Navigating M&A in an Uncertain World

INTRODUCTION

Although change seems to have become the only constant, a board’s role is immutable: listen, advise, approve. This is true for normal course oversight and decisions on business strategy, operations, and financial management, and especially true for capital allocation and M&A.

Today’s environment of greater uncertainty elevates the scrutiny and second-guessing boards will likely face regarding their decision-making, particularly with regard to M&A. Any decision or strategic action approved will be judged by stakeholders with perfect 20/20 hindsight.

As directors consider M&A opportunities for 2024, they should also anticipate and prepare for specific challenges. They may face longer and more costly M&A processes, as well as increasingly complex financing and deal structures. Meanwhile, they can expect criticism from stakeholders—especially shareholders, activists, employees, and politicians—and enhanced scrutiny from regulators and the media. This will be against a shifting regulatory landscape as rules are finalized and implemented.

KEY PROJECTIONS

VOLATILE ENVIRONMENT FOR M&A

The year 2024 is expected to be yet another dynamic year, and the risks facing companies, management teams, and boards weighing major strategic decisions are as numerous and varied as ever.

The global geopolitical environment is increasingly unstable. US domestic politics will be shaped by a presidential election certain to be divisive. US monetary policy, which has major impacts on global financial markets, is unlikely to shift favorably. Although the Fed and the European Central Bank both announced rate pauses late in 2023, their “higher for longer” policies could return if inflation remains unchecked.

While geopolitics and monetary policy are not the only determinants of M&A activity, they are undoubtedly suppressing M&A volumes. Global M&A activity has fallen precipitously from elevated levels in late 2020 through 2021, with deal volume through Q3 2023 down approximately 33 percent year-to-date and down 43 percent from the comparable period in 2021.

Persistent uncertainties in 2024 will likely sustain the valuation gap between buyers and sellers. And even if this gap could be closed, an increasingly adversarial regulatory orientation in jurisdictions around the world clouds the risk assessment for both sides of potential transactions.

GROUND SHIFTING BENEATH OUR FEET

New merger-filing rules and guidelines proposed this summer by the Federal Trade Commission (FTC) and Department of Justice cast another pall over the landscape. With these rules not yet finalized, M&A complexity for 2024 is further increased, and may yield unintended consequences. The proposed pre-merger filing process will be more cumbersome, with companies needing to disclose more information. Updates to the Hart-Scott-Rodino Form could also prolong the overall process.

MORE HURDLES = LONGER PROCESS

Even under “normal” conditions, the greater the number of hurdles within an M&A process, the lower the probability of success. But with the number of potential impediments increasing, both targets and acquirers will need to invest more time and money earlier in the M&A process to accurately assess the probability of success.

Once a merger agreement is signed, greater antitrust scrutiny is further extending timelines to close. The FTC and other regulators have shown willingness to oppose more deals and submit legal challenges, regardless of the likelihood of victory in court. The Microsoft-Activision deal and the Meta-Within acquisition are two notable examples. Whether the FTC submits long-shot challenges as a signaling mechanism or to seed the ground for future opposition, their motives may not be understood for years, and one should assume they are playing a long game.

How these factors will impact overall M&A activity is unknowable today. For companies evaluating strategic options—whether as a buyer or seller—there are still deals to be made. However, the new rules may scare some buyers out of the market or create barriers to certain types of transactions, such as vertical mergers, or acquisitions where regulators perceive that a market-dominating company is acquiring an upstart company to kill future competition.

MAJOR BOARD IMPLICATIONS

After two years of depressed activity, potential acquirers may take advantage of M&A to weather the stormy horizon, whether by acquiring new products, capabilities, customers, or scale.

However, M&A is rarely a silver bullet to solve a near-term business problem. In the best cases, M&A can enhance or redirect a company’s ability to create long-term value. At worst, M&A may not actually improve shareholder returns, and M&A can result in steep integration curves and other issues.

For companies open to selling, there may be high-quality, well-financed suitors waiting for the right opportunity, but they may be few and far between when that time comes.

In an environment marked by a wide range of outcomes, the long-term business case and underlying rationale for a deal must be that much stronger, and successful integration becomes even harder.

All of this raises the bar for pursuing M&A. Boards of acquirers and of targets should keep in mind four principles in their evaluation of M&A opportunities:

• Ask the right questions.
• Protect your company’s interests.
• Ensure a fair and transparent process.
• Manage qualitative and reputational risks.

1. THE RIGHT QUESTIONS

There are any number of good, complex, multipart questions a director could ask management, fellow board members, and the company’s advisors when evaluating M&A. However, two deceptively simple questions should be on the top of every director’s list: “Why this?” and “Why now?”

Why this? Rising interest rates, a more challenging operating environment, and compressed valuations may yield potentially attractive opportunities. But just as public-market investors should be cautious about catching falling knives, companies should be mindful of adopting dogs with fleas.

For targets, the same uncertainty that pushes acquirers to seek acquisitions may increase the imperative to find a partner to combat existential risks.

