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Corporate Law: Investment Activity And Deals In An Uncertain Market
The talk focused on corporate law: specifically investment activity in small and midsize UK companies. Topics included what we expect to see happening over the course of the rest of the year based on current trends.
With rising inflation, interest rate rises, and increased odds of a recession, we have looked at our historic data to identify recent trends in corporate activity to help understand what might happen in the future: how things might play out for small businesses looking to raise capital, or looking to engage in M&A activities.
MarkotMarket seeks to be the gold standard data platform for information intelligence data on small and mid-size businesses. We are focused on providing that data to our customers in corporate finance, accountancy and legal firms. Very specifically, what we do can be split into four parts. First, there is Origination/Business Development: we help our customers in the law industry connect with businesses they want to work with. Secondly, Market Intelligence: we help our customers understand the dynamics that are relevant to their clients. Third, Deal Data: we help our customers understand what is going on in the market in terms of transaction activity and prices being paid for assets, valuation multiples, active buyers, etc, and finally Marketplace: a portal for connecting with other advisors on live transactions.
Overview: UK Corporate Transaction Market
We have looked at the volume of deals that happened over the last 18 months, and what we have seen is fairly typical.
Looking back over a longer time period, we tend to see between 10 and 12,000 events per annum. These are companies that either raise capital or are involved in an acquisition or a merger. This is broadly split 50:50 between mergers and acquisitions and fundraising. These events fluctuate seasonally. We typically see spikes towards the end of every tax year as people rush to get deals completed. This was particularly prevalent in the tax year ending 2021 when there were some anticipated changes to entrepreneurs’ relief, which, in the end, did not transpire.
Taking M&A first, we have looked at the past 18 months’ data here and what we can see is that volumes have been trending down for the last 18 months. We expect to see about 500 transactions in the market involving UK businesses per month. Recently that has been trending down somewhat. If you look further back in the data there was a real fall-off in mergers and acquisitions activity in the second half of 2020. As lockdown conditions were imposed there was clearly a lot of nervousness around the market. It started to recover towards the end of 2020 and then rebounded very strongly. Over the 18-month time period we are looking at, the last 18 months, we are just starting to see a bit of tailing off in M&A activity.
If we flip to fundraising it’s actually the converse. Over the same time period of the last 18 months, there has been an upwards trend in the number of companies raising equity capital. At face value that might seem off if mergers and acquisitions are declining. However, there is a logic to it. Companies that do not have to engage in M&A activity, because of nervousness about the outlook, will not do so. Typically, companies engaged in mergers and acquisitions tend to be more mature profitable businesses. Of course, there are exceptions when you have distressed situations, but by and large, companies can pick and choose when to sell themselves or when to buy another company.
With equity fundraisings, typically the company will be at an earlier stage; perhaps burning cash, and will therefore have the runway and need to raise capital in order to continue to grow and often to stay alive, so that their hand is forced somewhat in terms of coming to the market to raise capital and the way that companies engaging in M&A and do not have their hands forced.
We have looked at deal value and seen that, lately, M&A has been trending down a little. Fundraisings, on the other hand, have been trending up over our 18-month period. Looking at trends in deal values, what we can see again is a trend down in the gross value of businesses transacted over the period.
Typically, in the UK we see between £10 and £14 billion of deal value transacted per month. That takes into account the whole spectrum of business sizes, so any anomalous deals can have an effect. So if you have a deal like the £29 billion takeover of Alexion by AstraZeneca, it has the effect of skewing the data for that particular month. Again, we have seen a bit of a downward trend lately in the value of business transacted in the M&A markets.
The other thing that we look at very closely is the valuations of businesses. There has been a view that everything has trended up in terms of deal values over the last 18 months to two years.
Our data backs that up. We look at EBITDA (Earnings Before Interest Taxes Depreciation and Amortisation) multiples for an average figure, minimising month-on-month volatility. While EBITDA is a good indicator of a business’s underlying profitability, any month’s average multiple will be influenced by the types of businesses being sold. This value can be dragged higher if you have a greater number of high-value-sector deals (eg. technology) in a given month. Conversely, that multiple will come down if you have lower-valued sectors transacting. Similarly, bigger businesses tend to attract higher multiples than smaller businesses. Again, this has an effect on any given month’s valuation multiple. The median multiple over this period was 10.5x EBITDA, but that is across the board, with very small businesses in that sample as well as large businesses.
What Happens To Company Values When The Market Softens? Nano Cap Deals
We collect data and track multiples paid for companies that have sold between £0 and £2.5 million for our Nano Cap Index.
What we see happening in our time period of the last 18 months is that, whilst the aggregate of data for the overall market multiples have trended up a bit, multiples have actually declined for these very small companies. In 2020 the aggregate multiple trended down from 6.3x to 5.9x and that continued to trend down in 2021.
People often talk about the small-cap effect and this flight to larger businesses when people feel unsure about the outlook. This tends to be beneficial for larger companies and detrimental to the valuations of smaller businesses, and that message is consistent with what we have seen in the data.
What About Micro and Small Cap Deals?
The next segment size that we cover is Micro Cap deals. These are companies that are valued and sold between £2.5 and £10 million. For these companies, we saw a sharp downturn in the aggregate multiple paid for these companies in 2020 versus 2019, down from 9.4x to 7.6x. Interestingly, in 2021, we saw a sharp reversal of that. Multiples expanded again from 7.6 to 9.2x. Even if you look at long-term data, this is a healthy multiple and illustrates how quickly the markets snapped back.
