M&A Report 2023: United States

Following a more moderated deal environment in 2022 compared with previous years, the outlook for the US M&A market in 2023 is cautiously optimistic.

Headwinds that muted the pace, breadth and depth of the M&A market in 2022 persist. These include increased scrutiny from regulators globally, rising interest rates, global tensions and stock market volatility.

However, there are factors that point to an accelerated, more robust outlook in 2023. These factors include:

• Financial sponsors with ‘dry powder’ at the ready;

• More attractive valuations as buyers and sellers internalise valuation expectations;

• Event-driven investors catalysing opportunities; and

• Well-capitalised strategic corporates undertaking transactions that look beyond the current economic cycle.

Dealmakers will continue to heavily consider regulatory enforcement in 2023. Legislation in the US remains pending with respect to wide-ranging antitrust/competition reform and it is expected that regulators will continue a more aggressive approach to merger investigations and enforcement.

The policies of the US Department of Justice and Federal Trade Commission are in line with the more aggressive approach of non-US competition authorities that have also stepped up enforcement actions, in some cases based on newer theories of competitive harm and newer legislation intended to prevent an abuse of market power.

Similar to antitrust/competition enforcement, foreign investment review in the US (including the Committee on Foreign Investment in the United States, or CFIUS) and around the globe (including the EU foreign direct investment review) will require increased attention and analysis by market participants. The trend of closer scrutiny with regard to non-domestic investors is expected to continue. Dealmakers and corporate boards must take these considerations into account when evaluating strategic transactions and assessing risk and deal certainty.

The market continues to be driven by private and public M&A transactions, although private M&A is more prevalent because there are many more private than public companies. The cost of capital and the availability of debt financing is a driving factor, particularly for private company and private equity (PE) dealmaking where acquirer stock is not available as transaction currency. For public companies, well-capitalised balance sheets and an ability to use stock as an acquisition currency remain key drivers for potentially strong deal volume in 2023.

Regulation

Increased scrutiny and evolving models of antitrust enforcement and review continue to be topics of conversation among M&A participants within the US and around the globe. US regulators have been reviewing, and continue to actively review, challenging business combinations. Regulators are focused on particular industry verticals, including technology and healthcare. In the US, regulators challenged and sought to block a number of high-profile transactions within those industries. Regardless of the agencies’ win/loss record, regulators are undeterred because the potential for new legislation within the US with respect to horizontal and vertical mergers may alter long-held views on antitrust review and enforcement.

M&A practitioners continue to discuss approaches with regulators to maximise outcomes. The changes would include preparing to divest assets in advance of approaching regulators (‘fix it first’ approaches) such that settlement packages are part of the proposed transaction rather than provided by regulators.

Practitioners have also extended ‘outside dates’ of transactions with an understanding that regulators may be reviewing transactions, and thus extending executory periods of proposed combinations.

In addition, requiring parties to litigate with regulators in court to the extent that regulators seek to enjoin transactions has become more prevalent, and in some cases necessary to win competitive auction processes.

The 2022 M&A market was markedly different from 2021 and more recent years. M&A activity set records in 2021. Early 2022 benefited from those tailwinds. Overall, however, 2022 transaction volume declined by approximately 35%. The second half of 2022 was the primary culprit, with transaction volume declining significantly from the first six months.

There was a confluence of events that weighed on the M&A market. Stock market volatility, monetary tightening by the US Federal Reserve Bank in the form of significant interest rate hikes, the conflict in Ukraine and general macroeconomic uncertainty combined to dampen activity in the M&A market. Generally speaking, confidence in corporate boardrooms lessened and market participants were cautious in a different economic paradigm from that which had been in place for nearly a decade.

However, market participants are cautiously optimistic that deal flow will improve through 2023. PE buyout funds continue to maintain high levels of uncommitted capital for M&A transactions. In addition, strategic acquirors are still focused on growth, with a focus on M&A and organically. In particular, it is expected that M&A activity may be concentrated in certain industries, including energy/infrastructure, technology and healthcare.

Market participants with better internalised valuations in the current environment (as opposed to measuring versus previous 52-week highs), greater clarity from the US Federal Reserve Bank on interest rate hikes (and when they may cease), event-driven investors (which often create their own events) spurring potential transactions, and easing trade tensions (particularly between the US and China) could be the catalyst for a pick-up in transaction volume. Strategic players and PE sponsors have capital to deploy and with a boost of confidence in the markets, M&A activity seems likely to follow.

Increased scrutiny and creative solutions

Transaction participants have been more keenly focused on the scrutiny that regulators will apply to M&A transactions and how such risks are allocated among the parties to transactions. Regulators in the US have explicitly signalled a heightened sensitivity to the competitive effects of certain transactions and have taken more aggressive actions, including prohibiting the consummation of transactions based upon the presumed anti-competitive effects. This increased regulatory scrutiny has impacted, and will continue to impact, transaction strategies in the global markets. In particular, industries such as technology, industrials and healthcare will remain subject to heightened oversight.

