Finding M&A value in an economic downturn

During a recession or economic downturn, M&A activity will typically decline as sentiment dampens among dealmakers and causes companies to pause ambitious growth plans in order to focus on safeguarding their operations.

As a result, M&A activity carried out during recessions and downturns is often driven by financial distress, with the economic shock causing companies to struggle and ultimately fall into insolvency, or by companies making divestitures and selling off non-core assets in order to raise funds and streamline their business to weather the crisis and target growth further down the line.

Downturns also make those that typically finance M&A transactions more cautious whether they are banks or private equity firms. This makes it harder for those that do want to target acquisitions to raise the funds they might require.

Of course the other major source of acquisition finance is through the offering of equity, and the value of this, whether quoted or unquoted, will be impaired during a downturn or recession.

Therefore deal volumes and values will both typically drop off, something that can act as a further deterrent to dealmaking, spreading a mood of uncertainty and caution among potential buyers and discouraging potential sellers from going to market.

However, history has consistently demonstrated that the best M&A deals (in terms of the value they deliver for buyers) are often done during economic recessions and that companies that make acquisitions during downturns will often perform better in the medium to long-term than companies that are overly cautious and avoid dealmaking.

With much of the world potentially at risk of entering recession at the start of 2023, businesses might be tempted to put M&A plans on ice and simply look to ride out the crisis. However, companies would actually be well advised to act boldly, rather than being overly cautious, and consider the very real benefits they could see from targeting acquisitions during an economic downturn.

What is the global economic picture?
2022 began with tentative optimism, following a year in which economies and the M&A market rebounded from the catastrophic impact of the COVID-19 pandemic. Despite plenty of lingering uncertainty, hopes were high for a year of solid M&A activity and continued economic recovery.

However, these hopes were rapidly put to rest by Russia’s invasion of Ukraine in February, an event that sent energy prices soaring, compounded ongoing supply chain disruption and brought a new level of uncertainty to economies throughout the world and particularly in Europe.

Since then, businesses have been hit by rapidly escalating prices for raw materials, energy and labour, as well as feeling the impact of plummeting consumer confidence, with household spending sharply declining amid rising energy bills and huge cost inflation.

At the outset of 2023, these factors have left businesses on the verge of collapse (if they haven’t already) and numerous economies face severe uncertainty.

In a poll of 22 chief economists held ahead of the 2023 World Economic Forum, all economists surveyed said that they expected weak or very weak growth in Europe this year. Highlighting the global nature of the current economic uncertainty, 20 of the 22 economists also forecast weak or very weak growth in the US.

Not all of the projections have been uniformly grim, however. Despite previously forecasting that a third of the world’s economies would enter recession in 2023, the International Monetary Fund (IMF) more recently said that it expected the UK to be the only advanced or emerging economy to shrink this year.

What has the impact of the downturn been on M&A so far?
Economic headwinds have been apparent in the M&A market for close to a year now, with the global economy having been rocked by Russia’s invasion of Ukraine in the first quarter of 2022, which sent inflation, interest rates and energy prices spiralling and had a severe impact on supply chains and overall economic sentiment.

The rise in deal value that had been seen during 2021 was halted, with global M&A seeing a 13.7 per cent year-on-year drop in value from $5.4 trillion to $4.7 trillion, as per the 2022 edition of Pitchbook’s annual Global M&A Report.

However, despite these issues, M&A in 2022 was also a story of resilience. Deal value may have dropped, but still remained 20 per cent above the levels seen in the three years to the end of 2019, while early estimates show that overall deal volume increased from 40,403 in 2021 to 44,377 last year.

The resilience of dealmaking in the face of economic headwinds was driven by high levels of private equity capital (estimated to stand at around $1.3 trillion worldwide), low valuations (with median deal multiples falling from a 14-year high of 11.1x in 2021 to 8.8x in 2022) and a proliferation of distressed assets as companies were hit by the downturn.

The uncertain economic picture saw dealmakers increasingly turn to add-on acquisitions, which increased to a record 71.9 per cent.

In Europe, the picture was similar, with value falling 6.1 per cent, but deal volumes rising 11.9 per cent to a record 17,900 deals. Much of this was driven by an influx of cross-border M&A, especially involving buyers from the US, who accounted for 1 in 10 acquisitions in Europe last year and 21.2 per cent of European M&A value ($315.3 billion).

