Private equity-led M&A trends – from boom to?

September 2022 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2022 Issue

2021 was a record-breaking year in terms of private equity (PE)-led M&A: PE buyouts comprised 27 percent of global M&A activity, the highest percentage on Mergermarket record (since 2006). In our recent PE study, we reviewed over 100 M&A transactions we acted on in 2021 where one of the parties was a PE fund, in order to identify key market trends. A snapshot of the more interesting highlights is below.

Buy, sell or add-on

Based on our review, across Europe over the last two years we have generally seen considerably more new investments (70.6 percent of deals) than exits (14.7 percent of deals; with the remainder being secondary buyouts, i.e. deals with a PE investor both on the sell side and buy side). This is consistent with an environment where fundraising is still very active, and therefore cash is in need of deployment, but the uncertainties of the pandemic delayed many possible exits, as PE funds are waiting for better valuations to fully maximise their returns. In 2021, the number of exits and secondary buyouts have started to increase compared to 2020 (by just over 3 percent according to our study), with market participants seemingly having started to feel more optimistic again.

Interestingly, the percentage of add-on acquisitions increased significantly in 2021 compared to 2020 – 40.9 percent of the deals reviewed in 2021, versus 27.1 percent of the deals reviewed in 2020. This shows how PE investors have seized on opportunities to develop and grow existing portfolio companies through this M&A strategy, which is perceived to be lower risk.

From a sector perspective, most of the deals analysed involved the technology, media and telecoms (TMT) sectors (23 percent). This is in line with the overall market trend. According to Mergermarket data, 2021 saw huge deal volumes in the TMT sector with a total of 3913 deals, which is close to double the still rather healthy activity in 2020.

Foreign direct and indirect investment controls

Over the last few years many countries in Europe, including the UK and many member states of the European Union (EU), have seen the introduction or tightening of approval regimes for direct and indirect foreign investments (FDI) in a fairly wide range of sectors regarded as potentially strategic or sensitive. These include sectors traditionally caught by such rules, such as defence and aerospace, but increasingly also a range of broadly defined areas including energy, transport, water, telecommunications and technology (e.g., artificial intelligence and robotics), which can catch parties off-guard.

For PE funds this topic is particularly relevant, as many of them or their investors are based outside Europe and even minority portfolio investments may be captured by FDI regimes. The European Commission suggested in its 2020 guidance paper that the acquisition of a shareholding as small as 5 percent might be of relevance in terms of security or public order scrutiny, where such shareholding confers certain rights to the shareholder or connected shareholders under the national company law.

Our study looked at how many PE deals in 2021 featured FDI approval as a condition to completion of the acquisition or sale. We found that, in 2021, 14.8 percent of transactions included the need to obtain approval or clearance: in most cases (83.3 percent), the process only took up to three months, while in 16.7 percent of cases the procedure lasted between three and six months.

While in the vast majority of cases the parties believed that FDI approval was a legal requirement, in 25 percent of transactions the FDI process was voluntarily triggered as a precaution to prevent any possible scrutiny (and potential unwinding of the transaction) after completion. This demonstrates how in many cases, given that FDI rules have been implemented only in the last couple of years, there is still a lack of clarity on their interpretation and practical application, which has added a layer of uncertainty to the deal process.

Reviewing the FDI position early on, and planning around it, will have to become the norm on transactions, if delays and unwelcome surprises are to be avoided down the line.

Purchase price adjustments and earn outs

When there is a gap between signing of the contract and actual completion of the deal – for example because merger control or FDI approval needs to be obtained first – purchase price adjustment mechanisms are often used in order to ‘true-up’ the valuation of the company based on the net debt and, in certain cases, working capital and/or net assets position as of the completion date.

A purchase price adjustment clause is seen as a rather buyer-friendly approach, as it ensures that the buyer does not end up paying too much if the value of the target company decreases between initial valuation and completion date, although a buyer may well end up paying more if the company outperforms expectations. In contrast, the certainty of a fixed price with no completion adjustments, referred to as ‘locked box’, can be broadly more favourable to sellers, as it guarantees the consideration to be received irrespective of what happens (subject to leakage provisions) and removes any delays or disputes related to adjustment calculations.

