M&A in financial services - digitisation, disruption and divestments

As M&A activity dropped worldwide last year, the financial services sector remained something of an anomaly. Globally, deal volume and value both fell, as the industry was hit by headwinds such as increasing regulation, geopolitical uncertainty, recessionary fears and the general slowdown in M&A.

However, despite this, activity in the sector remained strong, fueled by digital disruption and growing interest in emerging sub-sectors. In the UK, meanwhile, financial services M&A continued to be buoyant, returning the highest deal value of the six key industries tracked in PwC’s report on UK M&A activity in 2022.

This relatively strong performance, amid a significant downturn in M&A, has boosted hopes that activity in the financial services industry will see continuing growth during 2023, as companies turn to M&A as they seek to digitalise, transform their business and streamline operations through strategic divestments.

How did financial services M&A fare in 2022?
Reflecting the overall downward trend in M&A, global dealmaking in the financial services sector dropped off last year in the wake of a record breaking 2021. The war in Ukraine and its associated financial sanctions and disruption added a huge degree of geopolitical uncertainty to the market, which, along with the expected decline following 2021’s inflated figures, saw global M&A volumes and value fall 17 per cent and 42 per cent, respectively, during 2022.

During 2021, there were 6,490 M&A deals globally in financial services, a figure that fell to 5,249 last year, while global deal value fell from $675 billion in 2021 to $368 billion last year.

While this may seem to be a dramatic decline, there are mitigating factors. Overall, deal volume remained high, with the drop lead mainly by a significant decrease in megadeals (M&A deals valued at over $5 billion), which fell from 21 in 2021 to five last year. 2022’s figures were broadly in line with those seen in 2019 prior to the COVID-19 pandemic and were relatively strong, given the wide range of headwinds the sector faced.

In PwC’s report on UK M&A last year, (which focuses on deals in the financial services, health industries, industrial manufacturing and automotive, technology, media and telecommunications, consumer markets and energy, utilities and resources sectors) financial services had the highest deal value (£6 billion), accounting for nearly a quarter of the total deal value.

Furthermore, despite a drop-off in the second half of the year, UK deal activity hit a seven-year high in the first half of the year, with deal appetite driven in particular by buyers seeking to develop their digital capabilities.

What factors will drive deals this year?
Acquisitions can enable companies to reposition or consolidate
2023 arguably represents the start of a crucial period of change in the financial services market, as competing factors such as rising geopolitical tension, increasing regulatory scrutiny and digitalisation force companies to consider how they need to strategically adapt to a new environment.

In such a rapidly shifting world, inorganic opportunities would seem to be a natural response, enabling companies to quickly add the capabilities they require to meet new challenges while simultaneously continuing to grow. Through M&A, financial services companies can add the talent, new technological capabilities and exposure to emerging sectors that can position them better for the future.

This repositioning can enable companies to add elements to their business that could help them to grow once the economy begins to recover from the current downturn. Economic shocks can deliver significant changes to factors such as regulation and consumer behaviour and these are things that might be particularly acutely felt in the financial services industry.

Anticipating trends that might emerge out of an economic crisis can enable financial services businesses to make acquisitions that could position them for significant future growth. As the cost-of-living crisis continues to escalate, traditional banks could seek to draw in more customers by acquiring neobanks with capabilities that appeal to households concerned about money, such as early direct deposits, a feature used by several banking startups that pays a customer’s paycheck into their account up to two days early.

Equally, with the threat of a recession looming, companies across all sectors of financial services could look to acquisitions to help them consolidate their existing position within their core industry, build greater scale and increase their geographic presence. The UK wealth management sector is a perfect illustration of this.

Highly fragmented, the sector has seen several highly acquisitive consolidators - such as Kingswood and Fairstone Financial Management - emerge over recent years. While the UK’s economic outlook has grown steadily worse, these firms have not slowed down their acquisitive activity. In December, Fairstone completed its sixth acquisition of 2022 and has already kicked off its dealmaking in 2023, with the acquisition of Surrey-based IFA Mantle Financial Planning. Looking ahead to the rest of the year, Fairstone says that strategic acquisitions of financial advisory firms in its core wealth management market will remain at the centre of its ongoing growth plans.

Despite the threat of a looming global recession, acquisitions are arguably beginning to be seen as one of the key responses to emerging challenges.

This mindset is reflected in several recent polls, which illustrate that financial services firms are looking to ramp up their acquisitive activity in the new year. According to PwC’s 26th Annual Global CEO Survey, 65 per cent of CEOs at financial services businesses say they are not planning to delay their M&A activity, the highest percentage from the six industries polled in the survey.

