Consensus opinion coming into 2022 was that high M&A volume would continue, albeit not quite at the record-setting pace of 2021. The market had other plans. Volume decreased much more sharply from the 2021 high than was commonly expected. While overall deal volume was generally in line with averages from 2017-2020, 2022 was a tale of two halves—there was a marked drop from H1 to H2, with Q4 representing the lowest Q4 global deal volume in the past six years.[1] Significant stock market volatility wrought havoc on valuations. Higher interest rates and a retreat by large banks from the leveraged loan market chilled leveraged buyout financing. Macroeconomic and geopolitical uncertainty turned confidence to caution. Valuation disconnects scuttled deals as sellers continued to expect 2021 multiples. Regulatory scrutiny made execution more complex. Entering 2023, many of these headwinds continue.

Yet, 2022 was still a strong year for dealmaking. And opportunities still abound.

With several significant macroeconomic variables in the balance, there is less consensus on the outlook for 2023. Will this year be in line with five year averages? Is there room for rebound from there or will we see significant further drop off? Only time will tell, but we expect forecasts to vary by sector, with outlook as a whole significantly affected by how quickly inflation stabilizes and the timing and depth of potential recessions in the U.S., EU and China.

Furthermore, the structural drivers that fueled a record 2021 and buoyed M&A last year remain largely intact. The disruptions induced or accelerated by COVID-19 and its aftermath will continue to drive consolidation in a number of industries. Cash-rich corporates continue to look for opportunities to position themselves strategically for the long term. And although the fundraising environment is facing additional headwinds, private equity buyers who spent more time tending to their portfolios in 2022 will look to deploy their still substantial dry powder opportunistically as valuations reset. The onset of a recessionary environment will provide acquirors with strong balance sheets or capital to deploy with even more fertile ground for deal-making.

Our sense from boards, senior management teams, private equity professionals and other dealmakers is that M&A is very much on this year’s agenda. What follows are some key themes we expect may play out in 2023, as well as some lessons from 2022 that they should bear in mind.

Muddy Waters, Many Fish. Amidst the stream of murky macroeconomic events, we expect dealmakers to wield an expanded toolkit to catch passing opportunities.

• Corporate carveouts, particularly in the form of tax-free spin-offs, maintained a steady pace last year despite overall M&A deal volume fluctuations. We expect this to continue in 2023. Portfolio reshaping will remain a driving force for dealmaking, as corporates look for opportunities to separate high-growth from low-growth assets and achieve multiple re-ratings, and spin-offs avoid valuation disconnects between buyers and sellers. Leveraged spins can also provide an attractive opportunity for the parent company to de-lever or put cash on the balance sheet.
• As acquisition financing costs are likely to continue to increase at least in the near term, we expect to see private equity sponsors, who very much need to put dry powder to work, continue to innovate in the absence of affordable financing for typical leveraged buyouts. In 2023, we expect to see private equity firms increase equity checks, turn to founder-based strategies and smaller deals (as larger PE funds invade the realm of venture firms), rely on the direct lending market, focus on strengthening portfolio companies through add-on acquisitions and other strategies, and consider minority investments or targets with portable debt structures (which can reduce the need for acquisition financing and avoid repayment of legacy lower cost debt). The latter trend, paired with demand for corporate carve-outs, may also lead to an increase in sponsored spin-offs.
• In private transactions, we expect to see an increase in seller financing and use of earn-outs to bridge financing and valuation gaps.
• Other creative deal structures, including joint ventures and partnerships between strategics and between strategics and private equity firms or their portfolio companies, will also provide opportunities to diversify balance sheets, share costs of R&D and unlock synergies.
• We also expect the large number of high growth, low revenue public companies that emerged from de-SPAC transactions, as well as depressed valuations in the tech sector, to continue to spur take-private activity.

Antitrust the Process. As we predicted at this time last year, the recent trend of increased scrutiny of transactions from competition regulators, particularly in the U.S. and Europe, continued in 2022. But in the U.S., substantial shifts in announced antitrust policy and bold public statements from antitrust enforcers have not yet been matched by a surge in actual enforcement, and the agencies suffered unprecedented setbacks in court. For further discussion of these antitrust developments, see 2023 Update: U.S. Antitrust Sets Sail Into Uncharted Seas. Despite the fact U.S. enforcement statistics have not quite matched the rhetoric to date, merger review in 2023 will continue to create complexities in transaction planning and execution. Deals raising horizontal or vertical issues will continue to get done, but will require thoughtful planning.

• U.S. antitrust agencies (particularly the Department of Justice) are likely to continue challenging the adequacy of merger remedies, placing an onus on parties to address issues proactively and “fix it first” or be prepared to “litigate the fix.”
• U.S. agencies have also expressed some hostility to private equity firms in general, complicating some private equity transactions, particularly with respect to portfolio company “add-on” acquisitions. In particular, in the context of antitrust remedies, the agencies have challenged private equity firms as divestiture buyers, which will require these buyers to demonstrate their experience and expertise in the relevant industry and have a concrete plan for the target business (which will likely be viewed more favorably by a court if it shows investment in the business relative to the standalone plan).
• Although for the most part the agencies’ bark has been worse than their bite, the rhetoric has injected a measure of wariness into the market, particularly on behalf of sellers. In cases where regulatory remedies are likely, we expect to see increasing prevalence of regulatory reverse break-up fees and ticking fees in order to incentivize buyers to obtain timely clearance and avoid the need for sellers to prove damages.

“Fool me once, shame on you…” Between the COVID broken deal cases and the drama to emerge from last year’s market dislocations, sellers have now had two vividly recent opportunities to consider the importance of conditionality and deal remedies when a buyer finds remorse. We may not be through the turbulence yet, so they are advised to give careful consideration to deal protections in negotiations this year.

ENDNOTE

^[1]  Data taken from Bloomberg.

This post comes to us from Cleary Gottlieb Steen & Hamilton LLP. It is based on the firm’s memorandum, “M&A in 2023: A Year of Cautious Optimism?” dated January 17, 2023, and available here.