An article by Iain Campbell of FC Corporate Finance
In the thirty or so years I’ve been working in mid-market and SME mergers and acquisitions, I have as you would expect witnessed a lot of change. The market has developed vastly in terms of the number and value of deals of course, and in addition the whole process around deal execution and structuring and funding deals has become much more technical and voluminous than it used to be when I was a young Corporate Finance Manager at Coopers and Lybrand Deloitte (as it was known then) and did the foundation course with the British Venture Capital Association (as it was also known then). In those days, the market for venture capital/private equity in the UK was mostly just 3i and a few banks and insurance companies that had venture capital direct investment divisions, and at C&LD we knew them all, which was useful as there was no internet to go looking for them. Now there’s so much private equity driving the mid-market that every time we do something at FC Corporate Finance that might have a PE angle we have to research the market and we always come across plenty of funds we have never heard of before. This is no bad thing of course in the work FC Corporate Finance does in the PE space, which is mostly sell-side disposal or partial disposal/cash out mandates. Apart from, or perhaps at least partly because of, all the liquidity that PE puts into the market, in the UK we typically see a premium of 10% to 15% on the pricing of PE deals compared to trade buyer deals.
The deal flow and price premia that we in the corporate finance adviser community can get selling mid-market companies to PE are fine by me of course as they drive fee income and growth in our sector. However, it’s not as simple as “let’s find a decent-sized company and sell it to PE”. Well, usually not, anyway. As I have alluded to in previous articles, selling to PE and selling to the trade are different propositions. In particular:
- In a trade sale, selling shareholder directors will almost always be leaving quite quickly. Even if that isn’t the intention, it will usually be what happens. The buyer will have its own management team and way of doing things. It will have its own governance arrangements and IT systems and, within reason, it won’t matter that much if the target is a founder-owned business that has grown to scale without putting big-company governance and systems in place or, indeed, if management and management succession are inadequate or if there are other problems that need sorting. A trade buyer will almost always want to buy 100% and integrate the target as a permanent part of its enterprise and will look to identify and sort out problems as part of that. Certainly, that’s what we do when acting buy-side for corporates.
- PE is completely different. The PE house won’t normally have a full senior management team or even a partial management team it can put in to replace the incumbent team. Whilst I don’t know the statistics and there must be exceptions that prove the rule, anecdotally I would say that PE deals done on this basis are destined to fail. I guess that’s why management buy-ins went out of vogue sometime in the Britpop era. It isn’t usually PE’s job to put in governance or systems either, but all of these will be needed during the period of the PE investment and for the exit at the end of it. Consequently, selling shareholder directors are unlikely to all be able to exit 100% on the first exit and, in theory at least, the target needs to be ready for PE in terms of management succession options, governance and systems. For many mid-market companies, particularly those that have grown rapidly (which are typically the best ones that PE wants) the price premium comes at a cost of the first exit being only partial and the requirement for extensive preparation before the first exit can be sought.
Sometimes of course there’s also a halfway-house option of selling to a trade competitor or trade-aligned buyer who already has PE investment. That might in some cases give the opportunity to access PE pricing and liquidity without necessarily ticking all of the boxes that would have to be ticked for a direct sale to PE. Other deal structuring issues will tend to be pretty similar though. The PE-backed buyer will typically already be well-leveraged and, in my experience, there will typically need to be some new PE capital that comes in to facilitate further debt, so the technical structuring and the execution process isn’t that different to doing a direct PE deal.
As a last bit of scene-setting, it should be borne in mind that there are some sectors where PE activity in the mid-market is truly prolific. The cynic in me would say that this is because PE is basically about doing what everyone else does – in fashions and cycles – and that’s why the PE funds heat the market and overpay, but I don’t want to be too controversial. There are some spaces and times though when you can’t ignore PE. For example, FC Corporate Finance is very active in the IT channel space and, with the exception of very small businesses, we have researched every single one in the UK in detail. When we did this, I was staggered to find that (depending on where you set the bottom bar for what counts as mid-market), PE and hedge fund ownership is probably a bit over 50% already. If you’ve now got something of decent size and quality to sell in that space you will be dealing with PE in your process whether you want to or not.
