals.
Smaller does not, however, mean less deal complexity. It may be particularly tricky to get to “yes” in transactions involving growth-stage or founder-owned companies, particularly in terms of structure and governance rights.
On the other hand, joint ventures, minority investments and club deals emerge as alternatives for expensive acquisition finance. As sponsors feel the heat of constricted market conditions which may evolve in higher investor scrutiny and intensify dispute activity, there is noticeably increased attention on investment terms from involved deal teams.
As an overall result, outside of a distressed deal scenario the path to deal closing is bumpier, negotiations are lengthier and deal terms are under enhanced scrutiny from involved deal teams.
3. Bridging the gap between seller and buyer expectations
The disparity between vendor and buyer valuation expectations is still preventing a number of assets to come to market and keeping buyers cautious and on the lookout for potential mark-to-market adjustments. Notwithstanding this, parties that are willing to get creative can explore various tools to bridge the gap and close the deal.
After having lost in the popularity contest during recent years, earn-out mechanisms are making a comeback as a tool to align the interests of the buyer and seller and bridge any gaps in the different expectations with respect to the business' potential.
Earn-outs, being contractual arrangements whereby the buyer will agree to pay the seller an additional price based on financial or non-financial metrics achieved by the company over a specific period of time post acquisition, carry inherent risk. Parties should be aware that earn-out clauses can be the source of legal disputes, necessitating careful negotiation and drafting to ensure terms are plain and enforceable. In addition, they require ongoing monitoring and reporting to ensure that the company's performance goals are met and that any earn-out payments are calculated and paid accurately.
Against the backdrop of a decline in traditional acquisition financing, vendor financing is sometimes explored as an alternative to get buyers comfortable with a higher acquisition price. The structure of vendor financing can take the form of a simple deferred or contingent purchase price payment, or more frequently, vendor loan notes issued by the buyer to the seller. Typically, these loan notes will be subordinated to the senior debt but will have a reduced interest rate compared to mezzanine debt.
Minority acquisitions are also seen as an attractive tool for buyers to get a footprint in the business, which can be expanded with support from appropriate call option agreements allowing the buyer to acquire the remaining shares at a price calculated in accordance with pre-agreed principles. Despite not acquiring a controlling stake in the business, the buyer will often ask for enhanced contractual protections in terms of veto right on reserved matters, board nomination rights and information rights. Such minority acquisitions are often an effective tool to ensure the portability of (existing, lite-covenant and low-interest rate) debt and avoid the application of change of control provisions.
4. The rise of private credit
The growth of the private credit sector has accelerated during the past year following the retreat of the banks from the commercial lending market due to their difficulties to offload debt from the balance sheet. With opportunities to take up the place left vacant and LPs willing to continue (more conservative allocations) to private asset classes, private credit is now the sweet spot of private capital.
Borrowers also embrace the flexibility of the direct lending space - both in terms of deal structuring options and instruments made available by private credit providers (which cover a wide range varying from classic and pure debt instruments to ones with equity-like features or combinations thereof, such as preferred or redeemable shares or warrants).
While the buoyancy in the private credit market provides a much-sought after counterweight to the relatively negative outlook in the private equity space, hopes remain high that the direct lending activity will contribute to a reignition of M&A activity towards the last quarter of 2023. However, as the crystal ball does not - to the authors’ knowledge - exist in real world, it remains to be seen whether the hopes built up so far will be confirmed by movement in the market in the rest of the year 2023.