This article was first published by the Financier World Wide

Largely due to the worldwide economic turmoil caused by the global coronavirus (COVID-19) pandemic, recent years have seen global business disruption on a grand scale – a scorched corporate landscape ripe for distressed mergers and acquisitions (M&A) practitioners to pick over.

Trends in traditional M&A activity

In 2021, global dealmaking value topped $1 trillion in each quarter for the first time on record. Moreover, according to analysis by EY, in the first six months of 2021, M&A activity hit an all-time high, with deals worth more than $2.6 trillion, up from $926bn year-on-year and surging past the pre-pandemic five-year average of $1.6 trillion in H1 2015-19.

Despite the strong headline figure however, M&A activity in 2021 was not evenly spread across the globe, with the main centres of outbound and inbound transaction activity located in North America and Europe.

Indeed, more than half of the M&A transactions seen in the first six months of 2021 were recorded in North America, which saw deals worth $1.4 trillion (up from $345bn in H1 2020) – almost double the average seen in the five years prior to the pandemic ($784bn). In terms of European activity, the EY analysis records deals valued at $412bn, up from $245bn in H1 2020 and exceeding the H1 2015-19 average of $356bn.

“Dealmakers will always be on the lookout for innovative funding solutions, and special purpose acquisition companies (SPACs) started 2021 as the main show in town,” says Andrea Guerzoni, global vice chair of strategy and transactions at EY. “After recording peak numbers early in the year, SPAC activity has slowed recently, but the M&A momentum has continued pointing to a fundamentally strong market moving forward.”

That said, levels of activity on the scale seen in 2021 were unlikely to continue ad infinitum, and so it has proved. Due to a range of factors, notably a surge in inflation, tougher regulation and the Russian invasion of Ukraine, global dealmaking in 2022 has fallen to its lowest level since the start of the pandemic, a slowdown that ends a record-breaking period for M&A.

According to the GlobalData report ‘Mergers and Acquisitions Deals by Top Themes and Industries in Q1 2022’, global M&A activity has clearly weakened in the first quarter of 2022. The report notes that a total of 9207 M&A deals were announced in Q1 2022, representing a drop of 10 percent from the previous quarter, with total transaction value dropping to $725bn – almost 23 percent lower than Q4 2021. Over the same period, the number of mega deals – those valued at more than $1bn – fell by a third.

“With the impact of disruptive events continuing to touch companies, sectors, countries and individuals across the globe, such an environment lends itself to distressed investment opportunities.”

“M&A deal activity saw a dismal start to 2022, with activity in Q1 registering lower than every quarter in 2021,” points out Snigdha Parida, a senior research analyst at GlobalData. “This is largely due to the dissipation of the COVID-19-driven boost to dealmaking and the broader economic outlook. We will now start seeing things return to ‘normal’.”

This normalisation, however, will not be without difficulty. “Looking at the current mix of macroeconomic conditions, geopolitical uncertainty, supply chain disruptions and other factors, dealmaking in the coming quarters of 2022 will continue to face significant challenges,” adds Ms Parida.

Regional developments

In a challenging environment, where investment opportunities remain strong, it is now more important than ever for dealmakers to carefully consider macroeconomic, political, and legal and regulatory developments as part of their M&A strategies.

As the main focus of M&A activity in recent years, US and UK market fluctuations can tell us much about current and forthcoming trends and help players anticipate obstacles, adapt to evolving regulation and innovate M&A strategies.

“The UK market has actually remained quite flat through 2021 and into 2022,” observes Ian Benjamin, a partner at Stephenson Harwood LLP. “Support measures introduced by governments have been highly effective in propping up ailing businesses – at least for the time being – however, the future remains uncertain, now that those measures have been switched off.

“However, this has only served to delay the problems which mid-market companies will eventually have to face,” he continues. “Spiralling inflation, supply chain shortages and delays, and staffing issues will all impact business in the UK in different ways.”

In comparison, in the US, M&A activity has been very strong over the past 24 months, driven by the large fiscal stimulus, confidence post-lockdown, favourable valuations, the availability of both equity and debt capital and cheap credit – factors that have served to keep most M&A practitioners extremely busy and deal flow strong.

“Given the buoyant economic conditions and minimal insolvencies, this has meant fewer distressed deals than usual, on the whole, in recent times,” affirms Peter Bowden, a partner at Gilbert & Tobin. “However, it has also meant intense competition for deals leading to good outcomes for stakeholders and higher prices being paid for assets. Therefore, those who have been able to move quickly have been able to secure those distressed deals that made it to market.”

