How has the recovery from the pandemic played out for private M&A and what could be in store for the year ahead? 

by Sarah Lunn, Senior Knowledge Lawyer at Osborne Clarke 

There was a strong recovery for UK merger and acquisition (M&A) activity in 2021 as it pulled out of the sharp downturn in the first half of 2020 when the Covid-19 pandemic first struck.

Investor confidence has bounced back following the national vaccination programme and more certainty in the UK economic outlook.

We analysed a sample of M&A deals advised on by Osborne Clarke UK's corporate team in 2021 and compared them to our analysis in prior years to identify recent M&A trends and a look forward to what this might mean for deal activity in 2022.

Deal values rising

In 2020, our sample of 55 deals had an aggregate deal value of £1.6 billion; in 2021, our sample of 50-plus deals had an aggregate deal value of £1.9 billion.

While Osborne Clarke continues to be instructed on high-value transactions, it is likely that this increase also reflects a wider trend in the market due to higher business valuations that have resulted from improved investor confidence, increased levels of competition for attractive targets, readily available funding (including private equity funds), and low financing costs.

More cross-border work

Cross-border transactions are increasingly viewed as a quick route to new markets. Osborne Clarke has seen a large increase in cross-border deals since 2019. In 2021, 63 per cent of our sample had a cross-border aspect compared with 30 per cent in 2019 and 40 per cent in 2020. This demonstrates both the growing international nature of Osborne Clarke's work and that businesses are looking to gain more immediate access to overseas markets than they do through organic growth.

Cross-border transactions tend to be more complex in terms of structuring considerations, regulatory approvals, language and culture, with such complexity flowing into deal terms.

Locked box wanes

There has been a slight downturn in the use of "locked box" mechanisms in transactions in 2021 from 37 per cent to 35 per cent of deals as this approach lost a little of its popularity.

In the last two years, deal terms have been more purchaser friendly, and the slight reduction in the use of the locked box – despite the certainty it gives parties – is likely a result of the challenge that financial due diligence poses amid the economic uncertainty. It is also difficult to rely on figures in the latest accounts without being able to do a post-completion "truing up" exercise. Also, in some deals, there has been a preference for the absolute certainty of a fixed price, particularly where there was competition for the target; in the market, the overall trend has been for less price adjustment mechanisms.

Earn outs return

It was widely predicted that the, for some, unpopular "earn outs", which are a tool to ensure vendors get full value, would make a comeback as the economy recovered.

Earn outs can enable purchasers, who are uncertain of a business's value as a result of the uncertain global health, economic and political outlook, to hold back some cash to improve its liquidity. They can also encourage a vendor to sell in the knowledge that it could earn the desired selling price by achieving specific financial targets after completion.

This prediction has been borne out in our data where earn-outs were a feature in 20 per cent of deals in 2021; the figure was lower at 16 per cent in 2020. With valuations and financial due diligence proving challenging, however, agreeing on appropriate metrics and targets for any earn-out has been problematic.

Simpler price retentions

Security for claims have also been disappearing in favour of simpler price retentions. One area that is bucking the trend for purchaser-friendly terms has been the use of escrow funds for claims. There has been a distinct decrease in use of escrows in our sample deals from 37 per cent in 2020 to 27 per cent in 2021. Purchasers have more confidence that a vendor will have the cash to settle a claim and that their liquidity has improved since the early days of the pandemic.

There has been some suggestion in the market that purchasers are, instead, relying on simpler structures, such as deferred cash consideration or a purchase price holdback, which are more widely used in the US. The simpler solutions will be more attractive to the purchaser, as they give less scope for dispute and are quicker and cheaper to negotiate.

With external providers being used to provide escrow services that traditionally have been provided by UK law firms, deal costs have increased. This may also have deterred parties from using escrows.

W&I cover rises

Last year, there was warranty and indemnity (W&I) insurance on nearly half of our deals. In 2019, one in six deals relied on W&I insurance. This rose steeply to 45 per cent of deals in 2021, despite the well-reported capacity issues in the W&I market due to the large volume of deals that had been seeking cover.

