UK M&A trends in 2023: deals in the workforce solutions sector

As a result of these broad factors, global M&A fell by a third in the year to December 2022 – a record percentage fall – and the UK followed this downward trajectory. In particular, there was no usual year end boost in activity in 2022, with private equity particularly losing momentum. Given the prevalence of private equity buyers in the workforce solutions market, this naturally had an impact on the sector's transactions too. 

We have analysed a sample of M&A deals that Osborne Clarke UK's corporate team advised on in 2022 in this context and compared them to our analysis in previous years to identify recent M&A deal terms trends, and to predict deal characteristics and activity in 2023 in the workforce solutions sector. (See our infographic on M&A deals advised on by Osborne Clarke.)

Deal values static

Deal values remained static across all sectors with our sample of more than 50 deals in 2021 having an aggregate deal value of £1.9bn and our sample of 40-plus deals in 2022 having an aggregate deal value of £1.3bn, though a larger proportion in 2022 related to deals completed earlier in 2022 before the market contraction.

Cross-border work more challenging

2022 was a more challenging year for cross-border work in many sectors, with the normally globally acquisitive US buyers impacted by increasing borrowing costs (which has certainly affected workforce solutions M&A), Chinese overseas investment declining, confidence in UK and other foreign assets dented due to geopolitical and financial turmoil, and a focus on deglobalisation and domestic energy security.

In 2022, 43% of Osborne Clarke's deals across all sectors were cross-border, down from 63% in 2021, but still remaining higher than previous years (30% in 2019 and 40% in 2020), as foreign acquirers with readily available cash took advantage of the weak British pound to acquire cheaply, and many acquirers still view cross-border M&A as the quickest route in to a local market (which has been the case over the years in the workforce solutions sector).

Tech M&A the leading sector

Globally, tech M&A has been a strong sector for a number of years, and we saw an increase in the percentage of our deals in this category in 2022. Tech M&A accounted for 35% of our deals (30% in 2021). M&A of financial services targets also came to the fore.

The urgent need for businesses to digitalise or adopt technological solutions by acquiring relevant assets to keep pace with the changing world and competitors drives the strong performance of tech M&A. 

In the workforce solutions sector, interest in tech-driven deals has reflected this overall trend, with some acquirors motivated by a desire to strip out manual processes in target companies and replace them with automated processes, making the target more profitable post deal. At the same time, in 2022, valuations of companies that have already become "tech enabled" businesses held up relatively well and there was a decent flow of start-ups in the UK workforce solutions sector for acquirers to approach as part of their journey towards automation by acquisition. 

'Locked box' back in fashion

For those interested in the legal minutiae of M&A deals, there has been a slight uptick in the use of "locked box" mechanisms in transactions in 2022 from 35% to 38% of deals. In 2021, purchasers preferred the deeper dive of completion accounts amid the economic uncertainty of the pandemic. The reversal of this trend in 2022, to rely on the simpler locked box mechanism, reflects the improved confidence in financial data, at least in the first half of the year.

'Earn-outs' ever more popular

There is a continued reliance on earn-outs to bridge valuation gaps; with macro-economic uncertainty, purchasers are wary of over paying, but some sellers' expectations are yet to adjust to the lower realistic valuations the downturn has brought. In the workforce solutions sector sellers tend to be particularly loathe to drop their price expectations given that trading has generally held up well because of ongoing skills shortages and, of course, founders of staffing and recruitment companies tend to be more optimistic than most other types of business leader.

In uncertain economic times, an earn-out can persuade a seller to sell, in the hope that their higher valuation is achieved. But it also gives a purchaser comfort at the outset that they are paying the right price for the market conditions and can hold back cash needed to cover increased costs, like debt servicing, unless and until the earn-out is achieved.

Earn-outs are also prevalent in the sale of tech and other new businesses, including workforce solutions businesses which are moving to automated processes, which may not benefit from years of historic tested financial data or revenue.

