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The investor landscape as recovery era M&A driver
Investors now view M&A as an efficient means for most issuers to achieve short-term increases in trading multiples (through bolt-ons and divestitures) or premiums (when selling the whole company). Clients facing this pressure include many outperformers. For investors, outperformance is not an excuse to stay away from M&A if a multiple bump is within reach through a divestiture or acquisition. Moreover, investors are rarely inhibited by the regulatory hurdles or complexities when pushing for M&A.
Additionally, within the investor community the continued shift of money away from actively managed funds (such as T. Rowe, Fidelity and Capital) is putting pressure on them to outperform in the near-term, which in turn drives them to push the issuers in their portfolios to engage in M&A. Meanwhile, the bonds between the passive strategy groups (ETF and index – e.g., BlackRock, State Street, Vanguard) and the true activists continue to grow (e.g., as the activists profess allegiance to ESG concerns). In return, we expect the passive strategists to support the M&A alternatives for which the activists push.
Macro forces further fuel deal activity
The recovery era will see enhanced dispersion – we are entering a time of winners and losers – which results in overwhelming pressure to be grouped with the winners. Many CEOs view M&A as a vehicle to achieve this outcome.
Especially in battered industries, we are seeing clients aggressively seek to emerge as consolidators.
Additionally, the competition among both cash-rich and distressed companies to acquire business lines that will be favored by the recovery era is fierce.
The availability of financing, whether from banks and capital markets for the financially healthy or equity PIPE financing for those with more challenged financial conditions, further fuels these M&A strategies.
In addition, the markets have looked favorably on a number of businesses during the period leading up to the recovery era and therefore, whether or not their equity is publicly traded, they are entertaining the use of their stock as acquisition consideration.
Finally, some “winners” may emerge too strong, and we will therefore see divestitures either mandated by antitrust authorities or preemptively taken on to mitigate antitrust scrutiny – both within and outside the context of transaction clearance processes.
Valuation disconnects will haunt recovery era M&A
The recovery era will be characterized by market volatility, disconnects between internal management forecasts and Wall Street forecasts, and uncertainties about macro factors. These dynamics will make meetings of minds on valuations difficult. We are already seeing an increasing tendency to try to lean on earn-outs and contingent value rights (CVRs), and creative exchange ratio formulas to bridge the gaps.
Moreover, in anticipation that it will not be possible to bridge these gaps, buyside clients are dusting off their hostile bid playbooks of bear hug letters, strategies for tender offers to function as symbolic market referenda in the face of poison pills, buying shares to have standing to bring fiduciary duty litigation against target boards, and planning proxy contests to replace directors supporting poison pills and opposed to exploration of strategic alternatives.
Longer periods between sign/close and enhanced regulatory execution risk will impede recovery era M&A
The emergence in recent months of enhanced foreign investment regimes across the world (including the material expansion of CFIUS reviews) and bold antitrust scrutiny of mergers will lead to longer periods between signing and closing.
The consequences of this will include further need for creativity in interim operating covenants (compounding the difficulty of figuring out how to articulate what is “ordinary course” in times that are dynamic and extraordinary), innovation in addressing needs for financing by target companies between sign and close – especially in the case of targets that are burning cash (e.g., buyers may have to serve as sources of credit to help their targets make it to closing) – and increasing pressure on the covenants, conditions and reverse termination fees that allocate the risk and specify the procedures for addressing execution risks arising from regulatory clearance requirements.
As more deals in the coming months fail to reach the finish line – notwithstanding undertakings that had been described to the target boards as having been guaranteed by the acquirors’ “hell or high water” commitments – regulatory covenants in merger agreements will need to become more granular to permit efficient specific performance suits by targets and sellers.