If we go to what we call Small Cap deals (deals valued at between £10 and £50 million), the multiples here held up very well throughout 2020 and 2021.
Looking at quarterly data, you can see the impact in the second quarter of 2020 of the first wave of lockdown restrictions. But over the year as a whole, multiples held up very well, and in fact expanded in 2020 versus 2019, declining a bit again in 2021. However, multiples are still not back up to where they were in 2018. What this all illustrates, is that larger companies have driven a lot of the recovery in prices paid for businesses; and whilst we’ve seen some of that at this smaller end in the market, a lot of that recovery has been at the larger end. That is perhaps something to bear in mind as we enter perhaps a more uncertain environment.
Response By Sector
The other thing that we look at is different sectors. How do different sectors respond to uncertainty in the market?
Cyclical Vs Non-Cyclical
As a general rule, we would expect cyclical industries to perform worse than non-cyclical at times of uncertainty. Probably the best example of a cyclical industry is the consumer sector. Of course, it is quite a broad church. There are certain companies within the consumer sector that you might expect to be more robust in a downturn, and we certainly saw trading at food retailers, for example, continue to be strong, as well as businesses with subscription-based models. But the broader retail and leisure sectors also have a lot of discretionary spending, which obviously took a significant hit from lockdowns in 2020. And we can see the effect of that. Consumer sector valuations were hit very hard in 2020 versus 2019. They recovered a bit in 2021, but are certainly not back to where they were.
Technology, Media & Telecom (TMt) sector
On the other hand, in the TMT sector, multiples expanded rapidly in 2020 and 2021. We actually saw strengthening, and this is again consistent with anecdotal evidence about the valuations of technology companies throughout the lockdowns. The valuations from the last couple of years have reflected that, by and large, technology companies performed well as a group.
If we look at very recent data in some of these sectors to see whether there is consistency between what we saw a couple of years ago with how these companies were performing versus now, this paints quite an interesting picture. We are currently seeing a slowdown in transaction volumes in some sectors in the first half of 2022 versus 2021.
The reason we looked at a few sectors was to determine whether this was specific to more cyclical sectors. The evidence we have seen suggests it is not. We have seen a really sharp slow down in retail deals in the first half of this year, relative to last year.
However, we have also seen a slowdown in a traditionally less cyclical and more robust sector: software. Here we have also seen a 16% decrease in deals done. This suggests that, based on the data, this gentle slowdown in deal activity is indiscriminate when it comes to sectors.
What About Private Equity?
One thing that we keep a close eye on is private equity activity. PE is a key driver of deal flow in the UK market.
Private equity is a good forward-looking indicator of the amount of capital that is going to be deployed for acquisitions and growth capital events in the market. There is currently $1.8 trillion of dry powder capital tied up waiting to be deployed. Most of this is in 10-year LP funds. This has to be spent, so we expect this to hold up activity in the market.
Interest Rates And Inflation
All other things being equal, increasing interest rates will drive prices lower for companies. That is because the cost of capital rises whether you’re funding the company with equity or debt. With a more onerous interest burden, leverage will fall as interest rates rise, so the affordability for companies to borrow to buy will fall. This will have an impact on pricing. So, we would expect to see some price pressure this year as interest rates rise. We have already seen this in the public markets.
We would also expect to see a higher stock versus cash component. If companies have the choice of issuing equity in their own businesses versus borrowing to buy other businesses, we would expect the balance of stock versus cash to increase in favour of stock if borrowing costs rise. This assumes that companies do not object to issuing their own stock at lower prices as their valuation has come under pressure.
There may be a higher weight towards earnouts as well. Earnouts are a key component of deal structuring, especially at the smaller end of the market. Buyers will use anything that reduces cash at completion to reduce upfront risk and commitment, including reducing borrowing costs.
Looking at inflation, contract due diligence will come under the microscope. How much of these contracted price rises will businesses pass on to their customers? This increased level of due diligence could lead to elongated deal cycles. If you cannot pass those cost increases on to your customers, margin pressure is going to result in cost increases. This will reduce profitability and, in turn, lower prices for assets.
In conclusion, we have been living through a volatile time. Recent events provide some guidance on the impact of market volatility. Each crisis is different and impacts sectors in different ways. The technology sector was a fantastic example of that. Covid sent the technology sector into a financial frenzy. The number of deals and transactions, and the valuations that were being achieved, were very high. This time, however, inflation has brought prices and deal volumes down.
It is difficult to use a previous crisis as a straight read across to a current softening in the market. We cannot expect the investment activity that played out two years ago to be replicated this time around.
The live data that we have suggests a gentle slowing in investment activity, not on the scale of 2020, but enough to notice.
This is having an impact on valuations. It feels very logical because private markets tend to follow public markets in this respect, albeit following a lag.
We believe that all sectors are experiencing some pricing pressure this time, not just cyclical industries.
The data we have tracked shows that smaller businesses are affected more by valuation headwinds, which is what we expected. It is important to note that we expect fundraising will continue for early-stage companies. Those that are raising equity will not be able to take a step back from the market. If we do experience stronger headwinds, they are likely to continue with their plans to raise equity, although the amount of capital sought may be reduced.
Using MarktoMarket’s data platform, you can ensure you are selecting the right data to gain the most informed insight into business valuation. MarktoMarket’s auditable data gives users the confidence that they are dealing with intelligence that can be trusted.
To continue the discussions about how data can support your business, contact Doug Lawson.