The increasing activity of US buyers in Europe resulted from the 20-year high in the US dollar, which prompted US firms (particularly private equity firms) to target acquisitions in European nations with weaker currencies. This is one trend that is forecast to continue driving M&A even if the economic picture worsens in 2023, with volatility creating further opportunities for well-financed US buyers to target distressed and strategic takeovers in Europe and the UK.

Furthermore, environmental, social and corporate governance (ESG) issues have and will continue to grow in importance as an M&A driver, whether in or out of recessionary times. Problematic assets, i.e. divisions or subsidiaries with a high carbon footprint, for example, may be carved off. On the other hand, businesses that can help companies meet their ESG goals will be attractive targets. Scrutiny of ESG credentials will become a vital part of the due diligence process.

Significant hurdles to dealmaking
M&A took a hit during 2022, both because of economic uncertainty and as a result of a natural slowdown in activity following the pent-up demand that drove dealmaking during 2021. With the economic picture worsening at the start of 2023, there are numerous difficulties facing potential dealmakers, leading to many predictions that activity will continue to slow down.

One of the main hurdles that buyers will be facing this year is a significant tightening of financing conditions, with banks and private equity lenders likely to rein in their M&A investments as the economic downturn deepens.

Higher interest rates will make financing more expensive for buyers to attain, which will subsequently deplete the resources they will have remaining to complete acquisitions, even if they are successful in securing funding, and weaken their purchasing power.

Sources of financing will also become more cautious in the midst of an economic downturn, meaning that buyers will face stringent due diligence processes and a high degree of scrutiny from potential sponsors. Lenders will place a particular emphasis on examining a buyer’s acquisition plans in order to determine that their M&A activity will deliver value for them. Furthermore, during a downturn, there will also be even greater scrutiny on whether a buyer’s finances are solid and the company is not in any danger itself.

This could all possibly serve to drag out the timeframes that buyers will face before they are able to secure financing, something that could prove detrimental during a downturn, when deals are often motivated by financial distress and there is an emphasis on closing sales quickly.

Another factor weakening the purchasing power of would be buyers is the weakness of the UK pound, which has put UK-based acquirers at a disadvantage to overseas parties, especially those from the USA.

Despite these hurdles, history has often demonstrated that, from a value perspective, the best M&A deals are done during recessions. For that reason, if buyers do have the cash available to make acquisitions, the current downturn is no time to avoid deals.

Analysis: The 2001 recession
A prime example of the value that M&A during an economic downturn can deliver is the 2001 recession. The rise of the internet and fears surrounding Y2K led to huge computer and software sales during the 1990s. In the wake of the millennium, sales subsequently plummeted, leading to the collapse of many tech companies. The situation was further exacerbated by the Federal Reserve raising its interest rate several times, as well as the impact of the 9/11 terrorist attacks.

This resulted in an economic downturn that lasted for eight months and, in addition to the USA, impacted many European economies (although not the UK), as well as several others worldwide. In the US, the fallout from the downturn was so severe that, more than a year after the crisis ended, unemployment continued to climb and hit 6 per cent by June 2003.

As is often seen during recessions, M&A activity took a hit during the downturn, with deal volume and deal value both plummeting during and after the crisis. During 2002, even though the recession had ended, aggregate deal value stood at less than half the comparative figure from 1998, prior to the crisis beginning to take hold.

However, numerous analyses showcase the fact that companies that ploughed ahead with M&A during the 2001 recession delivered higher value from these transactions and performed better than their less-active counterparts in the aftermath.

Bain & Company analysed approximately 24,000 M&A transactions that occurred from 1996 to 2006, with the analysis showing that acquisitions carried out during 2001 and 2002 generated close to triple the excess returns of deals completed in the years leading up to the recession.

Analysis from PwC of acquisitions completed by public companies during the 2001 recession, meanwhile, showed that acquisitive companies fared significantly better than competitors in the wake of the downturn. According to the analysis, median shareholder returns at companies that made acquisitions during the recession outstripped their respective industry averages by 2.43 per cent six months after the recession ended and by more than 7 per cent a year later.

M&A during a recession, then, can deliver significantly greater value than deals completed during times when economies are healthier and deal appetite is perhaps greater. Data also shows that it is better for those with an appetite to target deals during a downturn to act early on in the crisis, rather than waiting for sentiment to improve slightly.

