Private capital insights for 2024

As we progress into 2024, we wanted to share insights from our private capital experts for the year ahead and what factors are likely to have an impact on deal activity, access to capital and the availability of liquidity for private companies and their investors.

Renewed M&A activity

The prevalence of higher interest rates and a year of political change and economic uncertainty will continue to mean that the “valuation gap” between seller and buyer will take time to converge. Deal structures will help bridge that gap, and we can expect to see the continued use of earn-outs and consideration shares in the buyer vehicle (known as “stub equity”). Due diligence will become a higher priority with a more thorough approach to diligence on acquisitions. We can also expect to see business issues arising as a consequence of a historic trend of limited or “red-lines” diligence on previous M&A activity, and potentially increased warranty claims for previous transactions. Find out more here.

However, liquidity is available from both UK and international buyers and will be more readily deployed into specific sectors. These include fast growth businesses (specifically scalable technology and AI), where there is a clear underlying demographic which requires investment (such as the wealth management sector or assisted living) and infrastructure, such as life sciences and data centres.

Distressed M&A

In parallel with renewed M&A activity, we will also see a rise in distressed business sales. The rise in interest rates and the consequential increase to discount rates for future cash flow has produced both a tighter market for equity fundraising, in particular for companies that are yet to operate on a cash flow positive basis. This, when combined with a more challenging trading environment in certain sectors and increased costs, has led to accelerated fundraisings, distressed M&A activity and businesses being sold out of a formal insolvency process.

All of this will place a higher value on those with capital who are able and willing to move quickly and are willing to accept the greater risks that come from purchasing businesses in this environment. Preparation is key as opportunities will need to be taken quickly, and vendors will place a high value on those who can demonstrate liquidity, deliverability and a credible professional team with experience of operating in this type of M&A. There will be opportunities for nimble buyers and “patient capital” is likely to be at a significant advantage. 

The focus on governance

Governance and corporate accountability will be important for private businesses this year for regulatory and commercial reasons, with practical implications for private company boards and private capital investors. It will no longer be enough simply to put in place governance policies. Instead, steps will need to be taken to ensure that good governance is incorporated into the operation and culture of the business. Private companies will need to adopt a pro-active approach to future (and historic) governance and ensure that this is reflected in a transparent and accountable manner. This is particularly relevant and “on trend” for wider stakeholders in UK businesses and it is a focus for UK regulators too as they oversee the continuing adoption of generative AI and machine learning technologies. Public attention has been drawn to questions on whether governance and the oversight of corporate decision making has been fit for purpose, as a result of high-profile examples such as the Post Office and Carillion, and the direction of travel in this area is likely to be only one way.

ESG

ESG remains an important consideration for private capital. Even if the UK and European reporting requirements do not yet directly affect all private capital backed companies, there will be stakeholders who are likely to require enhanced due diligence and reporting in order to monitor compliance with the EU’s Corporate Sustainability Reporting Directive, Corporate Sustainability Due Diligence Directive and European Sustainability Reporting Standards, alongside the UK’s Sustainability Disclosure Standards. More broadly, the UK’s march towards Net Zero 2050 means that, particularly in real estate, ESG will continue to present both challenges and opportunities for investors.

Artificial intelligence

In the UK, technology will remain a major focus for all businesses and, reflecting that, we expect to see further M&A activity where the target business’s technology is the main priority for the buyer. AI will continue to dominate the headlines, but with an increased focus on the practical delivery of safe, robust systems and how AI can support and develop businesses. Company boards will need to understand and ensure an AI strategy and usage policy is adopted and communicated to their businesses as they look to adopt AI into their operating models. Other businesses, for example, in the media and publishing industries, will need to protect and adapt their industry models to take on the opportunities and the challenges of generative AI as it continues its proliferation and becomes more powerful, more useful and (for content owners and others) more of a threat.

Supply chain integrity

As global unrest shows little sign of abating in the short term, supply chain pressures will continue to be a business risk this year across a range of sectors. More than ever, it will be important for businesses to build resilience and to have effective contingency plans to adapt to these pressures. Businesses should monitor their key suppliers, allocate risk and pricing in contracts and find alternative options to deliver their goods and services. This will be of particular significance for commercial real estate development, which is already under pressure from the cost of borrowing. A dynamic and agile approach is required to ensure the impact on business operations and financial performance is minimised so far as possible.

Recruitment and retention

People will remain a top priority for the year ahead. Recruitment and retention of key staff will remain an important element in many sectors. In an M&A and investment context the strength of the management teams will be vital. In parallel, businesses will need to firm-up their approach to agile working and physical presence in the office, as this year will determine the long-term working structure for many businesses and sectors. Staff productivity will also be an increased focus, not least as higher wage growth bites. The recruitment, retention and remuneration of staff will remain a particular challenge in specific industries, such as the healthcare and hotels industries.

Financing

Pressures on corporate borrowers will continue, driven by the high cost of debt, income pressures, reduced appetite amongst traditional lenders in certain sectors and fixed rate facilities taken out in the low interest rate environments (including those under the Covid loan schemes) coming to the end of their term this year and next. Borrowers will need to look to “amend and extend” existing facilities (where they can) or seek alternative lenders (including direct lending from private credit providers) to refinance where they cannot. Layered funding structures will continue to be utilised, equity injections may be needed and equity may need to be given up to debt providers as borrowers look to wait for the predicted medium to long term fall in inflation to reduce higher borrowing costs, which is expected in the latter part of 2024.

Having said that, for borrowers with the right backing, a strong management team and a good track record, competitive and well-structured funding packages remain available from debt providers, especially those in the non-bank market. There will be particular focus on how development or operational overruns in sectors such as healthcare, assisted living and hotels will be funded and the development risk allocated between stakeholders.

When looking at financing options the backdrop can be a potential enforcement scenario. It is particularly important to understand where value would break in any enforcement scenario as this will be a key driver in how different parties conduct negotiations and how willing certain creditors will be to consider compromising their position in order to realise or protect their funding position.   

Regulatory

The application of the National Security & Investment Act for inbound investments and acquisitions will continue to be relevant to transactions at all levels. Acquirers and their advisers will have to conduct an ongoing assessment of whether any share acquisitions (including minority stakes) will require a mandatory or voluntary notification under the legislation: see our article on the Act here. Transactions in the Act’s sensitive sectors will require their own strategic planning at an early stage in the process.

The introduction of the UK’s Economic Crime and Corporate Transparency Act in October 2023 provides a number of reforms to Companies House powers and various changes to company administrative matters (see our article here for further information). We understand some of the provisions will be implemented in the first half of this year and we expect there to be a greater burden on companies once all of the changes are in force. Among other things, companies will eventually be required to:

• Verify the identity of their directors and persons with significant control with Companies House. This additional step, when it comes into effect, will need to be anticipated in corporate transactions and company incorporations, and
• Ensure compliance with the new “failure to prevent fraud” offence if they are a large organisation (if they meet two of the following conditions (i) more than 250 employees (ii) more than £36 million turnover and/or (iii) assets of more than £18 million). Businesses’ audit and oversight processes will need to ensure they can comply with this part of the legislation.

With thanks to our partners in the corporate team Tom Bruce, Jonathan Haley, Marie Bates, David Fletcher and Richard Lane.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, January 2024