Meanwhile, in EY’s latest CEO Outlook survey, 61 per cent of financial services CEOs say that, in spite of the raft of challenges facing the industry, they expect to see a “significant” or “moderate” increase in financial services M&A over the coming six months.

A need to refocus could drive divestments
Just as acquisitions can drive transformation at financial services firms, a similar repositioning can be achieved by divesting assets and subsidiaries that are no longer central to a business’ operations or are less profitable than other units.

Given the huge array of changes impacting the financial services industry, divestitures can enable companies to refocus their strategic approach almost as significantly as acquisitions, especially as companies seek to lock-in long-term value and lower their exposure to risk, with recessionary fears and geopolitical uncertainty continuing to increase.

With financing, including for acquisitions, likely to be tight as recessions take hold in 2023, firms could increasingly look to raise funds by disposing of operations that no longer deliver value or carry too much risk.

According to EY’s CEO Survey, 30 per cent of financial services leaders say that they will be making divestitures of non-core business units a strategic priority over the next six months, indicating that this will be a major driver of M&A activity during 2023.

Over recent years, Buy Now Pay Later (BNPL) has been one of the biggest trends to emerge in the payments market. However, with mounting concerns over consumer protection and household spending amid the cost-of-living crisis and the growing likelihood of close regulatory scrutiny of such platforms, there have been suggestions that the momentum BNPL has enjoyed over recent years may begin to slow this year.

As a result, financial services institutions that have invested in BNPL platforms over the past few years may be among those tempted to offset assets as they become less profitable, less popular and more tightly regulated by authorities.

Delayed deals and unspent capital could tempt private equity buyers back
One of the main factors behind the downturn in financial services M&A during 2022 was a decrease in activity by private equity firms, who are typically among the key drivers of dealmaking activity across the sector.

As economic conditions worsened last year, valuations took a downward trend and debt financing tightened, private equity firms paused much of their M&A strategy, with private equity exit volumes falling 80 per cent in 2022.

During 2023, it is anticipated that private equity activity could recover significantly, both as a result of a backlog of delayed deals, increasing clarity around economic conditions and the need for investors to resume deploying the huge reserves of capital they have accrued since the beginning of the COVID-19 pandemic.

Private equity buyers are expected to take a greater interest in several key financial services sectors this year, including emerging trends such as fintech, regtech, insurtech, payment and financial platforms, resulting in increasing buyer-side activity.

Private equity acquisitions could also be boosted by an accelerating trend for exits at other PE firms, as well as among venture capital businesses and financial services companies. With divestments set to increase this year, the large volume of businesses coming to market could result in lower valuations for potentially highly valuable assets, giving private equity firms the opportunity to acquire attractive targets at scale.

However, there are caveats that could conceivably temper private equity activity. With the economic backdrop worsening, private equity buyers will need to undertake extremely thorough research and due diligence to ensure that potential acquisitions will deliver significant value, adhere to the strategic priorities of their portfolio and do not come with excessive exposure to the risks posed by recession and geopolitical turmoil.

Tight financing conditions and falling valuations create distressed opportunities
Of course, the likelihood of global recession will not exclusively be a deterrent to M&A activity in the financial services sector, with an economic downturn likely to create the scope for distressed acquisitions by opportunistic buyers.

Divestments will form a key part of distressed M&A during 2023, as financial services institutions looking to reposition their businesses and shed non-performing units may make these assets available at a heavily discounted price in an effort to quickly get them off their balance sheets, accelerate a shift in strategy and raise the funds required to target acquisitions of their own.

Tighter financing conditions may mean that many emerging startups with significant value potential could struggle to access the financing they require to maximise their growth. While this may result in some highly promising firms simply failing to make the grade, it could also lead some startups to seek buyers in order to safeguard their futures, potentially creating cost-effective acquisition opportunities for buyers such as private equity firms and industry incumbents looking to expand into emerging sub-sectors.

Furthermore, after emerging financial services startups enjoyed years of lofty valuations, the recent economic slowdown has meant that valuations are now falling. As a result, financially powerful buyers could be well-placed to acquire innovative companies with extremely high potential at lower prices.

Which sub-sectors could significantly drive M&A?

Fintech
Digital transformation will be paramount for financial services firms looking to reshape their business strategies, with capabilities such as data analytics, cybersecurity, compliance tools and wealth management technology increasingly vital.

