Rising inflation and the uncertainty over whether high interest rates will persist have created a challenging “expectation gap” between buyer and seller valuations in the M&A space, experts say.
According to Paul Joyce, Head of London M&A at Mazars, challenges presented by persistent rate hikes from the Bank of England combined with inflationary pressures are impacting the availability and cost of debt. This has raised the cost of capital when making an acquisition, subsequently affecting expected return hurdles.
“This has particularly impacted financial investors such as private equity funds, who focus heavily on expected returns when assessing whether to acquire and, also, tend to use a larger proportion of debt in their acquisition structures,” he explains.
“Rising inflation has also widened the ‘expectation gap’ between buyer and seller valuations. This is the difference between the price a buyer would ideally pay for the acquisition and the price at which a seller is prepared to accept.”
When expectation gaps become too wide, Joyce says, M&A transactions get more difficult to execute.
“A prolonged period of low interest rates and high demand for acquisitions has set sellers’ value expectations at historically high levels – conversely, the increased uncertainty in the financial markets have caused buyers to become more cautious.
“This combination has caused the ‘expectation gap’ to widen significantly over the last six months.”
According to EY’s latest M&A analysis, deal value has indeed more than halved year-on-year — falling from £11.5bn in the first half of 2022 to just £4.6bn in H1 2023. But while the value of deals has declined, activity has actually increased.
EY also reported a 16% YoY rise in deal volumes, with 50% of UK CEOs saying they plan to acquire in the next 12 months.
James Lawson, Corporate Finance Partner at MHA, says that the rise in activity has been particularly persistent at the mid and lower-mid market levels.
“In this market segment, inflation and interest rates will still have had an impact, but they are more likely to impact the headline valuations and deal structures, given that leverage tends to be more conservative,” he explains.
“M&A processes often act as a catalyst for founders to realise personal goals, as well as corporate or business strategic objectives — that remains the case in times of economic uncertainty as much as periods of rampant growth. Given it’s impossible to accurately predict macro-trends, timing a process just right for ‘the market’ is debatably a fool’s errand.”
‘Dry powder’ and early exits
In terms of the key drivers behind this the continued growth in M&A deal activity, advisory firms are pointing to an increasing number of founders looking for viable exit strategies.
“Financial challenges in doing business, increased risks in owning a company, and the impact of the pandemic on people’s priorities and life choices have encouraged business owners to reflect on the potential value of their business, retirement plans and succession options,” Joyce explains.
“Rising interest rates and the risk of changes in government policies, particularly related to capital gains tax, have also played a role in influencing business owners to consider crystallising value through full or partial exits.”
According to Joyce, there’s still a high volume of “dry powder” amongst private equity firms — which is why he says market participants should expect high levels of activity to continue moving into 2024.
“Technology has also been a significant impetus behind M&A activity over the last few years, both through VC and PE firms seeking to invest in high growth, disruptive businesses bringing new technology to market but also companies looking to access new forms of technology to transform their own businesses,” he says.
“The move to technology-enabled services and recurring SAAS or subscription models over more traditional revenue models is attractive for businesses looking to stay ahead of competitors and create more secure, repeating revenue streams.”
Enhancing client support
With deal volumes expected to maintain their existing momentum, Andrew Moss, Corporate Partner at DSG, says it’s essential that advisory firms are in a position to offer M&A clients a “full service” spanning the entire lifecycle of any given deal.
This requires accountancy firms to expand their service portfolio beyond ‘traditional’ accounting service lines – and Moss says that firms are responding to that demand in kind.
“We talk regularly to clients to understand their plans, whether it be to grow, or to exit, and work with them to help them achieve their goals,” he says.
“That might be giving them an initial indication of value, helping them search for an acquisition or potential buyer and providing complimentary services from provision of regular management information and forecasts to deal and company structuring to ensure the best outcome. We also work with clients in sourcing funding for transactions.”
By utilising this range of services and ensuring clients are choosing a partner capable of offering a one-stop-shop, Mazars’ Joyce says that founders will be better poised to take on new deals moving forward. This is particularly true surrounding due diligence and overcoming the emerging expectation gaps between buyers and sellers.
“The M&A process is a complex and challenging one. Not only does it impose significant burden on the business from a due diligence perspective, but the allocation of risk and value can be materially impacted by elements such as the completion mechanisms, working capital adjustments and deal structure,” he says.
“Understanding, analysing and negotiating on these key points can make the difference between a ‘good’ deal and a ‘bad’ deal.”