M&A Risk in Review H1 2021

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M&A Risk in Review 1H, 2021:

A Tale of Sharp Recovery and Resiliency

Few if any dealmakers foresaw the events of 2020. The damage wrought by the abrupt opening and closing of parts of the economy and the human cost of the pandemic has been acutely felt by companies. Investors have had to return to the drawing board to reappraise their strategies and determine the best course of action. The resilience of the M&A market in the 2H 2020 and 1H 2021 has been nothing short of remarkable. The rebound has come despite the elevated risk outlook, suggesting suggests that demand for M&A insurance will be high. Deal parties will be looking to protect their downside and improve their liquidity by circumventing the use of escrow accounts. Results of our latest survey of senior executives from corporate development teams, private equity firms and investment banks support this expected trend.

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Key Takeaways

M&A 2021

Identifying opportunities

Financing Prospects

Risk and Risk Mitigation

Litigation and Tax Risks

Trends for the year ahead

Key Takeaways

M&A 2021

Identifying opportunities

Financing Prospects

Risk and Risk Mitigation

Litigation and Tax Risks

Trends for the year ahead

Key Takeaways What we heard from our survey respondents

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Sectors with the most expected M&A activity

Anticipated hot regions for M&A

Critically important sources of funding

Top risk mitigation strategies

M&A 2021

Sectors with the most expected M&A activity

Last year and the beginning of this year was the most turbulent period in recent memory and our survey reveals that investors are divided on their expectations for 2021.

Soon after the coronavirus outbreak was deemed to be a global pandemic, financial sponsors and strategic acquirers refrained from participating in the deal market as they reassessed the risk environment and their strategies. This resulted in the lowest quarterly performance in a second quarter for more than a decade. The US$372 billion in transactions represented a year-on-year decline of 62%. However, with the easing of lockdown measures came a sharp rebound in completed deal flow in the third quarter and this recovery carrying over into Q4.

Over half, 52% believe that dealmaking will stay at similar levels or increase The remaining respondents feel that the number of M&A deals globally will decrease over the next 12 months, including 34% who think it will decrease by more than 5% compared to the previous 12 months

Ups and downs in dealmaking

The simple fact that target companies’ operational bandwidth is taken up navigating the challenges of today’s environment can make due diligence more burdensome than usual.

Reasons to be optimistic about the months ahead

Swift progress has been made in 2021, with the mass roll-out of vaccination quelling the rising pandemic in the US. If successful, this should prompt a return of economic activity in cyclical industries and those most exposed to the effects of the pandemic, such as energy, industrials, travel, leisure and the discretionary consumer goods sectors

Reasons to be optimistic about the months ahead

Reasons for caution

Identifying opportunities: Sectors and Regions

There were clear winners and losers with sectoral lines more pronounced than ever.

WINNERS

LOSERS

WINNERS

Big tech and the wider software and technology industry outperformed all others TMT has been a strong M&A performer in recent years but extended its lead in 2020 Investors are confident that these fundamentals will remain in place, with 52% of respondents expecting TMT to be one of the most prolific sectors for M&A activity over the next 12 months, followed by Consumer (36%), Pharma, Medical & Biotech (PMB) and Financial Services (32%)

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Regional Opportunities

APAC (excluding Japan) is viewed by 68% of respondents as being the most attractive region for deals over the next 12 months.

Choose a region to see the findings

APAC

China is the only major economy that is forecast to show positive growth having swiftly contained the COVID-19 pandemic, while a number of South-East Asian countries are on course to show huge growth over the long term.

“Expanding businesses and acquiring assets is easier in the Asia-Pacific region. Although there are strict rules about purchase of property by foreign companies, strategic mergers provide effective solutions for faster development.”

- Managing Director, Japanese Investment Bank

Financing Prospects

For 2021, it is not wholly surprising to find that more than 76% of respondents expect financing conditions over the next 12 months to be more challenging than they were in 2019, including 46% who expect them to be much more challenging.

The pre-pandemic financing environment already seems like a lifetime ago.

But financing prospects are looking up. After a punishing first half to 2020, equity and debt financing has eased in 2021 so far on the back of some positive news. The vaccine rollout has proved effective - increasing investor confidence and pointing to a brighter outlook for companies and their financing needs.

The pandemic has altered investors’ risk calculations, making them more selective in what sectors and companies they are willing to back – and at what price.

62% of respondents view PE and 44% consider non-bank lenders as the primary candidates, over debt capital markets, traditional bank lenders and cash reserves.

Sources of capital

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Risk and Risk Mitigation

A risk landscape turned on its head

Risk mitigation strategies

Due diligence: An even higher priority

Specialized Diligence

Credit Risk

What we heard

A risk landscape turned on its head

Putting the COVID-19 pandemic to one side, numerous other downside variables have the potential to impact upon dealmakers and the M&A targets they are seeking out.

