Last year is being termed a ‘tale of two halves’ for M&A activity. While global M&A saw record levels of dealmaking in the first half of the year, the second half experienced a considerable slowdown as the market was impacted by the war in Ukraine, inflationary pressures, rising interest rates and continued political uncertainty. 

The question for 2023 is how the M&A market responds to the ‘perma-crisis’ state we are now living through with geopolitical tensions raising political, economic and energy security issues. 

Inflationary pressures are challenging asset valuations in deals, and in some cases testing business viability. The rise in interest rates around the world, and associated increased cost (and lesser availability) of debt, may make some deals more difficult.

However, despite these challenging conditions, M&A markets are far from closed. Among the drivers of ongoing deal activity are carve-out transactions, as large companies look to reshape their portfolios in order to shore up balance sheets and deliver value to shareholders, and transformational deals as they seek to drive change in their business towards digitalisation, energy transition or rebalancing of supply chains. 

Political tensions are, in more extreme situations, forcing companies to consider whether and when to exit problematic jurisdictions. This means that many companies are already proactively modelling the potential impact of geopolitical risks and considering the role M&A might play in preserving value, even on an enforced exit.

Special situations

Because of the challenges some businesses are facing, there is likely to be an increase in distressed and special situations – and in well positioned buyers, particularly those where currency exchange rates work in their favour, seeking to maximise the opportunities those situations afford. 

Dealmakers need to focus on problem-solving in the most challenging environment for M&A since the financial crisis of 2008/2009 – and over a decade of low inflation and interest rates mean that parties need to rebuild experience of transacting within these more challenging conditions.

On the transactions that are being done, there are a number of recurring themes.

Foreign direct investment

Political tensions are feeding through to countries' national security regimes, with new foreign direct investment (FDI) screening regimes being adopted and existing ones being expanded on a regular basis. For example, the new regime in the UK (which came into force in January 2022) has seen nine conditional clearance decisions, three prohibitions and two divestment orders. 

While this remains a small number of transactions in absolute terms, it nonetheless represents a sea-change compared to the previous regime, where the government intervened in just 16 transactions between 2003 and 2021. And the UK is not the only country taking a tougher stance – at least 20 deals, across five jurisdictions, were blocked or abandoned in 2022. This means that, when planning a deal, FDI considerations are more important than ever. It’s critical to proactively look to where issues may arise, and develop a strategy on how any concerns could be addressed. 

Public M&A

On public M&A, shareholders continue to make their voice heard and boards can no longer assume that shareholders will follow their recommendations. Even where there is not a traditional activist campaign, many investors are increasingly willing to challenge a board's recommendation, to seek a change to the deal terms, such as the price, or put forward proposals of their own, including seeking changes to the board of directors. 

If boards are seen to be favouring deals that are not fully valued, shareholders are even more likely to be willing to speak out and use the full spectrum of tools at their disposal to oppose deal terms or indeed the transaction as a whole. The most successful deal execution has the board and shareholders working in tandem to maximise value. In the right circumstances, shareholder pressure to increase price can be leveraged by the board to persuade a bidder to pay more.

ESG

ESG is a focus on every deal. While it is now market norm for buyers to be conscious of ESG risk, those that follow international best practices actively consider and address ESG issues as part of their due diligence processes, transaction negotiations and post-completion integration. Some sellers will even diligence and/or seek covenants from the purchaser on an exit, to ensure that good ESG practices remain in place following the sale. This approach can also help in the quest for regulatory approvals – giving comfort to regulators that they are facilitating the transfer into a safe pair of hands.

Reducing periods between signing and closing – which is increasingly challenging given the willingness on the part of regulators to intervene in transactions – remains a key focus for transactional lawyers. And gap covenants, that cover the running of the business in that period, continue to be a focus for both buyers and sellers.

The challenge in the debt finance markets means that private credit, increased equity and, in the case of strategics, share consideration may all feature more. A more critical eye in due diligence is also front of mind, in particular after the losses suffered in the tech market. 

As the market digests tougher economic circumstances, it remains unclear whether the current slowdown in M&A will be short-lived or prolonged but the right deals will still be done, albeit needing greater creativity to drive the deals home and at a slower pace.

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