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Companies that were pursuing acquisition-led growth strategies 18 months ago may now be back in the market for transactions, but as the economy emerges from the impact of Covid lockdowns, the M&A environment looks wholly different.

In many cases, the strategic priorities are likely to have transformed from where they were pre-pandemic, says Tim Nye, corporate partner at Trowers & Hamlins: “Digitisation and business transformation has become, and will continue to be, much more of a focus going forward. One of the easiest ways to achieve rapid progress is through M&A, whether that means acquiring capabilities, skills, products or technologies that you need to operate efficiently in a changing world.”

Valuations for digital and technology assets are likely to continue to rise through 2021 as competition for those deals intensifies. Likewise, there is strong demand for acquisitions of businesses in logistics and other areas that have boomed in the past year. At the same time, the pressures in sectors that were badly impacted by the pandemic will intensify, leading to distressed sales in parts of the retail, leisure and travel markets.

On deal pricing, uncertainty continues to present challenges for dealmakers. “The issues of the past year have created an expectation gap between buyers and/or investors and sellers, largely because the trading figures for any business over the last 18 months do not give a clear outlook for the future,” says Nye. “That has driven down valuations in some sectors, as has uncertainty, which we hope may now be clearing up. Still, no one yet knows what the unemployment rate will look like through this year or how that will impact consumer confidence and so how confident can you be in valuing a business where recent actuals are not typical and the near term future is uncertain.”

This creates a mismatch between what sellers expect for their businesses and what buyers are willing to pay. The M&A market in 2021 is therefore likely to be characterised by innovative solutions to bridging that gap, whether that involves retentions, whereby a percentage of the consideration is withheld by the buyer until certain targets are met; or earn-outs, where a seller stays in the business to ensure certain financial metrics are met in order to achieve additional consideration.

“We are seeing all of those terms coming into transactions already and we expect that to continue,” says Nye.

Trowers corporate partner Alison Chivers says: “If you’re a founder or a seller at the moment there is a bit of a conflict. Although valuations have dropped and that might encourage you to retain the business and build it back up post-pandemic, there is also an understanding that the Chancellor is looking to raise capital gains tax rates down the track, which may encourage you to sell before those higher tax rates hit.”

From a risk management perspective there is a growing emphasis from buyers on achieving warranties relating to the Covid period, to protect against liabilities that may have arisen as a result of a lack of compliance in the business over the past year. This is particularly relevant to employee welfare and health and safety compliance, looking at how workers were adequately protected whether working from home or attending offices.

“Buyers are keen to get assurance that sellers were operating in accordance with guidance and regulations such as implementing proper social distancing measures and so on, because there are real risks associated with not doing so,” says Nye. Likewise, at a time when so many businesses are reviewing their employee contracts and working conditions, buyers will want to know about any promises made to the workforce over the past year. Some companies may have moved to four-day weeks and promised staff a return to normal, while others might have promised longer term flexible working arrangements that need to be honoured.

Warranties might also be sought around arrangements made with landlords or other stakeholders, where in many case rent or other payments were stalled for a period of time.

Due diligence processes will now place much greater focus on risk assessment than they did during periods of economic growth, with much more attention paid to the employee cohort, compliance with health and safety regulations, the security of supply chains and any special termination rights that may exist in key contracts.

Chivers says office space is also impacting pricing:

"A big thing playing into diligence at the moment is how businesses have adapted through the pandemic and are now looking at the future of the office and their real estate needs going forward. It is quite difficult to buy a business today with a lot of office space if you know you will not want that in the future."

Even the way in which diligence is conducted has changed through the pandemic, with some buyers using drones for site visits to progress transactions at a time when they cannot visit potential targets.

Material Adverse Change and Material Adverse Event clauses are becoming much more common too, and are more tightly negotiated, says Nye: “We are seeing far more of those in respect to transactions that have a split exchange and completion date, which is often the case where some form of consent is needed from regulators, competition authorities or sometimes key customers with a change of control clause. Pre-Covid we didn’t see many of those clauses as typically a Seller would reject them, but now more and more buyers are pushing for those protections.”

Finally, there are even more considerations to take into account where deals involve distressed sales or businesses that took on substantial government support.

Chivers says: “When it comes to government support, people are very concerned about diligencing furlough payments that people have received. The government is introducing a task force to look at furlough payments and make sure the scheme has been implemented properly, so that is an additional focus for buyers.”

Distressed M&A typically requires the buyer to accept the asset is ‘sold as seen’, with limited protections. Nye says: “A lot of buyers are talking about M&A opportunities once government support for businesses ends later in the year, when we can expect a flurry of distressed sales and administrations. We have already seen some high-profile casualties and it is hard to predict what will happen next when we don’t know what restrictions might remain in place and therefore how government support might end. We expect distressed transactions won’t really become a feature until the end of the year, once support dries up and we start to see who can trade their way out.”

For now, even more emphasis is being put on pricing, diligence processes and protections that can be put in place for buyers. Still, expect plenty of corporate activity in the year ahead.

Chivers says: “What has been proved is that there is more competition than ever for good businesses that are well run and have managed to navigate the pandemic and come out the other side. There is more capital to be deployed by investors than at any time in at least the past decade, so although there are challenges, if you are in a strong performer in a resilient sector there is going to be more competition to acquire your business than ever before.”