A quarter of our deals across all sectors used earn-outs in 2022, a solid increase on a fifth in 2021. Historically, there have probably been a higher percentage of earn outs in workforce solutions deals than deals in most other sectors, largely because of the cyclical and "people business" nature of the sector and perceived risk to future profitability if key people leave. This trend seems likely to continue in 2023.

With valuations and financial due diligence proving challenging, agreeing on appropriate metrics for any earn-out has, however, been problematic in the last year.

Fewer escrow accounts

With law firms no longer holding escrow accounts (that is, reserved parts of the sale price out of which claims can be settled) for regulatory reasons, deal parties' only option is to engage a third-party escrow agent. An agent's services come at a price, and for many clients this is a deterrent, particularly when finances are tight.

There has been a distinct decrease in escrows in our deals from 27% in 2021 (37% in 2020) to 21% in 2022. Fewer escrows may also have resulted from purchasers' improved confidence of sellers' ability to settle claims and reliance on alternatives, such as price holdbacks and warranty and indemnity insurance.

W&I insurance cover back to normal market levels

Warranty and indemnity (W&I) insurance has transformed M&A deals (above a certain size) for many types of company in recent years. This helps to reduce concerns that buyers might have about certain risk factors, and provides sellers with comfort that they won't be pursued for certain warranty or indemnity breaches post-completion.

In 2021, there was W&I insurance on nearly half of our deals. In 2022, 33% of deals involved W&I insurance. This is comparable to the percentage in 2020.

While we expect the trend favouring the use of W&I insurance to continue as the transaction insurance market continues to expand and mature, the decrease we have seen may be due to a lesser percentage of our private equity transactions (where W&I is heavily used) being included in our deal sample (private equity slowing in the second half of 2022), or a larger number of smaller deals, or those where W&I insurance is less often used (such as real estate or infrastructure) being included in the sample.

Workforce solutions is a sector that is supported and backed by the W&I insurance market, albeit coverage for industry-wide issues such as IR35 and National Minimum Wage (NMW) are often excluded and require other methods of risk apportionment.

Other trends

Other trends include:

• Increase in conditional deals and asset deals: to accommodate notifications under the National Security and Investment Act or to come outside of the mandatory notification rules in the act, and tough negotiations of material adverse change (MAC) clauses in light of political and economic uncertainty.
• Deeper due diligence: thorough due diligence (DD) is back in vogue after being squeezed in the bull market, and DD and warranty scope widening with increased focus on environmental, social and governance (ESG) matters, sanctions and export controls, cybersecurity and supply chains, and more scrutiny by W&I insurers. In workforce solutions deals we have seen particular focus on supply chain liability issues arising from things like IR35, reliance on "dodgy" umbrella arrangements, NMW and lack of compliance in international arrangements.
• Longer deal timetables, more challenging negotiations: a longer initial period to "court" reluctant sellers unpersuaded as to the valuation of their business, more stop-start deals, price renegotiations and aborted transactions, where valuations are declining, diligence more rigorous, parties more wary of risks and financing harder to come by.
• More distressed deals: meaning limited warranties, and shorter timetables, and non-conventional W&I products, with higher premiums and narrower cover.
• Non-traditional financing sources: such as private debt and joint ventures.
• Limitations periods for claims shortening: during 2020 and 2021, these had lengthened to allow for claims to show up in volatile accounting figures.
• Increase in M&A disputes: more focus on liability terms.
• Complexity: transactions became increasingly complex.

See also our summarised deal trends in Europe in 2022.

Outlook for 2023

M&A in early 2023 is expected to be subdued across most sectors until the third quarter, when analysts expect the market to slowly recover.

The highs of 2021 and early 2022 are not expected to be replicated any time soon, as the polycrisis of 2022 looks set to continue for the foreseeable future.

Some sellers will hold fire until the market is less depressed or while they focus on internal business challenges. Some acquirers will also wait until the market bottoms out. 