In 2021, irrespective of deal value, the vast majority of the PE deals analysed in the study (85 percent) calculated and fixed the purchase price at or before signing, which is interesting as in over 70 percent of those deals PE houses were acting on the buy side. This seems to suggest that PE funds are overall more comfortable with locked-box valuations even when on the buy side.

A minority of PE deals continued to use earn outs as part of the purchase price package, with a marked difference in popularity between deals of smaller value, where earn outs were used in 31 percent of PE transactions, and deals with a purchase price exceeding €100m, where earn outs were used only in 11 percent of transactions. Earn out clauses were most common in Benelux, Central and Eastern Europe, and Germany, with Germany being consistently more in favour of earn-out provisions compared to other European countries.

Where an earn-out mechanism was used, the majority of deals used earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortisation (EBITDA) as the metric (66 percent), with the next most popular criteria being turnover (14 percent) and earnings (7 percent), although turnover was the most favoured criteria on deals over €100m. The largest number of M&A deals (38 percent) had 12 to 24 months as the earn-out period, while PE deals preferred a shorter timeline, with 44 percent of PE deals having a six to 12 months earn-out period and a sliding scale in the longer earn-out time periods.

The data confirms that earn outs on PE transactions are the exception rather than the norm and are used only where essential to bridge uncertainties in the valuation, a position that we do not expect to change dramatically over time, irrespective of market conditions.

Management incentive schemes

PE funds are fundamentally financial investors and, while they may have differing levels of hands-on involvement with the management teams at their portfolio companies, they ultimately all rely on those management teams to deliver the expected growth to make the investment a success. Management incentive schemes are therefore an essential element of all PE investments, as a way to align management’s interests to those of the PE fund.

Our study looked at some of the key terms of management incentive schemes (MIS) and the prevailing features identified based on 2021 transactions include the following. First, up to 25 percent of proceeds were allocated to management in 80 percent of schemes, with a small minority allocating more. Second, most MIS came in the form of shares, meaning managers were given the opportunity to acquire shares in the business alongside the PE fund. Third, the time horizon was four to five years in 67 percent of MIS, with the remainder on shorter time horizons of two to three years. Fourth, most schemes contained provisions to cater for managers who cease to be employed by the company (‘leavers’), with 71 percent of MIS requiring managers to give up all their shares (whether ‘sweet equity’ or ‘strip’) if they leave. Finally, MIS categorised leavers between ‘good’ and ‘bad’ (and in some cases also ‘intermediate’ and ‘very bad’) depending on the reason for the departure, and shares were taken away from bad leavers in the vast majority of cases (84 percent of all schemes), while good or intermediate leavers were allowed to keep vested shares in 42 percent of schemes reviewed.

What about 2022?

Inflation, intensified by rising commodities prices and the sanctions on Russia as a result of its conflict with Ukraine, are taking their toll across the board. The ongoing stress on markets is visible through deal dynamics in 2022 to date: transactions are still happening, but the pace is significantly slower than in 2021 and unsurprisingly valuations are the main point of attrition and delay.

Given the recent downturn experienced by the technology sector, it will be interesting to see whether investment volumes in TMT remain strong or see a corresponding decline. Arguably, many companies in the sector are performing well operationally, despite the turbulence, and valuations may well pick up again once markets stabilise.

Finally, we should not forget the rising cost of debt, which will inevitably reshape how new and existing investments are managed by PE funds, after years of cheaply available debt capital.

However, global private equity houses are still sitting on vast amounts of capital in need of investment (an estimated $2.3 trillion according to public sources), which means deal volumes are expected to remain healthy in 2022, although perhaps not at as high as in 2021.

Valentina Santambrogio is a partner at CMS. She can be contacted on +44 (0)20 7367 3631 or by email: valentina.santambrogio@cms-cmno.com.