2021 saw record levels of M&A globally. So can we expect more of the same in 2022? 

While there are some grounds for caution – not least inflationary pressures and ongoing geopolitical tensions – there are also many reasons to expect another active (even if not another record) year.  Among the drivers for M&A in 2021 was the need for corporates to build business resilience, and to fast track their business transformation. Private capital was also focused on deploying record levels of dry powder. The M&A headlines in the first few weeks of 2022 have confirmed that there are more big, bold deals to come.  

These factors will continue to drive M&A in 2022 – businesses need to transform, not just in response to the pandemic, but also because of the drive to digitalisation, decarbonisation of the energy sector and the central place that ESG is assuming in global investment. Private equity will want to ensure they do not miss out on opportunities being thrown up by the pandemic and other challenges that businesses face in 2022. Add in to the mix the fact that SPACs (special purpose acquisition companies – listed cash shells with money which has to be spent on acquisitions) raised record amounts in 2021 and have a limited window in which to spend it (typically two years), and there is no reason why levels of M&A activity should drop significantly any time soon. 

ESG

In light of this, what are the themes that are likely to dominate M&A in 2022? The most obvious is ESG. 

ESG is something of a buzzword right now, for investors, corporates, finance providers and governments alike. But what does it mean and why is it important for M&A? 

ESG stands for ‘environmental, social and governance’ issues – whilst the primary focus is often on the environmental element, the social and governance aspects should not be overlooked. Similarly in the context of M&A, much of the focus on ESG has been in the energy sector – where it is not only influencing M&A but is also driving it as companies look to 'green' their businesses by acquiring assets that help their green credentials, or disposing of controversial assets. But the impact of ESG has spread well beyond energy companies. Across all sectors companies are looking to use M&A to help achieve their ESG goals, for example by acquiring assets focused on renewables, recycling, waste management, tech and aquaculture.  

Investors and finance providers are also focused on ESG issues, and so companies that are not seen as being environmentally friendly will find it harder to get backing or raise finance, or may find they have to do so at a greater cost. Corporates that have ESG issues front of mind are likely to find it easier to get funding or support for an acquisition. 

Many companies are pursuing a 'like for like' ESG profile across their asset base, by selling or demerging assets with a different ESG profile from the others. This avoids an ESG 'lowest common denominator' discount being applied by ESG-conscious investors to the company as a whole. While classic M&A is about synergy benefits which cause one plus one to equal more than two, an ESG-driven demerger or sale aims for two minus one to equal more than one – as different ESG-appetite investors will pay more in aggregate for those assets once separated than for a company which owns both assets. 

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Click here to download Herbert Smith Freehills’ annual M&A review: Global M&A Outlook 2022: FOMO Overcomes FOGO

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Legislation

Governments around the world are tightening their ESG-focused legislation – notably in the form of reporting requirements, corporate governance requirements and risk management obligations. The impact of an acquisition or disposal on a company's ability to comply with these (rapidly evolving) requirements needs to be considered, and if possible future-proofed against anticipated changes. Buyers of assets with less favourable ESG profiles need to pass muster with regulators and investors. 

On top of this, with ESG, it is not just a question of focusing on the requirements in black letter law and regulation but understanding that getting it wrong could involve substantial reputational damage.

Due diligence 

So how does this affect companies when conducting an M&A transaction? Depending on the nature of the target business, buyers may be doing increased due diligence, tailored to and targeted at the particular business. The Covid-19 pandemic has led to greater focus on the social aspects of ESG in this context – it has brought out the 'S' in ESG. Have businesses behaved in a socially responsible and ethical way, both in terms of the support it has drawn on and how it treated its employees? We are also seeing a greater focus on supply chains – not just their resilience but also any reputational issues they may bring. Depending on what emerges as part of that exercise, they may also seek to build specific warranties or indemnities into the protection package, and seek deferred consideration or earn outs to bolster the protection for the buyer.  

Sellers may look to conduct due diligence on the buyer to get comfort that the business will be properly supported post-closing and possibly seek post-closing covenants from the buyer to provide additional comfort, given the risk of reputational damage to the seller after it has exited, if the seller is seen as leaving the business in the wrong hands.  

Government intervention

In addition to ESG, another theme which should be front of mind on M&A transactions is the long-observed growth of government intervention in M&A, most clearly reflected in the increase in and expansion of national investment regimes. A prime example is the UK's National Security & Investment Act which came into force on 4 January 2022. With the reach of these regimes, and the penalties under them, expanding each year, it is essential any potential national security issues are considered and factored into transactions from the outset (bearing in mind that many regimes stretch the concept of "national security" well beyond its traditional meaning).  

2022 is not looking to be any quieter than 2021 on the M&A front, continuing the challenge of bandwidth for M&A professionals for the anticipated volume of transactions.  

Gavin Davies is head of global M&A practice and Rebecca Maslen-Stannage is chair and senior partner of Herbert Smith Freehills