In the workforce solutions sector, this is likely to lead to a shortage of supply and demand of acquisition targets in the first part of 2023 followed by a rush of deals after the summer through to early 2024, with a possible race for UK deals to be completed before potential changes in the political landscape (and corresponding higher taxes on capital gains) at the end of 2024. 

Opportunities in 2023 and predictions for deal terms

We anticipate that trends that arose as the market weakened in the latter half of 2022 will continue through 2023, and we expect completion accounts and longer limitation periods to be more common in 2023, though these trends may reverse as the market bounces back towards the latter end of the year and into 2024. 

Despite the headwinds, many opportunities remain:

• Transformative M&A to urgently address changes to the world of work and our lives more generally, including digitalisation and decarbonisation. Tech transformation seems to be a particular driver in workforce solutions M&A.
• Distressed sales of a few businesses that struggle in the current economic climate. Timetables will be short, and warranties limited. We will see an increase in group reorganisations and carve-out transactions. However, many staffing and recruitment companies have continued to trade well in this downturn; in any event, companies in this sector are generally very resilient in downturns, able to reduce costs quite easily with staffing companies in particular typically throwing off cash as turnover drops.
• Pent-up demand in private equity with plenty of "dry powder" which needs to be spent. We expect to see smaller non-leveraged private equity deals with more scrutiny at investment committee. Sales and secondary transactions by sponsors and bolt-on programs (with streamlined processes) or complementary acquisitions will be popular, and structures to limit third-party financing (for example, acquisitions of a minority interest, joint ventures with strategics, consortium acquisitions or other tie-ups with third parties).
• Keen individual sellers, with manager-owner burnout following several years of out of the ordinary challenges, means that many are preferring to sell out rather than rise to the next challenge, and pressure to sell in advance of changes to capital gains tax (the cut in the tax-free threshold and the tax-free allowance). Purchaser-friendly deals terms will likely follow, and accelerated timetables.
• Weak sterling is making UK targets attractive to overseas buyers.
• Cash-rich strategics as acquirers with readily available cash take advantage of low valuations to enter into synergistic deals. 
• Consolidation is occurring in certain sectors, particularly those that are very fragmented or have struggled in the pandemic or with high energy costs or heavily impacted by the changing world.
• Sales to employee ownership structures: where sellers are keen to sell, but there is no obvious third party purchaser, and where the business wants to democratise and improve ESG credentials. We are particularly seeing continuing interest in employee ownership trust arrangements (EOTs) at staffing and recruitment companies and have advised on several in the last six months.
• Some valuations holding up: with less supply of potential targets, those willing to sell a quality asset may achieve a good price, despite the general M&A market, for lack of alternative targets, and be able to deal on seller-friendly terms and through more competitive sale processes. There is evidence that, in tech-driven sales, tech buyers may be prepared to pay higher than normal EBITDA multiples for traditional staffing companies.
• Disputes advice: a volatile climate often leads to more claims. With more earn-outs, or if the price adjustment trend reverses in favour of purchaser-friendly completion accounts to mitigate the risk of uncertain financial data, we anticipate an increase in disputes over calculations. W&I insurers will also see an increase in claims.

We predict the following types of workforce solutions companies might see a strong M&A performance in 2023 (or at least late 2023 and 2024):

• Staffing and recruitment companies whose processes can be profitably automated.
• Workforce solutions companies with a good international footprint.
• Workforce solutions companies with a consultancy or hire-train-deploy model – these models may seem relatively less likely to suffer under any future legislative attack by any new UK government on traditional staffing companies.

M&A to rebound later this year

Notwithstanding the many obstacles, transactions will continue to be closed in the coming months, with the outlook improving after the summer, albeit more slowly, with increased scrutiny, more creative structures, non-traditional financing and in some cases on more purchaser-friendly terms. 

Owners of workforce solutions companies that are considering a future exit event should plan ahead of this rebound, using the quieter period in the market as an opportunity to review their policies and compliance practices ahead of any future diligence exercise that will be undertaken by a buyer.