Beyond lockdowns: FDI and cross-border M&A

April 2021  |  COVER STORY  |  MERGERS & ACQUISITIONS

Financier Worldwide Magazine

April 2021 Issue

Foreign direct investment (FDI) flows have increased dramatically across the globe in recent years to reach a volume of more than $1.5 trillion in 2019 – an increase that can largely be attributed to a rise in cross-border M&A activity.

Essentially, FDI and cross-border M&A are tools of the trade for companies looking to expand their operations overseas. They are an important source of value creation and provide the means to access new jurisdictions and take advantage of different economic, market and consumer dynamics.

“Several drivers continue to make cross-border M&A and FDI a prominent theme in today’s dealmaking landscape,” says Sawyer Duncan, a senior associate at King & Spalding. “The world is not getting any smaller and that means that corporate value chains, in businesses of all sizes, are increasingly global in scope and scale.

“And while foreign manufacturing and outsourcing are far from new trends, technology and e-commerce has made reaching overseas customers easier than ever before,” he continues. “Companies are no longer as hesitant to pursue growth via overseas markets through partnerships and M&A, and dealmaking in 2021 will increasingly demand cross-border and cross-cultural skills to reach the closing table.”

The reality, however, is that many cross-border M&A transactions fail to generate the expected value for shareholders, as integration hurdles often prove insurmountable. Yet such concerns have been rendered moot over the past 12 months due to the significant impact the coronavirus (COVID-19) pandemic has had on FDI and cross-border M&A activity.

“2020 witnessed significant shifts in M&A activity with a substantial reduction in activity during the first half of the year followed by a significant increase during the second half of the year,” says Simon J. Little, counsel at Davis Polk & Wardwell LLP. “Activity trends reflected the world initially contending with the uncertain impact of lockdowns and increasing optimism about the impact vaccines may have on the ability to exit the pandemic and return to normal levels of demand and economic activity.”

Trends

According to a January 2021 ‘UNCTAD Investment Trends Monitor’, global FDI activity dropped significantly in 2020, falling 42 percent from $1.5 trillion in 2019 to an estimated $859bn. Analysis by the United Nations Conference on Trade and Development (UNCTAD) reveals that FDI finished 2020 more than 30 percent below the trough that followed the 2009 global financial crisis and is currently back at a level last seen in the 1990s.

The UNCTAD Monitor also shows that the decline in FDI was concentrated in developed countries, where flows fell by 69 percent to an estimated $229bn. Moreover, flows to Europe dried up completely, including large negative flows in several countries. There was also a sharp decrease recorded in the US, which saw a 49 percent drop to $134bn.

In its analysis, the Organisation for Economic Co-operation and Development (OECD) states that FDI and cross-border M&A activity dropped by around 50 percent in 1H 2020 compared to the second half of 2019, the lowest half-year level since 2013. Furthermore, the OECD found that large negative levels of intracompany debt flows further accentuated the drop in total FDI flows during this period.

“Across the globe, FDI and cross-border M&A activity was down,” says Xander Benjamins, commercial director for the Americas at the TMF Group. “Developed countries saw a much stronger decline compared to developing countries. There was, however, an increase in specific regions and sectors due to some larger private equity (PE)-led acquisitions in 2020. For 2021, expectations are unclear, but it seems technology and healthcare are being impacted differently by the pandemic compared to other industries.”

Andrew J. Sherman, a partner at Seyfarth Shaw, considers plummeting activity to be a result of a ‘perfect storm’ – brewed by a combination of significant travel restrictions, a slowing economy, geopolitical tension, trade and tariff wars, immigration restrictions, social unrest, divisiveness and intolerance, as well as a desire by corporates to mitigate risks by focusing on domestic transactions.

“These variables have directly and indirectly influenced corporate development strategy, degrees of risk management and overall unwillingness to tackle multicultural challenges in a time of turmoil,” he points out. “It has also put a strain on post-closing integration objectives, if and when cross-border deals manage to close, and caused an uptick in earn-out disputes.”

Others, however, believe the market has been surprisingly resilient in the face of COVID-19, despite the upheaval. “Although activity is down compared to 2019, I think many deal professionals expected the market to be down by dramatically more than how it finished in 2020,” says Jonathan Corsico, a partner at Simpson Thacher & Bartlett LLP. “The big question is whether COVID-19 causes governments across the globe to again lock down. If that were to occur, I expect M&A activity to remain active, but damped.”

Planning

While the last 12 months has seen a major decline in FDI activity in favour of local or regional deals, for those cross-border M&A projects that are being pursued, parties need to contend with a range of planning issues.

In Mr Sherman’s experience, when undertaking a cross-border M&A transaction, key hurdles, such as overcoming the challenges posed by jurisdictional differences in laws, regulations and culture, should be managed in three distinct phases.

The first phase concerns deal flow generation and due diligence. Companies in different countries may have different viewpoints as to how much information they are willing to share and who a buyer may have access to before the transaction is complete. This can create frustrating challenges for the legal, financial and operational due diligence teams who need access to critical information for both valuation and deal structuring decision making.

The second phase involves recognising differences in international tax laws, labour laws and regulations. Differing forms of jurisprudence can directly impact both the structure of the transactions and the overall negotiation of the transaction in very important areas, such as representation and warranties, conditions to closing, allocation of risk and indemnification.

The third phase pertains to cultural factors and organisational alignment. Harmony in these respects can have a significant impact on the ease and seamlessness of post-closing integration, which can create unexpected and unpleasant surprises in critical areas such as human resources, technology, customer relationships and key vendor commitments.