Participants in the US M&A market would surely have seen more acute disagreement between buyers and sellers with respect to valuations in 2022. Sellers, having recently experienced higher valuation multiples and more active buy-side processes, were less willing to transact in the new valuation paradigms relative to recent 52-week highs. In an attempt to bridge the difference between the bid/ask spread in M&A transactions, the use of earn-outs, contingent value rights and other means by which buyers and sellers could mitigate pricing risks becomes more common.

Continuing a trend, representation and warranty insurance (RWI) remains a tool used by M&A market participants to bridge and disintermediate exposures for unknown liabilities. The absence of debt financing also dampened deal activity in the second half of 2022. With increased market uncertainty and volatility, lenders were less willing to back-stop M&A transactions.

In an effort to compensate for the absence of more traditional financing, parties were more active in 2022 in discussing alternative financing arrangements with direct lenders and the use of seller financing. In 2023, it is expected that private capital – financing from non-bank lenders – will increase and become part of the established landscape.

PE firms remain a driving force of dealmaking. Despite a rise in US interest rates and an increase in market volatility, PE participants are expected still to be active in 2023, with uncommitted capital at PE firms remaining at record levels. With the challenges in the debt financing markets, larger PE transactions have been more difficult to execute. ‘Middle market’ PE transactions (i.e., transaction values ranging from $50 million to $500 million) have been, and are expected to represent, a significant portion of PE M&A volume.

Shareholder activism is also expected to have a higher profile in 2023. The number of activist campaigns in 2022 was approximately 15% higher than in 2021 and that trend is expected to continue. Activists are expected to wage campaigns based on what would be considered usual and customary grounds (asset allocation, sub-par returns on investment), but also on ESG platforms and ‘say on pay’. These activist campaigns are often M&A related, with an underlying thesis that shareholders are better off with companies being sold or reconfigured to drive maximum shareholder value.

US M&A transactions are subject to regulation by the federal government and the target’s state of incorporation.

The federal government primarily regulates the issuance and sales of securities through the Securities and Exchange Commission (SEC), antitrust matters through the Federal Trade Commission and the Antitrust Division of the Department of Justice, and foreign investment that may have national security implications through CFIUS.

The laws, rules and regulations administered by the SEC are particularly relevant in the purchase or sale of a US public company. The laws of the target’s state of incorporation govern that company’s internal affairs and impose requirements for shareholder approval of mergers and the procedures for effecting mergers.

The Biden administration, the legislative branch of the US government, and government enforcement and regulatory agencies have publicly spoken about antitrust priorities in 2022 designed to address perceived shortcomings in antitrust enforcement and, importantly, perceived consumer harm resulting from business combinations. These evolving antitrust priorities will expand antitrust scrutiny, consistent with the changes practitioners are already seeing at the antitrust agencies within the US. The potential for new legislation within the US with respect to horizontal and vertical mergers that could alter long-held views on antitrust review and enforcement will continue to be top of mind for dealmakers.

In negotiating transaction agreements, practitioners will need to be aware of these risks and how they are allocated, the actions and undertakings that buyers must agree to secure regulatory approval, and the time required to navigate the antitrust review process and potential challenges and court proceedings.

Dealmakers and C-suite executives will likely demand increased attention as to how a transaction may be viewed and positioned from an ESG perspective. ESG has become a topic that investors review in their due diligence undertakings. Private firms have designated diligence groups and diligence protocols relating to ESG.

In general, the US framework of protecting ‘consumers’ rather than ‘competitors’ is being revisited writ large. Regulators are now more keenly focused on other constituencies, including labour, the environment and other ESG-related concerns. This potential revised regulatory framework, together with the time required to navigate regulatory review and the remedies that regulators may ultimately require, is something that all parties should consider thoughtfully when contemplating a potential M&A transaction.

Recently, regulators in the US have introduced proposals to potentially invalidate (but most certainly narrow) employee non-competition agreements. M&A market participants will need to review existing non-competition agreements and provisions and thoughtfully consider whether alternative protections, such as confidentiality agreements and other employment provisions (i.e., those related to incentive compensation), assist in providing the comfort required when evaluating the risks in acquiring a target company.

Unlike the locked-box approach that is more common in many non-US jurisdictions, in most US private acquisitions the purchase price agreed to at signing is usually subject to closing or post-closing adjustment based on the amounts of certain financial accounts of the target (for example, cash, indebtedness, and net working capital) on the closing date. Under this approach, the parties generally must spend more time negotiating the adjustment mechanics and related accounting methodologies.

Under the laws of most states, public target boards must generally retain the right (commonly referred to as a ‘fiduciary out’) to terminate the transaction agreement after signing but before the target’s shareholders approve the transaction to accept a higher offer. Shareholder litigation is common in such transactions, and the buyer is generally liable for related costs.

