Welcome to the LAVA team’s annual wrap-up and forecast of major mergers and acquisitions trends defining the sector.
In this first instalment of our two-part series, we reflect on the predictions we made last year and examine how they played out against the realities of the market.
After a year of hard-earned insights gathered from a range of deal structures in an ever-expanding list of sectors, from defence to tech and ESG to education, next week we will bring you our predictions for 2024.
For now, let’s delve into our team’s reflections on the past year and the major lessons we’ve learned in areas such as interest rate impacts, investment focuses in various sectors, and the evolving challenges of deal environments.
Increased cost of debt impacts private equity investments
– Hamish Martin, Partner
Predictions for 2023: “Cultural fit remains important, but deal completion is linked more broadly to the quality of the businesses involved and while there is still caution on the buy-side, things are looking more positive. Inflation has peaked, or is about to, and sterling has bounced back.
Interest rates also look as though they may have nearly reached the top, however they remain above historic levels so private equity investors are more likely to equity fund deals due to less available debt. Buy and build will be less popular for the same reason, with sellers approaching private equity investors earlier in the funding cycle.”
Reflections on 2023 prediction: “Well I was wrong about interest rates looking near the top as they rose from 3.5% to peak at 5.25%, although it does now look like any further increases are unlikely.”
The increased cost of debt is continuing to weigh heavy on PE investors, while they are still progressing with the assets they have conviction in, they are less likely to proceed with the assets they are less sure on, as expensive debt means more downside risk.
“We are seeing more deals being equity funded by PE, with debt being raised post transaction to fund M&A going forwards.”
Strategic adjustments in deal-making due to market uncertainty
– Simon Woodcock, Partner
Predictions for 2023: “Uncertainty has been a major barrier to deal completion in the past year, however as some of the unpredictability is removed from the market, higher costs can be priced into transactions, and we are now seeing more stable pricing in the debt markets.
The Covid hiatus in the deals market led to a rush to complete that boosted deal volumes. Similarly in 2022, many deals have not completed in the second part of the year, so if we continue to see more stability in 2023, there is a chance that there will be a similar boost to deal volumes.
Due diligence will still be intensively pursued, and buyers will continue to proceed with caution so all parties to transactions will need to prepare for an intensive due diligence process.”
Reflection on 2023: “The big wave of deals was slow to form given a hangover of disruption from 2022 and a real sense of caution being exercised by PE investors not wishing to be caught out with a turkey in a tricky market.”
Many companies struggled to deliver consistent results through extended M&A processes and so deals, that would otherwise make complete strategic sense, fell over as pricing mechanics driven by financial results failed to settle down and lock in.
“In response, numerous M&A firms and PE houses have spent time right-sizing their businesses and making strategic hires for what could be a great period for dealmaking in the first half of 2024.”
Private equity’s influence in driving the market
– Millie Counsell, Executive
Predictions for 2023: “We now expect private equity to drive the whole market, not just buy and build. And in areas where they can completely underwrite the deals themselves without the need for additional debt, they will be able to progress more quickly towards completion.
Where they have delayed deals due to recent uncertainty, many are now looking to create bolt-ons and move towards making an exit.
A number of sectors will again continue to see consolidation including early years providers driven by private equity backed funds at the top of the chain who are looking to build platforms. Those struggling with end game growth will acquire and create a platform, with many buy and build platforms likely to start with PE rather than debt in the first round.”
Reflection on 2023 prediction: “Picking out the equity underwriting in particular from that prediction, it was definitely an aspect we saw play out in the market when seeking deliverable deals for our clients.
Another part of this was having flexible buyers with shorter approval processes, key stakeholders/decision makers being looped in from the beginning of deals.
“In terms of PE driving the market, I think they were still responsible for a lot of the activity, however increasingly we’ve seen trade or PE backed trade jump at strategic opportunities, and outplay PE.”
Shifting focus in private equity due to market conditions
– Tom Rowe-Jones, Director
Predictions for 2023: “Possible further interest rate hikes across developed markets will mean that as firms refinance at a greater cost of debt, there will be more focus on servicing their debt and less cash expenditure, including on M&A.