Asking “Why this?” yields many strategic considerations for boards to explore for more thorough, thoughtful diligence. Is this the right price? Does the potential transaction appropriately value the asset? Is the buyer’s financing secured? Do we feel compelled to act due to external or unspoken pressures? How likely are global antitrust regulators to challenge this transaction, and what are the hurdles to overcome along the way?

Why now? Capital allocation is simple in theory. Companies with excess capital have four basic options: (1) reinvest in the business, (2) return capital to shareholders (dividends or buybacks), (3) pay down debt, or (4) pursue M&A. But after a decade of partying with low interest rates, the Fed just turned the lights on, and the dance floor looks different.

When interest rates are low and expected to remain low, the cost of capital is not as much of a factor and the capital allocation decision matrix is simplified. On a risk-adjusted basis, all capital allocation options look relatively attractive, including M&A.

But when interest rates and the cost of capital increase, the decisions become more complex. The hurdle rate for capital projects increases. Financing costs for debt-funded buybacks and M&A go up. The relative attractiveness of dividends versus the risk-free rate of return for investments is materially altered. Even holding cash might be the optimal risk-adjusted action (if earning enough interest to avoid devaluation).

Asking “Why now?” allows boards to pressure test whether a transaction is truly a fit with the company’s long-term strategic plan and if the opportunities for value creation outweigh the risks—or if this is simply growth for growth’s sake.

2. PROTECT YOUR COMPANY’S INTERESTS

M&A is episodic, especially on a large scale, and few management teams and boards have extensive experience executing more than a couple of transformative M&A deals across their careers. A limited sample size of precedents creates potential blind spots.

Legal, financial, accounting, tax, governance, and communications advisors who have managed innumerable M&A transactions of all shapes and sizes can fill these blind spots. These advisors play critical roles in helping boards evaluate potential candidates for an M&A transaction and in finding creative solutions to execute deals to overcome financing and valuation hurdles.

For example, as volatility has returned, more deals are getting done with bells and whistles like contingent value rights and earn-out structures to address valuation gaps, which adds complexity. With tighter credit markets, private capital is entering the void left by traditional banks, post Dodd-Frank, in a big way. These trends are unlikely to abate in 2024, and boards can leverage the expertise of its advisor group to help see around corners and mitigate risks.

3. ENSURE A FAIR AND TRANSPARENT PROCESS

It’s become axiomatic to focus on what you can control. In M&A, that means focusing on process, not outcome. Outcomes will ultimately be determined by many endogenous and exogenous factors and can be entirely unknowable when making a decision. But inputs are controllable.

When M&A transactions are challenged in court, judges typically consider the quality of process to determine directors and officers (D&O) liability. Was the board adequately informed of the risks? Did the board spend adequate time deliberating the risks and merits of the transaction? Were board members and advisors free from conflicts of interest? Asserting protection from liability based on the business judgment rule often depends on the answers to these questions, among others.

The importance of strong processes and controls is magnified under uncertainty, when the range of outcomes facing companies is wider and stakeholders are more likely to question a board’s decision-making.

4. MANAGE QUALITATIVE AND REPUTATIONAL RISKS

Managing these risks is even more complicated as the web of stakeholders becomes more interconnected, as news and misinformation travel with increasing speed, and as pundits and influencers proliferate. Political and regulatory risks are intersecting with business and capital market risk with greater frequency in more nuanced ways, especially for acquirers.

Synergies have long been central to M&A theses, and the general public is now attuned to the fact that synergies often equate to layoffs. Companies championing synergies as part of M&A transactions must be more sensitive to how various stakeholders will perceive and react to their plans.

With the balance of power shifting toward labor, achieving the cost savings necessary to make M&A successful may carry greater reputational risks and also bring legal and regulatory risks in certain jurisdictions. Employees are becoming increasingly empowered at most companies and are more likely to vocalize their concerns and advocate for their priorities. Media and public policy stakeholders are more receptive to worker issues and willing to amplify employee voices, with potential for harming a company’s reputation and negatively affecting other stakeholders’ perspectives.

The Best Antidote to Complexity Is Simplicity

Here is the good news—boards do not need a crystal ball to guide their M&A decision-making. Being clear-eyed in their role as directors, adjusting to the shifting ground of M&A policy, and internalizing these four M&A survival principles will help ensure that directors will be well positioned to fulfill their duties as stewards of company value.

BOARD OVERSIGHT QUESTIONS

1. Have we adjusted our M&A process and playbook to account for regulatory changes—both final and pending?
2. Do our M&A plans and processes appropriately reflect the uncertainties in the current external environment, including longer potential timelines?
3. Are management’s compensation and incentives appropriately aligned with other stakeholders, both pre- and post-M&A?
4. How do we guard against allowing sunk cost fallacy to cloud judgment at any point in the evaluation process?
5. Do we have a clear, well-articulated M&A philosophy for use with various stakeholders who may criticize a deal?
6. How would we feel if the Wall Street Journal were to run a cover feature about our deal and M&A process?