Middle market merger and acquisition (M&A) deal volume reached record high levels during the past couple of years. However, economists and media sources are forecasting economic slowdown and a potential recession in 2023. If the market cools, M&A activity can be expected to decline as buyers face a reduction in target inventory and capital sources, and founders delay their exits until revenues support a higher purchase price. Potential middle market M&A buyers and sellers will need to act strategically in order to weather a market downturn.
Strategic Considerations for M&A Buyers
During an economic downturn, buyers can expect reductions in quality acquisition targets and sources of capital to fund purchases. Accordingly, buyers should strategically consider distressed businesses as potential acquisition targets. Further, buyers may be able to acquire these targets at a discount.
It is to be expected that some businesses will not be able to weather stormier markets. Based on past trends, there is an uptick in bankruptcy and business liquidations during economic recessions. These distressed businesses may be looking to liquidate or divest certain business lines and assets at discounted prices. However, buyers will want to take care in acquiring distressed businesses to avoid inheriting successor liabilities and other problems that impact value.
Buyers should consider acquiring the assets of a distressed business as opposed to the equity while expressly excluding liabilities. In addition, buyers should be organized and prepared to conduct thorough diligence on the target, typically on a compressed timeframe for distressed sales, to uncover potential liabilities and negotiate deal terms to protect the buyer.
Buyers may also want to consider having multiple sources of recovery for potential successor liabilities. Buyers can negotiate indemnification protection from a solvent parent or affiliate. Escrowed or held back purchase price amounts can be sources of recovery for a buyer. Buyers can also treat part of the purchase price as an “earn out” to be paid over the next several years if certain metrics are met. Buyers can then negotiate to offset potential liabilities from the earn out.
Businesses that are undergoing bankruptcy proceedings can also be attractive asset purchase targets. Subject to the approval of the bankruptcy court under certain proceedings, a buyer may be able to acquire discounted assets free of claims, liens, and other encumbrances.
Strategic Considerations for M&A Sellers
As founders hold out for a more favorable M&A market, they should strategically take steps to avoid eroding the business value such as creating protections for industry disruptions.
An economic decline may cause further disruptions to various industry supply chains that are currently recovering from the effects of the COVID 19 global pandemic. Suppliers will want to review their form agreements and templates to make sure that they are protected in such cases. Suppliers should pay particular attention to their force majeure clauses.
Force majeure clauses address how parties will perform in extreme events such as natural disasters, wars, governmental orders, labor strikes, or national emergencies. Typically such a clause will state that the contract parties will be excused from performing in cases of a force majeure event. Suppliers should review their standard contracts to ensure that the force majeure events include supply chain interruptions, regional emergencies, public health emergencies (such as COVID variants) and government-mandated restrictions, and political uprisings (such as insurrections). In addition, suppliers will want to ensure that their customers are not excused from making payments as a result of a force majeure event.
2023 may prove to be a difficult year for M&A middle market players. However, these challenging economic times can provide opportunities for strategic buyers and sellers navigating a market slowdown or recession.