Assessing opportunities and risks in dynamic times

​​​​published on 26 July 2022 | reading time approx. 4 minutes

For more than a decade since the global financial crisis, the M&A market has solely shown an upward trend. After an initial standstill in transactions caused by the pandemic and following the record year 2021 – also thanks to catch-up effects from 2020 – we now face some question marks. Depending on the region, the pandemic has been overcome or progressed differently.  However, the fact that such an exogenous shock can occur at any time stays in the minds of the market participants – and since February 2022, the war in Ukraine has made us exposed to another set of circumstances we would have considered unimaginable before.

In addition to the pandemic and the war and the resulting consequences for the global economy, we experience disruptions because of the major global macro trends such as ESG, sustainability, green economy and digitalisation.

We therefore call these times dynamic times and have discussed the current situation and implications for M&A transactions in a panel at this year's Rödl & Partner M&A Dialogue titled “New World: Assessing opportunities and risks in dynamic times.”

In this article, we would like to summarise the discussion points from the panel for you:

• What is the current view of the market, which points do our clients and we currently consider to be relevant and in what way?
• What are the implications for the transaction business, how should you take these points into account in financial due diligence and company valuation?
• How should you structure transactions in such dynamic times?

Current view of the market

We see a fundamental spike in uncertainty in the current transaction environment, especially on the buy-side. Correspondingly, the speed of transaction processes decreases. Project delays and cancellations and resumptions at later points in time occur more often because the buyer and seller sides cannot agree on a common perspective and, accordingly, on circumstances acceptable to both parties.

Due diligence examinations are carried out more intensively in order to adequately account for uncertainty factors and to accurately analyse ongoing business development through constantly updated data.

We also see that reasons and drivers for transactions change:

• Increase in restructuring: Adaptation of structures with Russian participation
• De-globalisation: Relocation of production capacities against the backdrop of security of supplies and transport costs
• Vertical integration: Securing supply chains via acquisitions
• Portfolio adjustments: Increased carve-outs and spin-offs – companies put their portfolio to the test to focus on the core business and smooth the balance sheet.

With regard to the major macro trends outlined above, the following may be observed:

• ESG plays an increasingly important role for our clients. Awarding contracts to suppliers and financing is increasingly based on ESG. ESG reporting obligations and the impact of the Supply Chain Act affect companies of almost every size, and the need for legal certainty in this area grows strongly,
• our clients' investments in the digitalisation of their business models increase significantly – mainly through acquisitions and participations and via in-house incubator and accelerator programmes; and
• in the international context, our clients acquire competencies and capacities in the areas of digital, IT and engineering through acquisitions in Asia, particularly in India and Vietnam.

In the international context, Asia must be viewed on a differentiated basis. The trends of economic development, ensuing from the coronavirus-related policy of the individual countries, differ. Generally speaking, however, the pandemic-related restrictions in Asia have been much stronger and last longer compared to Europe. While the restrictions are being lifted very cautiously in China and the process of lifting restrictions in the ASEAN countries is being started very slowly, a dynamic development can be observed in India. Basically, we observe the development of alternatives to China, especially in the ASEAN countries.

In the USA, similarly to Europe, the main issues at the moment are logistics issues due to the shutdown in China and also the challenge of recruiting and retaining staff.

Financial due diligence

As a rule, the classic purchase price formula is still valid in the context of M&A transactions and, accordingly, financial due diligence should continue to evaluate the sustainable EBITDA as a valuation basis as well as the net financial liabilities and the sustainable level of net working capital and investments.

While during the pandemic, the COVID-19-related-adjustments were in part still manageable – especially with regard to temporary versus long-term cost structure changes – the determination of sustainable variables in current times is a challenge.

We outline some of these points below, which we currently work on intensively in ongoing due diligence projects:

• high need for normalisation and unclear view of the future due to increased supply chain problems and inflation trends,
• EBITDA reductions due to delays in supply,
• temporary boom due to the build-up of safety stocks at customers,
• adjustment of the business for the impact of the Russia-Ukraine conflict or customers in these markets,
• gross profit analyses with regard to price rollovers and supplier adjustments,
• determination of a sustainable working capital and assessment whether a decreasing level can be expected in the future,
• discussion on who has to bear the pre-financing of the increased inventory and receivables, and
• Capex shortfall analyses – delays in procurement of assets, postponement of capex

Company valuation

We currently observe rising return requirements due to uncertainty and macroeconomic effects (interest rates and inflation), as well as an increase in volatility on the equity markets. Valuation levels have fallen, and reduced EBITDA multiples can be observed on the stock markets in almost all sectors.

This uncertainty is a major challenge for company valuation – equally for DCF models and multiples. Simulation models can be used to account for this uncertainty, also value ranges can be defined and sensitivities analysed:

• Sales developments and shifts,
• Inflation rates and inflation-induced growth,
• Commodity price developments and personnel cost developments,
• Degree of pass-through to customers,
• Working capital level,
• Interest and capital costs or
• Insolvency probabilities.

The uncertainty regarding future developments and value implications outlined in the preceding sections results in a noticeable increasing shift of risks from buy- to sell-side. This is a first departure from the seller's market which has prevailed in recent years.

The mechanisms here can be different. In addition to earn-outs, we see gradual disposals based on option agreements or partial sales as well as creative structuring with vendor notes, which are priced depending on the achievement of milestones.

In the international context, it should be noted here that the freedom of structuring earn-outs or comparable models can be very limited. Foreign exchange law as public law limits the financial structures of cross-border transactions in most Asian countries. Legal models must be developed as a solution here, such as the creation of different classes of shares, as is possible and practised in some jurisdictions (but not in China). In some cases, however, the transaction may only involve a partial acquisition and thus a minority shareholding by the sellers – which in an economically and culturally demanding environment can also be in the interest of the buyer if one is confident of managing the company only with a significant co-participation of the seller.

Earn-outs should be well structured and thoroughly defined in order to prevent possible later legal disputes in the interpretation of certain components of the earn-out. Especially if adjustments to the result are expected to influence the basis of the earn-out, it is important to agree to these in a clearly defined catalogue.