This also means the cost of financing deals in the private equity market will be higher, which could impact activity. However, in the PE environment there is a lot of capital that has been raised due to the low interest environment we have had in recent history, and that capital needs to be deployed.
Similarly, businesses that have shored up their balance sheets over the past few years will now see opportunities to deploy their capital at more sensible valuations. This will be particularly in those sectors with defensive characteristics, including compliance-based professional services businesses.
While these businesses don’t have the same recurring revenue models as their technology counterparts, their repeat revenue, high percentage of contracted forecast revenue, and compulsory service offering make them attractive targets. If you then throw in the chance to drive innovation through technology, then the opportunity to create superior returns becomes compelling.”
Reflection on 2023 prediction: “I think it’s fair to say there hasn’t been a flurry of deal activity this year, particularly with new platform investments for private equity. This hasn’t been solely driven by interest rates as quite a few businesses have had to focus on managing their own affairs during a tougher trading period compared to the last few years, meaning it’s not the best time to take your company to market.
A lot of both private business and institutional owners’ focus has been on internal matters, including a lot of bolt-on activity across the portfolios of private equity investors as they seek to position themselves well for an exit in more favourable market conditions.
We have seen, however, that the appetite for investment in those compliance-based service offerings, such as the accounting and quality assurance certification markets to name a few, has remained strong and will continue to do so into 2024.
Challenging deal environment and focus on pricing power
– Rob Telkman, Associate Director
Predictions for 2023: “Moving forward into 2023, the hangover from high levels of economic uncertainty means it is likely to remain a challenging deal environment, at least in the short term.
I suspect that inflation will remain high for much longer than the market currently anticipates, and markets may become more volatile, however, interest rates may not go as high as some expect, and therefore rates are likely to remain negative (in real terms) for the foreseeable future.
The focus of investors will be on businesses with enough pricing power to protect margins and high levels of current (cash) profitability and less on unproven future growth potential.
However, disruption always breeds opportunity: There will always be investment and there are opportunities for those who are able to remain nimble and keep enough powder dry. It will also be increasingly important for vendors to have robust forecasting models and be prepared for more intense due diligence.”
Reflection on 2023 prediction: “Reported inflation has come down more than expected in the last few months, but it remains to be seen whether this trend will continue. Many businesses still report significant wage and cost pressures with no realistic prospect of reduced government spending on the horizon. We have seen a continued focus during due diligence on cost management and pricing power, and businesses struggling to hit forecasts which inevitably delays deals.
Interest rates moved more or less as expected, with no major economic blow-ups in the UK during 2023, but there has been a significant slowdown in the deals market – thus far more at the larger end due to the greater reliance on debt funding. This will inevitably filter through to the lower end over time.”
The impact of higher interest rates usually acts with a lag, often several years, and so, whilst some sectors have been hit harder than others, those that have managed to weather the storm so far will remain cautious.
Joining us in 2023, Loïc, Ivo, and Clare will be making their first predictions next week. Below Loïc and Ivo add their main takeaways from an eventful year in M&A.
Intensive scrutiny in due diligence leading to longer transactions
– Loïc Bourdonnec, Associate Director
Reflection on 2023: ” The past year has been a testament to the evolving dynamics in the M&A sphere. A key takeaway has been intensive levels of scrutiny in the due diligence phase across different business areas.”
This thorough approach has led to longer transaction durations, highlighting the importance for advisors in setting realistic expectations for both sellers and investors.
Focus on asset quality over quantity in deal making
– Ivo Brett, Analyst
Reflection on 2023: “The abundance of capital within private equity has not, as yet, been a dominant driver of deal volumes in the market.”
Continued political and economic uncertainty has kept the spotlight on the quality of assets with an emphasis on consistent financial performance and compromises have not been made over long processes despite the dry powder around.
Next week, we’ll unveil our much-anticipated predictions for 2024 in the second part of our learnings and predictions series. Keep an eye on LAVA’s LinkedIn feed to catch these insights as soon as they are published, and join us as we explore the future of mergers and acquisitions. Follow LAVA here.
