Forecasting can be a fool’s game. Who at the start of 2023 would have predicted the recent collapse of Silicon Valley Bank and its ripple effect across the banking sector? This difficulty in forecasting is no less present when it comes to dealmaking activity. However, while anticipating deals at a sector or market level is challenging, it is worth considering how M&A activity this year may align with broader economic and geopolitical trends.
In the decade that followed the global financial crisis, investors became accustomed to relative stability. Comparatively speaking, geopolitical factors were benign, the ascendency of globalisation and economic integration was unchallenged, and – with interest rates at near-historic lows – investors had abundant access to leverage. But, the dealmaking environment has changed significantly over the past three years.
A change in the status quo brings competition for capital
The Covid-19 pandemic started a process of real change for dealmakers. As the world responded to the threat of an unfamiliar pathogen, supply chains become dislocated, demand for various goods skyrocketed and governments and multinational corporates began to value resiliency over efficiency.
Russia’s invasion of Ukraine in February 2022 exacerbated some of these underlying trends, sending energy markets into shock and bringing inflation back to the top of the economic agenda, leading central banks to implement the most aggressive series of interest rate rises since the 1980s.
"Governments and multinational corporates began to value resiliency over efficiency."
All of this has had a material impact on the investment climate.
In terms of M&A activity in 2023, the higher cost of capital will favour corporations with strong balance sheets and private equity firms with existing dry powder reserves. Such investors will be less reliant on debt markets for financing and, with higher interest rates resulting in higher discount factors, they may take advantage of valuation corrections to pursue strategically transformational deals. For well-placed and experienced investors, these conditions may also make a more opportunistic approach to dealmaking more viable.
"Within large corporates or even within private equity portfolios, the more challenging financing environment will generate more competition for capital."
Within large corporates or even within private equity portfolios, the more challenging financing environment will generate more competition for capital. If growth slows, corporates and general partners alike may look at sell-side opportunities to realign their portfolios, realise value through the divestment of non-core assets, or reduce debt-servicing costs. For some investors, insolvent or distressed companies will present opportunities to acquire assets with fundamental long-term value – but short-term financing pressures – at an attractive discount.
Signs of easing conditions upstaged by dislocation in the banking sector
While current economic conditions are challenging to interpret, there had been signs in recent weeks that some of the factors contributing to the disruption over the last three years were starting to ease. Global supply chains have had time to recover from the pandemic-related disruption; at approximately USD 75 a barrel, the oil price has approached levels seen before Russia invaded Ukraine, suggesting energy markets have overcome the initial shock that followed the outbreak of war; and the pace of inflation appeared to be slowing in key markets.
The collapse of Silicon Valley Bank and the merger of UBS and Credit Suisse have punctured the sense of optimism for some. The outlook for the banking sector is now in sharp focus, with analysts watching for any sign of systemic weakness. The picture is further muddied by persistently tight labour markets – six out of the seven G7 economies have unemployment rates at or close to the lowest rates seen this century. Optimists view this as a cause for hope that inflation could be curbed while avoiding severe recessions in some markets; others view it as a key risk factor, indicating that higher levels of inflation are likely to persist due to the continuing effects of wage pressure.
Operational considerations shift opportunity sets
Setting aside the financing environment, the operational risks exposed by the pandemic and by Russia’s invasion of Ukraine will compel corporate and private equity investors to consider different or less familiar opportunity sets.
"Whatever the context, deal teams – both corporate and private equity – must navigate a broad spectrum of risk factors, ranging from the more challenging funding environment to the raft of geopolitical, sanctions, operational and reputational risks stemming from the war in Ukraine."
The supply-side disruption seen throughout the pandemic – and exacerbated by the invasion – will encourage some corporates to reinforce or reconfigure their supply chains via M&A. Some may pursue vertical integration to shore up the supply of critical inputs, whereas others may seek to reduce exposure to markets with higher levels of geopolitical or sanctions risk through divestment programmes. At S-RM we have supported clients in both scenarios in recent months, by providing pre-investment due diligence on the buy-side and by conducting in-depth integrity reviews of potential acquirers on the sell-side.
"History suggests that well-placed and discerning investors will make the most of an opportunity to pull off transformational deals at a time when competitors are preoccupied."
Ultimately, despite the more complex economic outlook, investors will continue to look for transactions that align with global macro-trends, including the energy transition and drive for energy security, the digitisation of traditional businesses, and a renewed focus on the defence and already hot cybersecurity sectors. Whatever the context, deal teams – both corporate and private equity – must navigate a broad spectrum of risk factors, ranging from the more challenging funding environment to the raft of geopolitical, sanctions, operational and reputational risks stemming from the war in Ukraine.
While uncertainty may continue to impact outright deal volumes, history suggests that well-placed and discerning investors will make the most of an opportunity to pull off transformational deals at a time when competitors are preoccupied with short-term challenges or are simply pausing for thought.