Returning to PwC’s analysis of deals completed during the 2001 recession, the report found that deals announced during the first half of the recession produced shareholder returns ten per cent higher than their respective industries a year on, compared to the average of 7 per cent mentioned above.

This suggests that buyers who move quickly when an economic crisis first takes hold will outperform those dealmakers that wait until later on in the downturn and will more fully reap the rewards that M&A deals struck in a recession can deliver.

Overall, M&A conducted during recessions can deliver two key benefits: strengthening the position of buyers against their more cautious competitors and providing them with the strategic options and sources of value to attain significant growth and strong returns in the wake of the downturn.

Acquisitions during recoveries may not deliver value
As figures from 2001-2002 demonstrate, acquisitions made during recessions and downturns can deliver significantly greater value for buyers than deals done when economies are growing or recovering from downturns. While this is not to say that acquisitions during times of growth do not represent good value, a very recent example can show why buyers should not wait for the economy to recover before pulling the trigger on M&A plans.

In the wake of the devastation of the COVID-19 pandemic, economies began to bounce back during 2021, with the UK registering GDP growth of 7.4 per cent during the year. This, along with pent-up dealmaking demand, helped push M&A to record levels during 2021.

However, while this reflected considerable optimism among both economists and dealmakers following a year wrecked by COVID-19, the M&A boom has not delivered the value that many buyers would have been hoping for, particularly as a result of the downturn experienced during 2022.

Last year, the top 10 goodwill writedowns on acquisitions made by S&P 500 companies totalled $35.4 billion, close to six times the amount registered for the previous year ($6.1 billion) and demonstrating that acquisitions made during the 2021 recovery, even if they are performing strongly, are vulnerable to goodwill writedowns.

KPMG Partner Dan Langlois commented: “When you factor in cost inflation that maybe wasn’t anticipated, when you factor in higher interest rates, which drive up the rate you might use in a discounted cash flow analysis, and then factor in some of the uncertainties associated with a potential recession, those things in totality will influence fair value.”

Sectors expecting to see strong M&A

While many observers are tempering their expectations for M&A this year, there are several sectors in which experts are forecasting that dealmaking activity will be strong during 2023, even despite the economic downturn.

Although markets have seen wavering sentiment and an understandable degree of caution among dealmakers, there are clearly some operators out there who recognise the scope for gaining scale, establishing a competitive advantage and improving future growth prospects that M&A during a downturn can provide.

Healthcare and life sciences

Following the COVID-19 pandemic, it is no surprise that healthcare and life sciences (HCLS) have been among the most attractive sectors for dealmakers worldwide. Even with inflation and interest rates soaring and recessionary fears deepening, there is little sign that M&A activity in the industry is poised to slow down.

According to the 2023 KPMG Healthcare and Life Sciences Investment Outlook, 60 per cent of respondents say they are, in fact, planning to increase their dealmaking activity this year, with around a quarter saying that they plan to do at least 10 per cent more deals than last year.

KPMG’s National Sector Leader Healthcare and Life Sciences, Ash Shehata, said that 2022 had been “a story of both tailwinds and headwinds” for the sector, with hospital systems hit by rising costs for labor and supply and biopharma and medical device firms impacted by logistics, supply chain and labor issues. Despite these struggles, Shehata commented: “Now is the time for HCLS leaders to adjust their strategies to build durability and resilience within their companies."

At the start of 2023, the key areas in which healthcare and life sciences buyers are looking to strengthen include operational efficiency, expansion into new platforms and offerings, enhancing technology and gaining a competitive advantage post-recession.

Kristin Pothier, KPMG Principal, National and Global Healthcare and Life Sciences Deal Advisory and Strategy Leader commented: "The tailwinds that drove M&A in the last two years-the need for innovation and the need to fill pipelines-remain in force. Companies are sitting on a lot of cash and assessing their opportunities to make strategic investments now that will set them up to gain a competitive advantage as we come out of a possible downturn.”

“Whether investing in new technology platforms, enhancing their digital ecosystem, or reimagining approaches to new geographies, deals are likely to continue to reflect the new reality of the industry, a reality that balances scientific and clinical advancement with cost."

Telecoms

Despite falling deal volumes and values across UK M&A last year, technology and digital infrastructure remained significant drivers of dealmaking activity, reflected in the fact that the UK Technology, Media and Telecommunications (TMT) sector saw £28 billion in M&A transactions last year.