All of that has set the scene, but what I want to address is the state of the M&A mid-market now in 2023 and prospectively into 2024 and what you should be doing as a prospective seller who is thinking about exit.
Figure 1 below shows from data we have collated from various sources the number and value of reported global M&A transactions from 1992 (ie around when I started working in M&A) up to the present date. To avoid too many columns, I have shown the first four as annual averages, then I have shown actual figures from 2014 to 2022 and also shown my extrapolated figure for 2023 based on reported activity in the first half of 2023 compared to the first half of 2022.
As can be seen from the chart, global mergers and acquisitions activity increased sharply in the 1990’s. By the time the financial crisis started in 2007/8, the rate of growth in the number of reported deals had slowed and the total value of annual transactions had stopped growing. Whilst the trend was for the number of annual transactions to keep growing after 2007/8, the annual value of transactions plateaued, and didn’t start to grow again until 2014. The figures stayed buoyant through to 2019 and then, much to everyone’s surprise – me included – when Covid hit in 2020 there was only a modest dip in M&A activity that year then, in 2021 whilst Covid was very much still around, there was a record year both in terms of number and value of transactions. The figures only started to drop off again from the start of 2022, which is when interest rate rises started in the leading economies and the war in Ukraine broke out. As interest rates continued to rise, and economic confidence continued to fall, the trend has continued, though the total value of annual transactions has dropped much more sharply than the annual number of deals – the number of global M&A transactions in in the first half of 2023 was down 9% compared to the first half of 2021 and the total value of deals compared for the same two periods was down 39%. This indicates that the downward trend has affected the largest deals much more than smaller ones.
Here in the UK, the trends were sort of similar but with some uniquely British deviations. Figure 2 below shows the number and value of reported UK M&A transactions from 1992 up to the present date. Even though these are data about UK deals only, I have presented them in US Dollars (translated at an appropriate yearly rate) for comparison to global figures.
As can be seen from this chart, and unlike the global trend, UK mergers and acquisitions activity dropped sharply when the financial crisis that started in 2007/8 (about 15% in terms of the number of deals and 25% in terms of the total value of deals) and, compared to the years that had gone immediately before the crisis, activity stayed low through most of the 2010’s. At least in the UK, the ultra-low interest rate environment that was introduced in the financial crisis and stayed with us until recently didn’t seem to shift the dial on M&A activity to any noticeable extent at all, and it wasn’t until 2018 (by which time we had had low interest rates for around ten years) that there was not only a revival in M&A but a surge to record levels. We don’t know the reasons for this delay in the recovery of the UK M&A market, but for me, like many things, it probably had something to do with Brexit.
Since 2018, the trend in the UK M&A figures have followed the global trend more closely – UK M&A activity too stayed buoyant through 2019 and the big Covid years of 2020 and 2021, and only started to drop off again from the start of 2022. The UK M&A downturn since then has been sharper than the global trend – deal volumes 20% down in the first half of 2023 compared to the first half of 2021 and the total value of deals compared for the same two periods down a whopping 70%. The reasons for this are likely to be Brexit (again), persistently high inflation, and ongoing political turmoil that between them have damaged confidence in the UK economy both here and globally.
That’s liquidity, so what about pricing? Well, there is, of course, significant correlation between the two – that’s just supply and demand, so there’s a similar trend. In mid- 2023, Pitchbook reported that global purchase price multiples had fallen 20% from their peak. Here in the UK, latest BDO’s Private Company Price Index (for Q2 2023), whilst marginally up on the previous quarter, reported average EBITDA multiples of about 9% lower than the peak in 2021, and their Private Equity Price Index, whilst again marginally up on the previous quarter, reported average EBITDA multiples of about 13% lower than the peak in 2021.
