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Beyond the pandemic: the future of M&A

Deal drivers: hedge funds beat a retreat

In the midst of a simultaneous supply- and demand-side shock, it’s no surprise cash is currently the world’s hottest commodity. Not only is cash conservation a growing focus for both consumers and corporates, our own analysis of court filings reveals a marked increase in money-related pre-litigation correspondence as companies look for ways to either obtain cash from others or avoid handing it over.

Against this backdrop activist investors are in retreat for the time being. Hedge funds have long urged companies with significant cash balances to use their reserves to buy back shares. But with those tactics leaving many targets exposed to the ravages of the downturn, their standing in the boardroom may take time to rebuild.

Activists shift focus away from M&A campaigns

The uncertainty of corporate forecasts has caused many activists to hit pause on new campaigns for now, and deal-makers also report a general dial-down in aggression as funds try to keep other stakeholders onside. While high-profile players including Carl Icahn and Starboard Ventures continue to attack, data from Lazard reveals that overall, hedge fund activism fell as COVID-19 took hold. In January and February activists targeted 42 companies, but by March this had dropped to 16. Just five of those campaigns had an M&A component – that is, were designed to force the divestment of a division or sale of an entire business.

Until the market outlook has stabilised, analysts are expecting a shift away from M&A and balance sheet campaigns towards those targeting perceived governance and operational performance failings during the crisis. There have been claims that more US corporates are adopting ‘poison pills’ to protect themselves from activists as COVID causes their equity valuations to fall. Our analysis, however, is that there’s not yet enough of a rise to call a trend, despite some boards citing the pandemic as a factor in their thinking. Similar legal mechanisms exist outside the US (for example in the Netherlands), but in the UK, shareholder proposals are rarely adopted due to hostility from institutional investors and general opposition from regulators to weighted voting structures. That said, boards will be considering their defence options while the outlook remains uncertain, so we will be keeping tabs on the data in the weeks and months to come.

Financial sponsors to the fore?

There have been predictions that the coronavirus downturn would spark a boom in sponsor-led buyouts, with private equity reportedly sitting on $2.5tn in dry powder before the pandemic took hold. There were phenomenal levels of PE deal activity in 2019, including the largest European acquisition in more than a decade (the $18.7bn Advent/Cinven-led buyout of Thyssenkrupp’s elevator business). In a world where stock prices have plummeted and businesses face a sudden liquidity crunch, there has been speculation financial sponsors are set for an M&A spree. That day is fast approaching, although the way those deals are done could be primed for change.

The classic PE leveraged buyout model is great for internal rate of return (IRR) on a successful exit, but it is likely to face significant pressure as businesses under, or exposed to, private equity ownership struggle for survival amid a cashflow crisis (car rental giant Hertz and UK-based restaurant chain Hawksmoor are just two in a litany of recent examples).

Just like other businesses, PE portfolio companies have been exploring the possibility of accessing state funds to ride out the crisis. That prospect has sparked criticism from commentators who argue that the number of jobs PE-owned companies support are of lesser relevance than the depth of their backers’ pockets. These questions aside, the bigger issue is often whether such businesses are even eligible for state help given the way their finances are structured. In Europe for example, companies whose accumulated losses exceed 50 per cent of their share capital are not able to access government support packages under EU state aid rules. Many PE-backed businesses find themselves in this category because sponsors’ use of debt tends to minimise their share capital, while the associated interest payments can result in statutory losses even when the business itself is generating cash. Against this backdrop, leverage may fall victim to the pandemic.

Synergies in the spotlight

Another favourite tactic among financial sponsors keen to put their best foot forward on valuations is to identify ‘synergies’; efficiency savings that often involve employee layoffs. Post-COVID – as an entire generation of workers comes to terms with the first mass unemployment event of their lifetime – boards of target companies may feel emboldened to push back on bids that need these measures to be compelling. Private equity has a superb track record of reinventing itself, and the fundamentals that drive businesses to embrace sponsors will largely remain. But we expect a shift in emphasis in light of the pressure on jobs, with private equity instead set to focus on driving growth via improved governance and strategic focus.

We also expect a surge of interest in private credit investing among LPs and sponsors. Special situations and tactical opportunities funds are built for times of volatility, and made huge gains in the wake of the financial crisis thanks to their flexibility to invest across asset classes. No one did better than Apollo, which at the height of the credit crunch poured more than $1bn into debt from plastics manufacturer LyondellBassel. This was converted into equity when the company filed for bankruptcy and years later, after LyondellBassel was reborn through a successful listing, Apollo walked away with a $10bn profit. According to Bloomberg it remains the most successful private equity investment of all time.

Not all private credit plays flip into overall ownership in this way. But sponsors may not need traditional ‘control’ in order to succeed under current market conditions. The usual route by which sponsors exert influence over their investments (ie acquiring a majority of the share capital and installing their own directors) are less important in times of high financial stress. Against the backdrop of COVID-19, private investors who provide a financial lifeline for struggling businesses will carry a lot of influence in the boardroom – and could find themselves wielding as much power as they do when they own large chunks of shares.

Will committed capital survive the shock?

While sponsors will have their eyes on deal opportunities, they will also need to manage their limited partners and investors with care. With so much financial stress in the system it’s possible we may see defaults on capital calls as we did in 2008. LPs may also urge caution among general partners keen to strike out before the pandemic’s full impact is understood. And GPs will have to clearly articulate their strategies if they want to play in the public markets. Data shows the number of PIPE deals more than doubled in the US in Q1, but LPs (who have an unprecedented understanding of investing in public securities), generally don’t expect funds they have earmarked for private capital to be redirected to the public markets without very preferential terms or a compelling strategic rationale.

For corporates themselves, private capital is a welcome option given the strings attached to government support. In the EU for example, emergency state aid rules prevent any company participating in a government equity-purchase scheme from paying dividends or buying back shares until the investment is settled. Similar dividend restrictions apply where member states provide guarantees for financing (including for the larger support packages in the UK which remain subject to the same rules during the Brexit transition period), while banks extending government-backed loans are also imposing further operational constraints. It is common for debt documentation to include limits on acquisitions, and we expect these to be tightened for COVID-related loans even if the borrower has the cash available to invest. And with the IMF warning that banks themselves should think hard about returning money to shareholders while they are taking on so much risk, private investment is set to play an even bigger role in business life after the pandemic.

If you are interested in discussing any of the themes in this report, please reach out to your usual Freshfields contact. For more insights on the current and future impacts of COVID-19, visit our coronavirus hub