“Cross-border M&A deal planning is inherently a nuanced exercise,” suggests Mr Duncan. “It requires decision makers to analyse the proposed transaction and situation from the lenses of several stakeholders. Whatever the myriad issues may be, a universal key to success is to formulate proactive strategies to mitigate the known risks and develop response planning frameworks for more remote, ‘unknown’ risks.”

Managing risk

In order to manage both known and ‘unknown’ risks, there are numerous approaches that transacting parties can take – which, according to Jan Willem van Drimmelen, market head for North America at the TMF Group, should be underpinned by five key points in particular.

First, do your homework. A deep understanding of local legislation is crucial in a cross-border transaction’s success, as is an appreciation of local culture. Buyers need to take time to engage with sellers, keep communication lines open and gain buy-in from employees, who will be critical to value creation in the new organisation.

Second, local advisers are imperative. Seek out specialist help to manage specific steps that are required to get the business running – from applying for business licences, opening local bank accounts and payroll tax registrations, through to electronic filing applications and establishing employee benefits. In some regions, these can become the ‘long poles’ that add complexity, delaying operational readiness if not properly managed.

Third, take local timelines into account. Some delays are out of a buyer’s hands, but there is much that acquirers can do to ensure plans take account of local timelines.

Fourth, keep it simple. Parties should consider simplifying operations. Rather than deploying a global enterprise resource planning (ERP) system to all countries where there is not a business case for system localisation, consider a straightforward outsourced solution that works from day one, enabling management to focus on strategic direction, revenue, transitional arrangements for employees and retaining customers.

And fifth, preparation is key. The value of preparing well when targeting a cross-border acquisition is very important. Rigorous analysis ahead of the deal should help identify potential issues that need to be managed and fed into a detailed project plan based on realistic time frames. This type of groundwork enables a buyer to determine where dedicated external resources will be needed to support management teams, and provides a framework around which advisers and outsourcing specialists can coalesce.

Politicisation

Another risk that transacting parties need to be aware of is the increasing number of jurisdictions taking a protectionist stance toward corporate transaction approvals and clearances. Indeed, governments have significantly broadened their discretionary powers to intervene in cross-border projects they feel pose a threat to national security or any other issue they deem to be potentially dangerous.

“In contrast to competition merger control, where regulators assess deals by applying the same underlying principles, FDI regulatory reviews are more at risk of politicisation, which increases the chances of divergent outcomes in different jurisdictions carrying out parallel reviews,” says Matthew Yeowart, counsel at Davis Polk & Wardwell LLP. “Deal teams should identify FDI filing requirements and design a global regulatory engagement strategy to mitigate adverse timing and execution risks. They should also be aware of potentially disruptive post-closing retrospective FDI reviews.”

Sustained and continuous in recent years, major jurisdictions deploying protectionist policies include the US, the European Union (EU) and China, among others. “Even before the pandemic, these jurisdictions appeared to be in a regulatory arms race to police cross-border dealmaking and exercise comprehensive oversight over sensitive industry activity and consolidation,” says Mr Duncan. “It remains to be seen whether this trend will abate or accelerate.

“A Biden administration will be heralded as more internationally cooperative, and hopefully some clarity on the European dealmaking approvals front will result as the Brexit process matures,” he continues. “Tax sensitivities are perennially front-and-centre during cross-border deal structuring conversations, and how to access and preserve attractive transaction tax attributes, such as tax-free spin status or stepped-up bases, will continue to be a critical issue for players.”

Post-lockdown

Against a backdrop of ongoing pandemic-related disruption, as well as pre-existing market volatility and geopolitical concerns, the outlook for FDI and cross-border activity remains uncertain. That said, on the back of a mass vaccination rollout, there are good reasons to believe that the worst of the pandemic will soon be behind us, and to expect emerging opportunities beyond lockdown.

According to the UNCTAD Monitor, global FDI flows will remain weak for the remainder of 2021, with a further 5 to 10 percent slide in activity forecasted. The Monitor also states that due to a hesitant and uneven world economy, investors are likely to remain cautious in committing capital to new overseas productive assets. Moreover, the effects of the pandemic recession will linger and an FDI recovery will not take place until 2022 at the earliest.

“In the short term, the pandemic will likely continue to impact the level of FDI and cross-border M&A,” suggests Mr Little. “Continued uncertainty about the timing of a return to normal economic conditions, disrupted or protracted rollouts of vaccination programmes or unexpected public healthcare developments could, of course, damage confidence and stall potential FDI activity.”

In Mr Sherman’s view, cross-border M&A activity is unlikely to fully, or almost fully, normalise until 2022 or even 2023. “Advisers and dealmakers will need to closely monitor the deployment of the COVID-19 vaccine, as well as the pervasiveness of new vaccine strains and their impact on the achievement of herd immunity across the globe. More developed economies are likely to rebound faster than emerging economies, where distribution of the vaccine may be slower and where access to healthcare may be more constrained.”

For the moment, uncertainty is the only certainty when it comes to what a post-pandemic environment will look like. “Many jurisdictions are in and out of lockdown, local governments are continuing to debate support packages, and buyers and sellers are misaligned on target valuation,” concludes Mr van Drimmelen. “On the positive side, COVID-19 vaccinations are rolling out globally, allowing for a ‘return to normal’ in the near future, and interest rates are at a record low. There is a lot of dry powder sitting unused, waiting for an opportune moment to be deployed.”

© Financier Worldwide

BY

Fraser Tennant