All of the above market information is relative, of course, to the top of the market and none of it means that M&A will grind to a halt or that pricing will collapse. Whilst the typical acquiror’s cost of capital has increased significantly in the current interest rate environment, smart trade buyers who are fortunate enough to have cash at this time may see the relatively favourable pricing environment as a good time to be making more acquisitions. Indeed, research published in the Harvard Business Review in 2020 concluded that acquisitive corporates with strong liquidity positions who carried on making acquisitions through the financial crisis in 2007/8 generated total shareholder returns in the five years that followed of more than three times that of other companies. If you are a seller who is ready to go now and if – for whatever reason – it’s very likely to be a trade or strategic buyer who will be the acquirer, it’s not necessarily the right thing to wait for better market conditions. Timing is everything in all aspects of corporate finance, M&A included. My experience is that, despite market-driven things being naturally cyclical, if you are ready and in optimum shape to start the sale process, time is your enemy. I have seen far more things go unexpectedly badly in the process than I have seen things go unexpectedly well. In fact, I’m struggling to remember any at all.
As I allude to above though, these days private equity is in the mix across swathes of the mid-market and in some market sectors it’s everywhere. In my experience, PE, like banks, will always tell you they are open for business despite challenging market conditions, even when they’re not really open for much business. It’s inescapable that the PE model when it works well is built around leverage, and it benefits from banks and other creditors taking some of what really ought to be equity risk at low or no pricing. Given that these leveraged deals will always, or almost always, incorporate ratio-based interest and debt service cover covenants, the amount of leverage PE can get into deals has to be significantly lower at the moment. That means that, to make a deal work, either the pricing has to be lower or the PE return has to be lower (as proportionately more equity is required) or both. It’s fairly clear from all of the above that, if you are a prospective seller of a mid-market company and private equity is significantly in the mix in your buyer pool (which it probably is) then now really isn’t a good time to be starting a managed sale process. However, market conditions have always been cyclical in the past and there’s no reason to believe it’s any different now. PE funds exist to invest and won’t survive in the medium term without doing so. Whilst PE was a major factor in driving record M&A activity and pricing in the period immediately prior to 2022, there was also record PE fundraising taking place that was more than replacing the capital being invested. As a result, private equity “dry powder” in mid-2023 was approximately $2.5 trillion according to S&P Global, up 11% from the December 2022 figure and up 40% from the height if the M&A market in early 2021. Also in mid-2023, Bain &Co reported that PE funds were currently seeking to raise a further $3.3 trillion. Whilst that will exceed the capital available to be raised, dry powder will inevitably increase significantly beyond the current record levels. All that money will have to go somewhere.
If you are a prospective seller to PE and have decided that now’s not the right time, the chances are I would agree with you even though it’s part of my job to sell mid-market companies. I do think, though, that there are enough factors in play to suggest that better market conditions are likely to return quite quickly. It’s a big part of what we do at FC Corporate Finance to help companies prepare for exit. Our style is to get pretty hands-on when we do this with clients so we have a lot of experience. Bearing in mind what I say above about the need to attain certain governance and systems standards before a first-stage exit to PE (or, if you winged it last time, maybe a stage two exit) is feasible, now is the time to be laser-focussed on getting ready. As the market recovers:
- Interest rates will very likely still be significantly above where they were in the 2010’s;
- PE returns will potentially still be lower;
- PE will likely be:
- More risk averse;
- More cautious in due diligence
- Less inclined to turn a blind eye to governance and systems imperfections in otherwise attractive targets; and
- Less inclined to countenance inadequate availability due diligence data than maybe they sometimes were at the height of the market.