Private equity fund vendors use W&I insurance as a standard solution on exits to underwrite claims, where their fund rules do not permit them to give warranties other than as to title and capacity. We have seen a large number of private equity exits and secondary transactions in the past year that have used W&I insurance. The use of W&I insurance has also added certainty to transactions while so much has been uncertain in the past two years.

Some of the growth in the use of W&I insurance is attributable to parties and their advisers having a more mature understanding of the benefits it brings. From a vendor perspective, that maturity means that more and more deals are being closed with W&I insurance on a limited-recourse basis: in other words, with a £1 cap on vendor liability and the purchaser's only recourse being through the W&I policy.

Liability caps increasing

There has been little change in the average cap on liability of a vendor for warranty and other claims. However, there is general market consensus that caps have increased from the common recent positions where the cap was regularly less than 100 per cent of the consideration.

It is possible that there has been an increase in the caps on some deals (being a purchaser-friendly position), but that that increase has been offset by an increase in the number of deals setting a £1 cap where claims are covered by W&I insurance.

Other market trends

Other trends include:

• Shorter deal timetables - this is due to a competitive market, to save deal costs, and minimise price uncertainty. 

• Slightly longer limitations periods - this allows for claims to show up in volatile accounting figures. 

• Material adverse change clauses being drafted in more specific terms - for example, these could refer to Covid-19 or Brexit.

• W&I policies that exclude claims relating to Covid-19. 

Outlook and risks 

There is a strong expectation that 2022 will be a superb year for M&A. There is a strong need for dealmaking as businesses address digital transformation and decarbonisation.

Acquisition is a straightforward route to buying in the required technology or diversified assets. Private equity funding remains plentiful and borrowing costs remain low for the time being, although macroeconomic conditions may have an impact. There's plenty of pent-up demand from transactions that went on hold in 2021 and 2022, and cash-squeezed vendors will want to dispose of non-core assets.

However, many risks remain in place, including: 

• The pandemic

• Weak consumer demand

• Energy costs

• National Insurance increases

• Worker shortages

• Brexit and global supply chain issues

• An increase in borrowing costs due to inflation

• Global political instability

• Winding down Covid-19 financial support packages 

All these issues may have an impact on not only deal flows but also deal terms that are agreed.

Trends and changes in 2022

Will the deal term trends continue in 2022? We anticipate some trends will continue, particularly transactions becoming increasingly high value, complex and cross border; the reliance on W&I insurance; challenges to deal execution.

We also foresee some changes through 2022.

• More regulatory intervention means more conditionality. There will be additional regulatory approvals needed to transact in the UK not least due to the National Security and Investment Act 2021. The legislation requires deals to be notified to the UK government and gives it the power to intervene in transactions on national security grounds. In addition, deals may now need UK competition approval in addition to EU competition approval; the Digital Markets Unit will have greater scrutiny of technology transactions and the Pensions Regulator also has increased powers, particularly where the target has a defined benefit scheme. Consequently, more deals will be conditional with a longer timetable to completion, and with the pandemic and Brexit still relevant, material adverse change provisions may continue to be more closely considered when defining materiality. Some deals may be structured as a business and assets transaction in order to come outside of the mandatory notification regime for the National Security and Investment Act.

• More distressed sales. As some businesses struggle to recover from the pandemic, with government support ended, more distressed assets sales are likely.

• Environmental, social and governance (ESG) considerations to be front and centre. It is extremely likely we will start to see more due diligence on ESG matters and more specific warranties on them (such as compliance with Task Force on Climate-Related Financial Disclosures-based reporting).

• IR35 and Covid support scheme wind down protections. IR35 rules will mean there will need to be additional due diligence and warranty cover to reflect the increased tax risks, while more protections are likely that relate to HMRC enquiries due to the unwinding of government Covid-19 support schemes.

• Concerns about CGT reliefs may push timetables again. While the Chancellor seeks to find ways of funding the costs of the pandemic and social care, we may again see an acceleration of deals to avoid any additional capital gains tax charges which could be announced in a budget.

• Earn-out and completion accounts trends to go into reverse. Once companies' financial reporting becomes more reliable as the uncertainty of the past two years settles down, the trend of increased use of completion accounts and earn-outs may go into reverse. Likewise, if warranty claims around the accounts are likely to be less, liability caps may revert to lower levels.