RWI and transaction structures that provide for no post-closing recourse by the buyer against the seller except for fraud are increasingly common in private company transactions.

As a result of the pandemic, dealmakers have had to adjust to a virtual environment in which almost every aspect of an M&A transaction relies on technology, necessitating a keener focus on cybersecurity issues in the deal execution process. Also, data privacy and cybersecurity have become critical elements of the business and operations of most companies and thus should be a key focus of due diligence in any M&A transaction.

In light of the fiduciary duties of public company directors that generally require them to maximise shareholder value in a sale, target boards often conduct some form of a pre-signing market check. However, in some deals the target board will forgo a pre-signing market check in exchange for a ‘go shop’ right to solicit competing offers for a limited period (usually 30–60 days) after signing the transaction agreement.

While state law generally requires target boards to preserve a fiduciary out to accept a higher offer under certain circumstances, buyers usually negotiate for a prohibition on the target’s right to affirmatively solicit competing offers (except in the case of a go shop right), and the right to receive a break-up fee if the target’s board terminates the transaction agreement to accept a higher offer.

Most states require shareholder approval (usually by a majority of outstanding shares) of most mergers. Certain regulatory approvals – including clearance under the Hart–Scott–Rodino antitrust statute, and for non-U.S. acquirers, from CFIUS – must be obtained before an acquirer can take control of a US company. Acquiring a US company in regulated industries such as financial services and energy may be subject to additional regulatory scrutiny at the federal and/or state level.

Public company acquisitions can be structured as:

• A one-step merger between the acquirer (or, more commonly, a subsidiary of the acquirer) and the target (typically requiring majority shareholder approval); or

• A two-step transaction involving a tender or exchange offer by the acquirer for all the target’s outstanding shares (which is generally subject to a ‘minimum tender condition’ requiring the tender of at least a majority of the outstanding shares) followed by a back-end merger.

Both types of transactions are typically subject to the following conditions (among others):

• Accuracy of representations and warranties;

• Material compliance with covenants;

• No material adverse effect (MAE) on the target; and

• The receipt of regulatory approvals.

Nearly all public target M&A deals in 2021 included an MAE exception for changes, effects or conditions arising out of the COVID pandemic and governmental responses thereto, according to Deal Point Data. Many agreements also provide for greater flexibility under the interim operating covenants to permit the target to take action in response to COVID.

Public company merger agreements generally require the target to pay a termination fee if the target terminates the agreement to accept a superior offer, or if the buyer terminates because the target changes its recommendation in favour of the deal. These fees are usually between 2 and 4% of the transaction’s equity or enterprise value, but may fall outside this range based on deal size and other factors.

In some transactions, the buyer is required to pay the seller or the target a reverse termination fee under certain circumstances (for example, the failure to obtain required regulatory approvals or if all the buyer’s closing conditions are satisfied and it nevertheless fails to close the transaction). These fees are highly variable but often range between 5 and 7% of the transaction’s equity or enterprise value.

There was continued use of earn-outs in 2022, under which the seller will receive one or more additional payments, contingent on the target’s future performance, in part to account for increased earnings uncertainty due to volatility and macroeconomic uncertainties.

Completion accounts (known as working capital or balance sheet adjustments) are common in private company acquisitions. Locked-box transaction structures are much less prevalent in private company acquisitions in the US than in many other jurisdictions.

All the aforementioned conditions for public M&A generally also apply in private M&A transactions. However, in the absence of RWI, representations and warranties usually survive the closing in private M&A transactions and may give rise to post-closing indemnity claims.

Agreements are typically governed by the law of the target’s state of incorporation. If the state has sparsely developed corporate law, the parties sometimes agree that Delaware law will govern certain issues.

The exit environment in 2022 was markedly different from 2021 and the previous years. The market for IPOs slowed to a trickle due to economic and market conditions. At the same time, the pace of the M&A market slowed for similar reasons. As such, exit options became more limited and more challenging from a valuation perspective. Finally, de-SPAC (special purpose acquisition companies) transactions – i.e., mergers between SPACs and private companies – came to a virtual halt due to a combination of factors, including investors seeking to redeem their shares in SPACs rather than participate in the merged companies and an absence of investors willing to invest in the ‘pipe’ market (i.e., privately invest in the securities of the newly combined public company).

The first half of 2023 will likely continue to feature muted interest in the IPO market; however, there is optimism that there will be a more robust equity market in the second half of 2023. Trade sales are expected to remain strong, because corporates with well-capitalised balance sheets will have the opportunity to make acquisitions at more attractive valuations than in previous years. Sales to financial sponsors should also remain strong subject to available third-party financing.

There is confidence, albeit cautious, that M&A activity will rebound in 2023 and, in particular, as the year progresses. Among the factors that could lead to increased transaction volume are signs that inflation has peaked and interest rate hikes have ceased; greater confidence in a macroeconomic rebound, including the lessening of recessionary fears; better availability of credit; and improved trade relations between the US and China.