Contingency planning and scenario testing crucial as M&A starts to increase
While M&A activity was slow in the first half of this year, the level of activity has been increasing in recent months. When the fog lifts on interest rates and the macroeconomic environment, the market anticipates that we will see a backlog of assets for sale and buyers eager to do deals in Q4 this year and 2024. To this end, at McKinsey’s recent European M&A conference co-hosted with Goldman Sachs, more than half of participants polled said they expect to increase their M&A activity or pursue transformative deals this year.
Despite this, it is worth noting that the prevailing inflation and interest rate environment continues to drive a number of UK corporates issuing profit warnings, with a number of those sponsoring UK defined benefit (DB) pension schemes.
H1 saw more internal rather than external activity
The main types of activity undertaken in the first half of this year have been challenging refinancings faced by sponsors in light of the higher interest rate environment, deficit repair contributions (DRC) deferrals reflecting sponsors trying to either capitalise on improved scheme funding levels and / or mitigate cash-flow pressures in the context of refinancings. We have also seen internal re-organisations as sponsors explore opportunities to help drive cost savings to protect margins as inflation has persisted.
We expect a continuation of these activities through the second half of the year, given our expectation that UK bank rates will stay higher than previously estimated and for a more prolonged period. We have pencilled in an additional 50bps rate hike this year, taking the terminal policy rate to 5.75%. More importantly, we expect no rate cuts until H2 2024 and only a modest 75bps rate reduction in H2, meaning that the real policy rate will be high and the policy stance will be tight through 2024. Additionally, inflation projections indicate a further delay in reaching the target of 2% until 2025.
M&A activity expected to pick up in the next 12 months
Looking forward to Q4 and 2024, we expect M&A activity to ramp up given the high levels of dry powder among public companies and private equity funds and a more stable macroenvironment. Some activity has already started to emerge in particular, across the healthcare and technology sectors We expect to continue to see many listed sponsors more closely examine their operations and options to increase shareholder value.
For some this may be via M&A activity, for example purchasing or merging with another company so that it is better positioned to expand into new markets and/or driving economies of scale through consolidation. We could also see near-term shareholder value proposition achieved via the disposal of non-core operations.
In addition, the combination of devalued Sterling and improved scheme funding may make certain UK companies more attractive assets for potential foreign investors meaning pension scheme trustees could be faced with takeover scenarios.
Trustees should stay close to their covenants despite improved funding levels
Challenging refinancings of debt, internal re-organisations and M&A transactions all could have material implications for covenant risk dynamics. Therefore, despite the general improvement in funding levels, Trustees shouldn’t be complacent when it comes to covenant and corporate events, and so we encourage trustees to stay close to the situation and be ready to take actions quickly.
With quick decision making often crucial for trustees navigating a material corporate event, contingency planning can be a helpful tool to ensure trustees are prepared. As part of this, trustees should consider scenarios that could play out, such as a large debt-funded acquisition by the sponsor or a leveraged takeover of the sponsor by a trade buyer or private equity firm.
As a reminder, the following key areas are vital for trustees to understand with respect to transaction-related corporate events:
- the strategic benefits of the transaction, together with the risks it introduces;
- the impact on a sponsor’s capital structure (for example, increased debt and use of proceeds);
- potential value leakage, which could take many forms such as reduced profitability, dividend payments and intra-group movements either as part of the deal or post-deal;
- movements of assets in and out of sponsors post-deal; and
- the potential triggering of a section 75 debt and any impacts this has on trustee powers under a scheme’s trust deed and rules.
Such events could also create the need to re-assess if a scheme’s journey plan remains appropriate as covenant risk dynamics are potentially materially altered. Considering the uncertainty around the current macroeconomic environment, early engagement with the other stakeholders can also be a critical step to help facilitate negotiations in good time and achieve an outcome that is in the interests of all.