It’s more important than ever to prepare properly for the process. The sort of things you should be addressing include:
- Where your company is at on its strategic roadmap relative to its plans and to the competition. Particularly if it’s a technology or tech-enabled business, there should be clear sight of where the technology is, where it’s going, the investment required and the risks (including timescale and development cost risks) and this needs to be clearly evaluated relative to the product/service, the market and the competition and be documented and presented in terms that a PE or strategic acquiror will be able to understand and validate. These days, everyone is a disruptor and the emergence of AI as the next big thing will mean a PE buyer will want to see that you have considered and can explain and validate the robustness of your business model in times of technological change;
- How your company and its strategy are affected by current events, for example geo-political instability, inflation, Brexit (if you are in the UK or, possibly the EU too);
- The strength and depth of the management team, including whether there are any gaps to be filled, and what arrangements are in place for succession and for retention and incentivisation. This will often be much more cerebral than just looking at share options or long-term incentives. There are plenty of studies that show that senior management are often better motivated by other forms of remuneration and incentivisation;
- You should already have a comprehensive, dynamic virtual data room. Whilst you are likely also to use it for other purposes, it should include all the existing and historic documentation a buyer and its advisers will want to see in a full financial, legal, commercial and systems due diligence exercise;
- If you haven’t already, start to put together your sell-side advisory team. It’s especially important to have your lead advisor in place to help you assess your readiness for the process and, as a minimum, help you prepare a plan to address any shortcomings, if not to implement it as well. If you are planning to have vendor due diligence, it’s probably too early and uncertain to start the substantive work, but your preferred VDD provider should be lined up and you and your adviser should have undertaken a scoping exercise with them. This will further help you identify issues that need addressing and the information that will need to be in the data room before VDD starts;
- If acquisitions are a major part of your historic and future strategy and success story (which they may well be if private equity is your likely exit) then you need to have a decent current pipeline and a clear and demonstrable plan for where the acquisitions programme will go after that. If there are additional risks (eg you are going outside your traditional sector or geography) these need to be identified, fully considered and addressed, and all of this needs to be documented and supported by corroborating information;
- Mid-market private equity investee companies don’t need to have listed-company governance but are typically expected to operate to high standards that are nearer to those of a listed company than they are to those of a typical founder-owned or family-owned company. There will need to be (at least) full monthly financial reporting, both consolidated and granular, dynamic forecasting and budgetary analysis and quality, reliable business and management information, and properly designed and documented financial and business controls in place. Your company needs to have systems in place to do this reliably and consistently within short reporting deadlines. In or work at FC Corporate Finance, we quite often come across some really quite sizeable founder or family-owned companies that don’t have these basics. If you are in this category then it can be sorted if you start addressing it now. Depending on what your business is there doesn’t necessarily have to be a big IT/systems project. It will often be possible to reach PE standards using IT systems that are already in place, even if there are multiple legacy systems in place that aren’t integrated;
- We usually find there are a good few compliance issues that need to be addressed. Data protection is almost always one. Minimum wage and minimum paid holiday might surprise you as another quite common one. Reporting requirements that only kick in when companies are larger, such as modern slavery, carbon reporting, and equality data are often overlooked (even if there are international name auditors appointed) and there are sometimes no arrangements in place to capture the data;
- Risk management. By this I don’t just mean insurance. I mean all areas of business, financial, legal and other risk. Many years ago, I sold a small engineering business to a large international company and the deal took a year to complete. The reason for this was that the acquiror was not prepared to assume the legal risk in the contracts the target had with its customers. The target being a small company, and its customers being large companies, these contracts were typically signed on one-sided terms dictated by the customers that the target just accepted. The acquiror was, probably with some justification, concerned that the open-ended nature of the potential liability under these contracts wasn’t a practical problem for a small company (which could never afford to pay unlimited indirect liabilities anyway) but could be once the target became part of a multi-national. The solution was to put the whole deal on hold while we individually renegotiated the terms of over thirty of the target’s commercial contracts. Whilst that was worth doing in that particular case as the deal pricing was exceptional, that sort of problem would kill off most deals. Partly due to the effect the delay and extra work had on our margin on that job, I learnt a hard lesson from the experience, so legal and contract risk is something I always focus on in exit preparation or (with relationship clients) as an ongoing process;