Difficulty in accessing deal financing is the primary concern, cited by 38% of respondents as among the top two impediments standing in their way

Tax Risk

Litigation Risk

Tax Risk

Unlike other risks that may be more visible, tax risk can be harder to predict since it is at the whim of political policy or other unforeseen circumstances. A forward-looking perspective is vital.

Litigation and Tax Risks

Business disruptions caused by the COVID-19 pandemic have elevated risk to investors pursuing M&A. The unpredictability of the external trading environment and its potential impact on a deal target’s employees, key vendors and customers places priority not only on deeper due diligence but also taking out R&W insurance.

“Getting a general idea about the taxation norms in any region is not enough. We have to delve into additional details that are relevant to the industry and uncover discrepancies in the information provided in good time. Use of technology has been vital to streamlining this process and mitigating risks.”

- U.S. Director of Strategy and Corporate Development

The value of Technology and Technology Enablement

Intellectual Property Diligence and Insurance to increase with TMT activity

Risk Mitigation through R&W insurance

Deeper Due Diligence

Trends for the year ahead

The year 2020 has been a defining moment for M&A markets, bookending a decade-plus run. Over this period, there has been a steady uptake in R&W cover and other M&A insurance policies. Despite market challenges, deal activity has demonstrated resilience and, so far, record deal figures have been recorded in 2021.

Resulting in higher relative levels of insurance as investors continue to grow accustomed to this vital risk mitigation and capital efficiency tool Innovation has become the standard for insurers to find new approaches to protect against risks on the behalf of investors

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Reasons for caution

The macroeconomic outlook is far from certain and this may challenge deal processes, as buyers and sellers struggle to find common ground

Reasons to be optimistic about the months ahead

Reasons for caution

LOSERS

46% of respondents believe the Energy, Mining & Utilities sector will be the least productive in terms of M&A activity Two successive oil price collapses in 2018 and 2020 have set the EMU industry back significantly and this is likely to depress activity, except among corporates with a strategic imperative to transact or PE sector specialists seeking to capitalize on the market dislocation Nearly one-third of respondents also believe that the Real Estate and Construction sectors will deliver the least M&A activity. Both faced strong headwinds in 2020. The retrenchment of the workforce significantly reduced demand for office space, buffeting the commercial Real Estate sector. The true impact of this may only begin to be felt in 2021 as leases expire and businesses decide whether to renew their existing arrangements

LOSERS

WINNERS

The U.S. has enduring characteristics as the world’s largest economy and biggest M&A market.

North America

One factor deterring investors from Europe is the recently hawkish position on foreign direct investment. Following the lead of the US in its regulatory scrutiny of Chinese investment in strategic sectors, the pandemic has heightened protectionism in the EU.

Europe

Regulatory Headaches

While insurance is a valuable and necessary risk management tool, prevention is ultimately better than a cure.

Regulatory Headaches

“Sourcing and research teams are crucial in mitigating the litigation risks early on. Selecting the pool of targets and collecting background information is crucial to the process.”

- Head of M&A, German Corporation

Investors are highly aware of heightened litigation risk in M&A situations in the wake of the coronavirus pandemic and the sheer breadth of litigation risks can be overwhelming.

Litigation Risk

Regulatory Headaches

Tax Risk

Risks mitigation strategies

The heightened risk environment of 2020 and into 2021 forced investors to think smart and readjust their M&A strategies.

34% of our respondents participated in more minority deals and joint ventures and another 34% reduced the size of their deals 32% adopted distressed strategies to align with the deal environment

Risk mitigation strategies

Due diligence: An even higher priority

In these times of economic stress and uncertainty, deeper, more rigorous diligence is often warranted to triple test assumptions and ensure the fundamentals of the target business are as advertised.

An overwhelming majority of respondents - 96% - say they are dedicating more resources to due diligence because of current economic conditions Understanding the likely performance of a given sector or sub-sector is as important as determining the company’s performance within that space

Due diligence: An even higher priority

Specialized Diligence

Diligence comes in various forms and our research indicates no one type takes absolute priority.

28% of investors are paying particularly close attention to operational due diligence, putting it ahead of all other types of due diligence Commercial or market due diligence with 22% of respondents prioritizing and intellectual property due diligence with 20% are not far behind

Specialized Diligence

Credit Risk

The COVID-19 pandemic has unquestionably impacted companies’ credit risk. Businesses within sectors hit by the crisis, namely industries that rely on physical interaction and face-to-face working, have seen their revenues collapse in 2020 amid lockdown measures and the economic downturn.