Globally, the sector accounted for a huge amount of activity, representing approximately a quarter of both global deal volume and value and, despite declining from the record activity seen during 2021, standing 25 per cent and 38 per cent higher, respectively, than pre-pandemic levels in 2019.

Amidst a worsening economic backdrop, busy M&A activity is expected to continue in the telecoms industry this year. Nicole Perez of US firm Baker Botts commented that, despite recessionary fears, "there will still be demand for broadband and communication technologies domestically and digital infrastructure is somewhat recession proof, so I expect the industry will see modest deal growth next year, compared to 2022.”

Regarding areas where buyers might be able to target growth, Perez added: “There is also ample room for growth in developing markets such as Latin America and the Caribbean, where companies are increasingly focused on mobile and broadband services.”

Meanwhile, in its 2023 Global M&A Trends outlook for the TMT sector, PwC forecast: “The TMT sector is continually advancing and engineering new technologies, platforms and solutions to enhance capabilities across every industry. Sophisticated dealmakers appreciate these dynamics and will continue to engage in M&A that is accretive to their strategy and portfolio.”

“While some may choose to sit on the sidelines during these times, those that have strong balance sheets and access to capital will be rewarded with opportunities to acquire incremental assets that can drive long-term growth and capabilities across sectors.”

How should buyers proceed during downturns?
Of course, just because acquisitions made during recessions or downturns can deliver extremely high value, that is not to say that there isn’t a high degree of risk inherent in doing these kinds of deals. Ultimately, downturns are uncertain times in which any business transaction comes with a significant risk profile and M&A deals are no different, with the wrong acquisitions potentially likely to prove incredibly costly mistakes.

For that reason, buyers should proceed with the utmost caution when planning M&A during economic turbulence and bear several key things in mind to help give them the greatest chance of making successful acquisitions that deliver the best value.

Firstly, buyers will need a clear plan articulating how potential acquisitions would increase the company’s value and boost their competitiveness in comparison to other firms in their sector – whether that is in terms of customer base, brand strength or financial position. In order to be able to pounce quickly on opportunities as they appear, buyers should also have a clear acquisition model in place outlining the kinds of firms they are looking to acquire (e.g. size by turnover/employee headcount, sector and location). This will ensure the net is not cast too wide and the company can instead focus on acquisitions that are likely to be best suited to the business and deliver the greatest value.

Assessing the value of an acquisition could deliver is one area that highlights the importance of tightening due diligence processes when conducting M&A during a downturn. Key factors to analyse will include a potential acquisition’s cash-flow, which, during a downturn, can provide a clearer insight into a company’s worth than an asking price.

Buyers should, where possible, avoid making too many assumptions based upon a company’s valuation. Some buyers may be tempted to pursue targets with low asking prices in order to unlock the highest possible returns. However, a low valuation may not simply be a result of an economic downturn and may simply be an accurate reflection of a company’s worth. Put briefly, buyers shouldn’t assume that every low-cost acquisition made during an economic downturn is bound to be a bargain that will yield high returns.

Buyers should also consider how an acquisition target can help them strategically respond to the impact and broader changes that a recession might deliver. Downturns can drive huge changes, ranging from concrete factors such as regulation, to less tangible things, such as which business models are most likely to be successful in the wake of the crisis.

It will also be important to gauge a company’s potential exposure to the impact of a recession. Even if a company is solvent and performing well during a downturn, this can quickly change if other businesses within its supply chain suffer (and potentially collapse), which could lead to delayed payments or deliveries and negatively impact the firm’s operations and cashflow position. For this reason, conducting due diligence on vendors and other businesses within a target’s supply chain will be crucial.

Central to such an intensive due diligence and target assessment process will be having a strong deal team in place that is fully attuned to the company’s acquisition model, experienced at assessing the true value and future prospects of potential targets and prepared to act quickly to identify and move on the best opportunities that come to the market.

Providing buyers proceed with a well-defined strategy, a clear profile of businesses they are looking to acquire, solid due diligence and an experienced, properly prepared deal team in place, then there is no reason why M&A opportunities in the approaching downturn cannot deliver exceptional value and help businesses establish a competitive advantage and a platform to grow in the wake of a potential recession.

Also read:
2023 Outlook on developing mergers and acquisition trends
M&A in financial services - digitisation, disruption and divestments

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