Challenges and strategies

Given its inherent nature, the distressed M&A market comes with a plethora of risks for dealmakers, compounded by key legal and practical differences between distressed and non-distressed M&A transactions. Moreover, as is generally the case when acquiring distressed businesses (whether in or outside of an insolvency process), challenges are often due to issues around due diligence and timing.

“Access to information is always critical and lack of information will inevitably impact price,” says Mr Benjamin. “In the current market, it is no surprise that the deals so far have often been trade buyers acquiring ‘bolt on’ businesses, where their existing operations can often integrate more easily. Such consolidation has already been seen in the retail and hospitality and leisure sectors.”

At present, the major challenges facing the market are deal flow and strong competition, although with macroeconomic factors indicating a distressed cycle is more than likely on the way, a lack of deals may not remain a problem for much longer. “The ability to move quickly and transact on covenant-lite terms with minimal due diligence is key,” suggests Mr Bowden. “Ultimately, this goes to risk appetite and price.”

Ultimately, these factors are all key in enabling potential buyers to best position themselves to acquire an asset, allied with an open mind to providing funding to external administrators which may provide a competitive advantage to bidders.

“We have seen some acquirers use loan-to-own strategies to acquire assets, and this is best achieved by acquiring the secured debt in a target as the first step in the process,” notes Mr Bowden. “This can be a very effective strategy by giving the debt purchaser a degree of control over the restructuring process and access to people and information. It is particularly effective where the value of the assets – on any objective basis – breaks somewhere in the senior debt. If there is a return to equity, this strategy is less viable.”

Distressed assets

The economic uncertainty seen over the past few years has placed many companies in a difficult situation of being forced to sell assets and restructure their operations and debt in order to avoid a court-mandated sale at a later time. And while some have weathered the storm better than others, sectors such as non-renewable energy, construction and retail remain susceptible to distress.

One example is the collapse of fashion retailer Missguided, which had attempted to venture into physical retail and subsequently struggled to manage its suppliers. Ultimately, the company failed to restructure its balance sheet and fell into administration, whereupon Mike Ashley’s Frasers Group stepped in to acquire the business for £20m in June 2022.

“Certain sectors have attracted more activity than others, even if the overall level of distress has been relatively low,” says Mr Benjamin. These include energy firms – due to lack of sufficient hedging – and, unsurprisingly, retail and leisure, which is often due to high operational leverage.”

In the view of Mr Bowden, Virgin Australia was the most high-profile restructuring to have occurred in Australia in the midst of the pandemic. It was an extremely complex restructuring given the scale of the asset, its national importance, the sheer number of creditors and the significant associated value involved.

“What was interesting about Virgin is that it was restructured through a deed of company arrangement (DOCA) which, in some respects, ‘bucked’ the trend of the last distressed cycle which saw a large number of complex restructures facilitated through creditors’ schemes of arrangement,” observes Mr Bowden. “While ‘schemes’ will always remain a popular mechanism, particularly in complex restructures of listed entities, we think the trend toward DOCAs is likely to continue off the back of Virgin, given the flexibility of DOCAs and the post-pandemic case law that has developed and remains helpful to administrators seeking to implement restructures through DOCAs.”

Future shocks

With the impact of disruptive events continuing to touch companies, sectors, countries and individuals across the globe, such an environment lends itself to distressed investment opportunities, with those on the radar well-advised to adopt resilient strategies to withstand any future shocks or crises that may arise in the remainder of 2022 and into 2023.

Many macro-events continue to unsettle global economies. Among them are escalating complications following the UK’s departure from the European Union, the ongoing pandemic, and, most recently, the Russia/Ukraine conflict – two nations which are central to the supply of goods and natural resources across the world.

“There remains significant unused capital within the distressed investment sector ready to deploy as these scenarios unfold,” says Mr Benjamin. “I would expect to see an uplift, or continuation, of activity in energy, retail and leisure, manufacturing and real estate.”

According to Mr Bowden, it is essential for distressed investors to act quickly, be willing to be flexible and to utilise insolvency regimes to the maximum extent possible to preserve businesses and value, and protect creditors. “Do not be afraid of, for example, using the voluntary administration regime to give effect to restructures, as it provides acquirers with many levers that can be useful in effecting restructures of distressed assets,” advises Mr Bowden. “Dealmakers should also be on the lookout for opportunities to acquire distressed assets prior to a formal insolvency process commencing.

“More deal flow is expected as interest rates increase, inflation takes hold and confidence dips,” he adds. “We expect to see more distressed funds and private equity funds enter, or re-enter, the market looking for deals as traditional M&A activity cools.”