Sturdy credits in industries such as technology and non-discretionary retail, which have demonstrated extreme resilience to the effects of the pandemic, are highly sought after among lending institutions and bond investors and should not have trouble tapping markets to raise cash Highly exposed companies will have to pay high coupons in order to access debt, especially in high-risk periods if the pandemic continues to wax and wane

Credit Risk

What we heard

A risk landscape turned on its head

52% of respondents say macroeconomic factors are among the top two risks over the coming 12 months and 36% cite tax as a one of two major risks

Risks that impact deal targets

Top risk mitigation strategies employed

Top risk mitigation strategies being considered

When looking forward, a greater number of respondents, 52%, indicate they will pursue more minority deals or joint ventures 26% are looking to reduce with another 26% looking to engage on more inwardly focused activity

“Adequate due diligence preparation is essential to mitigate any litigation risk. Not just the target’s performance, but the external factors and geopolitical risks should also be measured appropriately.”

- Managing Director, Chinese PE Firm

“Dealing with credit risk will be challenging because financing opportunities are also limited. To ensure that operations are functioning at par with expectations, capital investments are required. If this is not possible, it will affect goals”

- Managing Director, Canadian Investment Bank

“The unpredictable nature of the pandemic and its downstream effects on companies and their suppliers also make credit risk open to a greater degree of interpretation. Terms of the agreement and warranty discussions are taking longer to formulate. Credit risk will also depend on perception, as we see in the case of varied opinions during valuation discussions between buyers and sellers.”

- Managing Director, Australian Investment bank

“Because Covid-19 has been a massive shock to operations, relying on the company’s most recent financial data is of limited help in judging credit risk”

- M&A Group Director, French Corporation

“It is vital to evaluate the external climate and its effects on the target, without discounting the company’s actual potential”

- U.S. Private Equity Firm

A large majority of respondents, 80%, say litigation risk is more acute now than in the recent past

Antitrust In our research we see that investors are primarily concerned with litigation connected to data protection and intellectual property antitrust issues Labor Laws With many companies under financial and operational stress in today’s environment, the potential for such issues to arise has increased. It is therefore important that investors pay close attention to what exactly their R&W insurance covers regarding labor representations and, if relevant, the target company’s IP

“We prefer emphasis on following the prescribed due diligence standards and timelines given the reputational damage that can be caused should a legal case be brought.”

- Head of M&A, U.S. Corporation

However deep diligence processes go, insurance will always be used as a last line of defense to protect acquirers in the event of a worst-case scenario materializing

The speed and severity with which the pandemic has buffeted companies has only increased the subjectivity of credit risk calculations Weaker turnover and earnings in turn inhibit the ability of a company to repay its existing liabilities, increasing credit risk

Such uncertainty calls for robust due diligence to test and reinforce investment theses, a process made more difficult by distancing measures and reduced travel

Risk aversion is likely to remain high in 2021 and this has the potential to result in deals lapsing, especially if circumstances and trading conditions meaningfully change

A spike in household savings rates in 2020 also bodes well for a return of pent-up consumption. After months of challenging trading and with the unwinding of government support, market dynamics should support opportunistic M&A strategies in a distressed deal environment

Well-capitalized corporates have an opportunity to make selective strategic acquisitions at attractive prices

Private equity (PE) continues to wield immense firepower, with an estimated US$1.7 trillion in uncalled capital as of July 2020

The macroeconomic outlook is far from certain and this may challenge deal processes, as buyers and sellers struggle to find common ground

The vast majority, 80%, of respondents say that tax risk is a more serious threat to deal success now than it was in the recent past

The greatest concerns identified in our research include increased rates, 34% and proliferation of anti-abuse rules, 26%

Tax insurance absolves this by transferring this unpredictable risk away from both parties and, like R&W insurance, means vendors can avoid holding capital in escrow, therefore improving their liquidity

2. What trends do you expect to see in M&A during the ongoing COVID-19 pandemic?

1. What do you think will happen to the number of M&A deals globally over the coming 12 months?

3. Which of the following sectors do you believe will be the most prolific in terms of M&A activity over the next 12 months compared to a year ago?

4. Which of the following sectors do you believe will be the least productive?

5. Which of the following regions do you believe will be the most attractive for M&A over the next 12 months?

6. How do you expect financing conditions over the next 12 months to compare to conditions in 2019?

7. What do you believe will emerge as the primary sources of financing over the next 12 months?

10. What are the biggest risks you foresee at potential M&A targets over the coming 12 months?

11. What steps have you taken to change your M&A strategy since the start of 2020?

12. Considering the current economic environment, are you dedicating more resources than in the past to due diligence processes when considering a transaction?

13. What steps do you envisage taking in the future?

14. Are you paying particularly close attention to any of the following types of due diligence?

19. How much more acute is tax risk to deal success now as compared to the recent past?

17. What types of M&A litigation has your organization been involved in over the last 24 months?

20. Which of the following tax-related issues is of the greatest concern to you?