Supply bottlenecks, rising demand as markets adjust from previous COVID-19 pandemic levels, and the recent increase in energy and food prices have put upward pressure on inflation worldwide. In Europe, the annual inflation rate was 10.1% as of November 2022. In response, the European Central Bank (“ECB”) raised short-term interest rates by 50 basis points on 15 December 2022: part of a series of interest rate increases during FY22 that amounted to 250 bps. The ECB expects to keep increasing interest rates to achieve the target inflation rate of 2%. Given that core inflation continued to rise to 5.2% in December 2022, the ECB’s guidance as of its mid-December meeting became more restrictive, and further interest rate increases may follow, according to Governor Lagarde.
Increasing interest rates have an impact on the economy at large (decreasing aggregate demand and slowing overall economic performance), but in addition to this, higher borrowing costs directly impact companies’ cash flows, either by increasing interest payments or lowering free cash flow.
Observed impact on M&A
In 2022 equity markets fell and yields on bonds rose as a direct result of the measures taken by central banks. This affected, amongst others, the following: Capital structure (mix of debt/equity used to finance transactions). In the current environment of decreasing liquidity and capital market turmoil, the debt/equity mix has taken even more relevance since capital has become so expensive. Cash flows The impact on net cash flows is driven by lower sales and increased inventories, as well as the growth in interest payments and more challenging scenarios to finance capital expenditure. Valuation The increased cost of capital creates the conditions for overall low multiples (Price-earnings, price-operating cash flows, Enterprise Value-EBITDA, are amongst those frequently used) which can incentivize sell-side participants to either defer or postpone divestment plans, or to accept lower valuations. Distressed M&A/Restructuring Decreased government support (COVID relief, stimulus funding, etc.), increased borrowing costs, difficulties to roll-over or to acquire loans and more pressure on companies’ cash flows (particularly for companies with weak balance sheets), will lead to an increase in M&A for companies in financial distress. In fact, according to a survey of 300 turnaround experts, 44% of them believe that M&A transactions involving distressed assets will drive their M&A activity.These effects will set the environment for M&A dealmaking for 2023. On one hand, there are industries that are more resilient to these conditions, such as defensive industries (e.g. healthcare), as well as industries that benefited from these conditions, like energy companies did from the energy supply shortfall; on the other hand, there are companies that are more sensitive to these impacts, particularly cyclical industries, as well as companies in financial distress.
Buy-side and sell side considerations
Buyers should find the optimal capital structure to finance their potential acquisitions, optimize operating cash flows (e.g., by raising prices, cutting costs, optimizing working capital, etc.) and seek attractive valuations that would enable them to materialize synergies.Sellers will take a closer look at their financial position and think about restructuring or optimizing their capital mix, take a deeper look at the main drivers behind their cash flow trends (capital intensive businesses, businesses that require high levels of working capital, highly cyclical companies, etc.) and assess whether value can be created under the current business model or, alternatively, if it would require a redesign.
Strategic vs. PE participants
Despite rising interest rates, year-over-year LBO issuance in Europe increased by 52% as of September 2022 (from €40.3bn to €61.1bn). Considering that the high interest rate environment is expected to hold in 2023, along with increasing default rates that derive from the pressure (e.g. highly leveraged companies), refinancing of Leveraged Buyouts will become a challenging task for Private Equity funds.Private Equity funds and other institutional investors have a single objective: achieving returns on invested capital. Investors are significantly dependent on the economic conditions at the time they expect to deploy capital or exit from companies in their current portfolio.M&A players consider private equity buyouts, corporations that have a strong financial position, and undervalued targets as the greatest buy-side drivers of M&A activity in Europe over the next 12 months. These participants are likely to be looking for opportunities to deploy capital, particularly in industries that are more resilient to inflation and distressed companies.
Why robust and tailored due diligence remains key
Given the current economic environment, due diligence will be required not only in its most traditional sense, but also in a more holistic one – by using it to obtain a thorough understanding of the target’s current and projected performance:
Current and forecasted performance – Financial due diligence should reveal the impact of current economic trends in the historical and projected performance (e.g., exposure and impact of inflation on sales and cost structure, exposure to foreign currencies, etc.)
Holistic approach – the scope of analysis under Financial Due diligence should be performed considering a holistic view on operational, financial and economic factors:
- Leverage ratios and restructuring scenarios (breaches of contract, bankruptcies, etc.)
- Fluctuations of foreign exchange rates, particularly on targets with international exposure
- Expected performance and landing analysis (estimated performance from year-to-date to the end of the current financial year), impact of supply chain bottlenecks on the cost structure and the value chain, and any other relevant topics.
John F. Kennedy once said that ‘When writing in Chinese, the word crisis is composed of two characters – one represents danger, and the other represents opportunity’. Adapting to negative market forces could give a competitive advantage to organizations which are able to demonstrate vision and agility. These turbulent times can be a good opportunity for boards to determine new mid-term strategies, including M&A, to accelerate business model transformations, but deep due diligence processes will be paramount to selecting the best strategic options.