- Taxation (of course). For the non-expert or inexperienced, there can be an assumption that, since any liability for pre-completion tax issues is traditionally assumed by the sellers (who would have had them anyway if they hadn’t sold), tax problems don’t really matter much. That’s not the case at all. If a historic tax problem emerges after completion there will be more at stake than just the back-dated tax and interest/penalties. The acquiror may suffer reputationally and may end up having its own tax affairs subject to onerous investigation. Also, there can be situations where the target has historically not been compliant with tax legislation and so far got away with it, but even if there’s no back-tax liability, the buyer will need to be compliant going forward, and the costs of doing this (for example in employment or sales taxes) will undermine margins and make the target less competitive in its markets. This can lead to a substantial price reduction in due diligence and in some cases even cause the acquiror to withdraw completely. FC Corporate Finance does a lot of buy-side due diligence and I think many people would be surprised how often we see these sorts of tax compliance problems. If you are not sure your company is 100% tax compliant then fixing it and understanding the value implications of the fix is unlikely to be a fast process and you need to be addressing it as soon as possible;
- For some businesses, revenue profile. Some acquirors focus their acquisition strategies on targets that have high levels of recurring income, by which I don’t mean income that’s just repeat business with a longstanding customer, I mean income with the same customer that is paid periodically (typically monthly, but not necessarily so) and is derived from an advance contractual commitment from the customer to pay that income periodically either for a fixed period of time or until cancelled in accordance with the contract terms. My experience in technology and IT deals is that targets that have high levels of recurring income attract multiples of 50% to 65% plus higher than targets that don’t, even if the target has very strong levels of repeat business. Sometimes I come across companies that could in theory have good levels of recurring income but they haven’t because they trade with repeat customers on informal terms or on T&C’s that don’t create any contractual commitment for ongoing custom. If the target is in that category, significant value can potentially be added for not all that much effort or disruption simply by getting customers signed up to a commitment. If there’s a spread of customers, the tie-in period doesn’t even have to be that long. Putting the right type of contract in place changes the categorisation of the revenue and creates value in the target by ticking a box on the PE checklist, even if the substance of the trading relationship between the target and its customers is unchanged.
There’s even more to it than all that – these are typically just examples. At FC Corporate Finance, we are still finding new issues in sell-side/exit preparation clients we haven’t seen before. The secret of preparing a top-quality exit preparation plan is deep knowledge of the sale process, knowing what sort of things will cause process or value problems and (crucially) knowing how to develop solutions and be hands-on in helping clients implement them. Whilst everyone waits for the inevitable improvement in M&A market conditions, there has never been a better time to address these issues and prepare, prepare, prepare!
FC Corporate Finance is a UK-based advisory firm. The areas we specialise in include, amongst other things, private company mergers and acquisitions (both in the UK and internationally) in the mid-market and SME space. We have very extensive experience in both “buy-side” and “sell-side” and are intensive and hands-on advisers and process managers through the whole cycle – acquisition strategy, origination, target evaluation, target valuation, deal structuring and negotiation, implementation, due diligence (if required), and detailed contract negotiation through to completion.
In recent years we have been particularly active on buy side, including in the IT distribution and IT reseller space, staffing agency, cleaning, security and other personnel-orientated businesses. We also have internationally-recognised capability and experience in deals in the passenger ground transport industry.
E-mail: ic@fccorporatefinance.com
LinkedIn: https://www.linkedin.com/in/iain-campbell-a7a9a126/
FC Corporate Finance Limited is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Institute of Chartered Accountants of Scotland. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide. FC Corporate Finance Limited has a policy of professional indemnity insurance with Arch Insurance Company (Europe) Limited of 60 Great Tower Street, London EC3R 5AZ. This policy has worldwide application except in relation to professional business carried on by the insured from its own offices in the USA or Canada.