The past month or so has seen a number of factors increase uncertainty in global markets and debt financing. From the potential default in payments from Evergrande to rising Covid cases in the UK, a market that has been red hot could now be approaching a cooling off point.

The impact of this development could be wide reaching, with a myriad of British firms relying on debt capital to finance mergers, acquisitions and growth in a period where the M&A market is at a high point. With this in mind, founding Partner of corporate advisory firm RWT Growth has analysed what uncertainty could mean for the UK M&A market, especially for SMEs:

Reece Tomlinson, founding Partner of RWT Growth:

With increasing uncertainty surrounding global debt markets, global equity markets, global real estate markets, supply chain issues, inflation rising at a staggering rate and the continued unwavering impact of Covid; it is pushing the need for buyers in an M&A transaction to have increasing levels of assurance surrounding the validity and viability of the transaction value itself.

Adding to this, we are observing Covid normalisations, which are an intentional normalisation of revenue or earnings to offset the impact of Covid on the business, being utilised in most M&A transactions on the market. The inherent problem with these adjustments, however, is that they are not a science and leave much up to the imagination.

Not surprisingly when adding a rapidly changing market with the lack of assurance surrounding Covid normalisations; the requirement for additional security from a buyer is pushing a higher percentage of the transaction to fall into performance-based elements of the deal structure (variable performance structures). These structures consist of:

Earnouts (Contingent Consideration Structures)

An earnout is an M&A deal structure, which provides for contingent additional payments from the buyer of the company to the seller. The term “earnout” simply refers to the fact that the shareholders earn additional compensation if the company hits previously agreed upon milestones.

Equity Claw Back’s

These are essentially the opposite structure of an earnout and allow for the buyer and/or the seller to regain equity if the company does not meet certain performance objectives. This deal structure is more preferable when the seller is accepting some level of compensation in the form of shares in the post transaction company.

Performance Based Vendor Financing (Contingent Vendor Financing Structures)

The rates at which lenders are lending on M&A deals have historically hovered around 2.5x to 3.5x EBITDA, however this has dropped to an average of 2x to 3x EBITDA in today’s world. To put this into perspective, if you were to purchase any given SME it will require more cash then ever before. Add uncertainty to this equation and it becomes more complicated. To combat this, we are seeing an increased reliance on performance-based vendor financing, which is essentially a portion of the transaction, which is being financed by the seller and is conditional upon certain milestones being achieved.

In conclusion, for the majority of SME’s who are seeking an exit, they are going to need to accept some element of variable performance-based deal structures. Unfortunately, the reliance on these structures is likely to increase throughout the remainder of 2021 and 2022.