CENTRAL & EASTERN EUROPE: An Introduction to Corporate/M&A
M&A volumes have historically tended to follow roughly seven-year cycles. Even after the global financial crisis, the cycle was only slightly elongated. However, in recent times it feels like we have lurched from one crisis to another. The pandemic caused M&A activity to plummet in 2020, and then it rebounded wildly in 2021. 2022 started off promisingly, but in the second half of 2022, activity tailed off due to the war in Ukraine and other factors mentioned below. Despite this, M&A volumes were actually not that far off pre-pandemic levels; however, deal sizes are smaller and may continue to be for a while.
We are always asking – is it different this time? There is either eager talk of “new paradigms” or, conversely, seemingly unprecedented events (or the halting of “abnormal normals” to which we had become accustomed, like persistent low interest rates). In 2023, we are facing a range of factors: the war in Ukraine, rising interest rates, inflation, post-pandemic euphoria tailing off, energy transition, increased regulatory scrutiny and protectionism, bank failures in the US and in Europe, and the unnerving advent of AI inducing fear and awe in equal measure.
How do we make sense of these headwinds? It is interesting to break down these factors, and identify some actually rather logical trends, both in terms of the impact on M&A sectors and in M&A deal terms.
Wider market uncertainty obviously means that deal makers initially hold back, and valuations become less certain and lower. Cash becomes king. Obtaining finance becomes more difficult. In turbulent times, more focus on the certainty of (and level of commitment in relation to) financing will generally be seen. More generally, buyers will want to apportion more risk to the sellers and delay handing over cash so buyers will push for things like earn-outs and retention escrow, or the use of warrant insurance.
Long-term trends have shown the inexorable rise of locked box deals, but locked box deals dip where there is less certainty around valuations, and buyers will push for more completion balance sheet deals to defer the transfer of risk. Similarly, the use of warranty and indemnity (W&I) has been steadily increasing over the years, and this can accelerate during uncertain times – so long as there is capacity in the insurance market to service demand. Sometimes, W&I and escrow can be hydraulic. If you have good W&I coverage, you might not need escrow, though it depends on the specific deal terms.
When markets are turbulent, you might expect buyers to insist on things like material adverse change (MAC) clauses – and they do – but at the same time sellers are extremely keen to secure transaction certainty. The last thing they want to do is sign and announce a deal only to have it unwound. So, sellers will fight hard to exclude conditions (MAC, financing conditions certainly), and will want to include provisions to lock in the buyer as much as they can – so you will see increases in sellers insisting on “hell or high water” clauses around regulatory approvals.
Increased regulatory scrutiny and more and more restrictive FDI regimes may make it more difficult to get deals over the line (or doing so will take longer).
After all the uncertainty, underlying it all is the pent-up pressure and demand to do deals. Private equity funds are keen to deploy funds (the ubiquitous “dry powder”), and deal makers are keen to get moving again. High inflation rates may spur the deployment of capital, and periods of uncertainty and disruption throw up opportunities. Post-2022 year-end surveys highlighted how deal makers and CEOs were ready to do deals again – but new uncertainties then emerged and AI has burst onto the scene, perhaps forcing some to think again. However, there will be bargains, and there will be reorientation of portfolios and business strategies that will allow dealmakers to move into areas that others are moving out of, for good reasons or bad.
One would assume that, with the massive potential disruption from AI, there will be significant movement in the tech sector, either emerging from new players in this market and the scramble to acquire dominant emerging players, plug-in developers and personnel, or fall-out from some possibly deep structural changes in the way many companies currently carry out their business. Elsewhere in the technology sector, there is plenty of activity in software and gaming, and deals around data will surely continue to grow. There is a lot of interest and focus on the metaverse and NFTs, but there are some concerns around hype, so it may be the case that the interest narrows to more provable use cases.
Although healthcare M&A activity has dipped temporarily recently, there is constant talk of ever-present underlying public health threats (such as zoonotic transmission) which may emerge again at any time, as well as calls for much-needed improvements in healthcare infrastructure and services, which may warrant investment (for example, in relation to an increasingly aging population).
The uncertainty in the energy market has led to some short-term setbacks, and re-investment in legacy infrastructure, but the longer term trend in the face of climate change and geo-political threats must be (and is) towards renewables, and in any event some form of diversification. It is not just a trend towards ESG, it is a more existential realignment. Companies that are pursuing sustainability-related initiatives (such as carbon reduction, positive social programmes or other strong ESG performance) will command higher valuations going forward. There will be likely increased focus on assets which are orientated towards sustainability, for example in renewables and recycling.
Companies are likely to face greater scrutiny of their management of ESG issues from investors, regulators, and other stakeholders. This means that companies will need to be able to demonstrate that they are taking ESG factors into account when making business decisions, and that they are managing their ESG risks effectively. Companies that are unable to demonstrate strong ESG credentials may find it more difficult to attract investors.
Geopolitical trends may also encourage investors to recalibrate and diversify their presence and supply chains, perhaps looking to bring certain activities closer to home, as well as there being more focus on logistics and the sourcing of raw materials. At the same time, widespread sanctions have restricted or slowed down the acceptance of clients, sometimes scuppering deals.
With the banking sector in focus again, liquidity issues may come to the fore, and we may see some distressed sales, non-performing loans (NPLs), and realignment and optimisation of portfolios. Fintech has been disruptive and will likely continue to be, though there have been recent headwinds associated with the increased scrutiny of start-ups and their valuations, and concerns around VC funding.
While there is uncertainty in the markets, you can expect to see more focus on due diligence. Deeper due diligence is being carried out, in terms of financial due diligence to get better visibility for valuation purposes, tax due diligence as tax authorities continue to scrutinise, and due diligence on legal issues, increasingly on ESG issues, to manage risk and seek better investor “fit”.
Due diligence may therefore take longer, though this may be mitigated by increased use of legal technology and AI tools, where advancements are progressing exponentially. Coupled with that, in more uncertain periods, buyers may be more assertive in the disclosure process, perhaps even insisting only on disclosure letters (rather than data room disclosure), or at least more warranties, and wanting to see a more robust process involving management and better and more detailed disclosures.
While in trying times buyers logically tend to seek more extensive protections, sellers are equally nervous and look to limit their exposure by trying to negotiate tighter limitations, for example in terms of setting caps and time limits. While many speak of a “buyer market” or a “seller market”, there are some nuances bubbling under the surface and even sometimes slightly counter-intuitive outcomes are generated, meaning that understanding the underlying drivers is essential to get mutually acceptable terms that allow the parties to get the deal over the line.
These effects are quite visible as the M&A markets wax and wane, and the M&A market in the coming 12 months will certainly remain extremely interesting and dynamic.