Out-Law Analysis 4 min. read
A look at PE deal-making in the UK reveals mixed picture but grounds for optimism
30 Apr 2024, 10:55 am
A return to the Covid era boom of private equity-backed deal making in the UK is not anticipated in 2024, but we do expect deal volumes and values to pick up as the year goes on.
In 2023, the overall picture was one of lower deal volumes and values than we had seen in 2022, but our experience was of a market split very much in two.
The predominant position was of “stodgy” market conditions: deals taking longer than we would normally expect to complete and requiring bespoke structuring to reconcile the gap between buyer and seller valuations, or failing to materialise as negotiations broke down.
Those features of the market were influenced by high inflation and the cost of finance. This served to make some investors more risk averse and influenced the price they were willing to offer and the attractiveness of management terms on offer. A lack of competition between investors for deals due to uncertainty in the market also meant buyers could drive a harder bargain and led to due diligence and decision-making processes being prolonged.
On the other hand, there were pockets of the market that were buoyant. Businesses with high levels of recurring revenues, good cash flows and a consistent record of growth, such as healthcare and tech-enabled businesses, remained hot tickets. This was particularly true of technology assets, such as software-as-a-service companies, given the undiminished appetite across the economy for technology-enabled innovation and the efficiencies they drive.
Opportunities for investment in those businesses were seized upon by investors, which enabled sellers to run competitive auction processes to drive deals, shorten deal timetables and achieve better terms for vendors and management teams alike.
With investors dropping offer prices across many sectors and with high interest rates on senior debt serving to dampen value expectations as well as impacting the proportion of sweet equity offered to management, we nevertheless saw some creative deal-making in 2023.
Ratchet mechanisms, for example, were popular in incentivising senior management – often so integral to the growth of those companies – to remain in position post-investment and drive future performance. Where they were used, they were more generous than in previous years, serving to bridge the gap between the proportion of day one sweet equity on offer and reward for overperformance on future exit. The exception to this was where there was a competitive and aggressive sales process for the minority of highly-sought-after assets. In those instances, management terms were of secondary consideration as the sale price was driven upwards.
Despite lower deal volumes, we also saw a surge in warranty and indemnity insurance (W&I) claims notifications pertaining to issues that have surfaced within businesses post-investment. This is a common trend we see in economic downturns, as investors and buyers turn to their insurance policies for increasing liquidity and to limit any adverse financial impact that may be suffered. However, the significant rise in the volume of notifications has not had a material impact on the price of W&I premiums, as the insurer market remains competitive and deal volumes are yet to bounce back.
For 2024, the pipeline of deals across the market that advisers are talking about is significantly larger than a year ago, but it is still a challenging market to get deals over the line.
Deal-making takes longer now than it used to. There is a lot to consider, from M&A and equity terms, insurance, commercial performance and positioning, and of course the underlying financial results, for example, and the economic uncertainty in the market has meant investors are understandably keen to take their time to ensure they encounter no surprises post-investment. Due diligence processes are more extensive than they have ever been as a consequence – even for the highest quality assets. While the proliferation of data that exists can help investors get comfortable with the risk they are taking on and make data-led decisions, the data also takes a lot of unpicking – even with AI and other technologies that can now help.
One specific trend we have seen that is serving to slow down deal-making is increased uncertainty and scrutiny of the risk of historic tax liabilities arising from the issuance of equity by the selling company. Many investors and their diligence teams are spending a lot of time probing whether or not any equity that's been issued has been issued at fair market value or at undervalue. We have seen a definite trend in investors taking out specific tax risk insurance to address the risks that have arisen from diligence. This has also increased the level of diligence around the pricing of any new sweet equity being issued on a deal, with a growing need for tax valuations to support appropriate management elections.
ESG reports provide some of the data points investors will examine too. These reports, in particular, give investors an insight into what sellers are doing to address the climate and sustainability agenda in their own operations and play into a company’s value – something that will continue to be the case notwithstanding the lingering uncertainty around how elections in the UK, US and Europe this year might affect the speed at which the drive towards net zero targets will be pursued by policymakers in the years to come.
As we look ahead to the rest of 2024, the ‘dry powder’ in the mid-market is higher than it’s ever been, with a significant pipeline of deals. With economic forecasts more optimistic towards the end of the year and with market conditions less turbulent than they were, there is cause to believe that deal-making activity will pick up pace as 2024 progresses, but to what extent is unclear given the willingness by many investors to sit on funds until the right opportunity arises.
In many instances, the focus of investors remains on running robust businesses within their existing portfolio, but we do continue to see opportunities for PE-backed takeovers of public companies that are trading at below value due to prevailing challenges in the market they are operating in, such as in consumer goods or hospitality.
In some sectors, we might expect PE-backed consolidators to remain popular as a way of deriving growth – and therefore value – through aggregation. We have seen this trend in the financial advice and wealth management sectors recently.
We also continue to see a rise in secondary transactions where investors sell to succession funds which allows limited partners (LPs) to achieve an exit. In the current market, many investors feel they are unable to get the value they want from a full exit, and so they are exploring selling assets to associated funds to unlock liquidity to invest in other assets or return funds to existing LPs, with a view to achieving a full exit for the succession funds when the market is more buoyant. We expect this trend to continue in 2024.
Co-written by Tom Leman and Kieran Toal of Pinsent Masons, Simon Cope-Thompson and Jamie Hutton of Arrowpoint Advisory, and Ella Shillingford of Howden M&A.
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