As regulation becomes more stringent and laborious for financial services firms to adhere to, acquisitions of regulatory technology (regtech) that enables businesses to streamline and optimise their compliance processes, through tools such as artificial intelligence, biometrics and machine learning, will be highly sought after.

Digitalisation is also continuing to accelerate in the crucial wealth management space and, even in the wake of several years of intense dealmaking, this is expected to continue driving dealmaking in 2023. Customers increasingly expect cutting edge service when it comes to wealth management and this is placing a greater onus on operators to acquire new wealth-tech capabilities.

Wealth-tech can enable wealth management companies to improve their client experience offering through services such as improved online platforms and digital advisers, while technology can also help rapidly expanding firms to increase their productivity as they build scale through acquisitions of smaller firms in the rapidly consolidating industry.

Increasing demand for such diverse fintech capabilities is also coming at a time when such targets may be becoming more attainable, two factors that could see a significant uptick in fintech M&A during 2023. Inflation and rising interest rates have led to lower valuations at fintech firms that may, in previous years, have attracted extremely lofty prices.

Meanwhile, the decline of the US IPO market means that options for insurgent fintechs that may previously have sought a lucrative public listing are now considerably reduced, opening the door for private buyers to make strategic acquisitions that could help them to increase their digital capabilities.

Finally, the fintech M&A boom that has occurred over the past decade or so has arguably seen some buyers make acquisitions that didn’t necessarily fit their strategic profile, with such firms perhaps likely to be among the first to be divested by companies looking to streamline their operations.

Banking
During rising interest rate cycles, it is not uncommon for banks to fare well, due to widening spreads between deposits and loans. According to S&P Global Ratings, banks in the UK are forecast to enjoy higher profits, despite prevailing economic headwinds.

It’s a throw of the dice, but banking M&A could prove quite active this year. Drivers include: a realignment to core business activities triggering carve-outs of low margin, high cost businesses; secondary sellers from the prior cycle of banking exits following the GFC; wealth management consolidation of smaller players who face burdensome regulatory obligations; acquisitions to pursue digitalisation opportunities (as above); and lastly, shrewd strategic acquisitions to align or support specific offerings.

Payments
The payments sector is one of the most rapidly shifting within financial services and perhaps one of the most prone to digital disruption, as trends such as Buy Now, Pay Later (BNPL), crypto, instalment payments, point-of-sale solutions, authentication and fraud protection take on greater prominence.

As a result, companies addressing these emerging trends and risks are prime acquisition targets for strategic buyers such as banks and payment providers, who must necessarily keep up with the latest developments or risk being left behind, as well as other buyers like private equity firms looking to tap into the latest emerging sectors.

The rate of change and disruption within payments has forced many big players in the financial services sector to target strategic deals, such as incumbent giant Square’s $29 billion acquisition of BNPL provider Afterpay and MasterCard’s partnership with crypto trading platform Paxos.

Again, however, payments is a segment in which M&A will also be driven by strategic repositioning and divestments, following several years of inflated dealmaking. In the BNPL space, for example, a tempering of the boom the industry has experienced over recent years could spur significant M&A.

At the start of 2022, the BNPL sector had registered an annual growth rate of 60 to 70 per cent in the UK and accounted for 5 per cent of e-commerce sales, as well as 50 per cent of the total deal value for M&A transactions in the payments industry during 2021.

However, this growth has resulted in a crowded marketplace that is now primed for consolidation, as smaller providers increasingly look to mergers or sales in order to safeguard their futures. BNPL firms are also being hit by the recession, with customers more likely to turn to instalment payments as they budget more stringently and seek to gain greater control of their spending.

Regulators are also taking closer interest in the BNPL sector, amid growing concerns over the need for clear terms and conditions and protection for consumers using BNPL services. These factors will place a great strain on small and medium-sized firms, potentially making owners more open to a sale or merger that could provide them with more secure financing and improve their ability to deal with a greater compliance burden.

The year 2022 showed that financial services is by no means immune from the global factors that have led to a broad downturn in M&A activity and value. However, the broad nature of the industry with its diverse sub-sectors, driven by near-constant disruption, technological developments and a changing regulatory landscape, means that M&A has remained vital even in a less active marketplace.

As companies seek to respond to the new challenges developing in 2023 and tap into emerging trends and technologies, acquisitions will continue to play a key role. At the same time, the recession and the requirement for firms to develop clear, streamlined strategies and raise precious funds could see an increasing number of assets and businesses being brought to market.

All of these factors are likely to result in another year of busy dealmaking for financial services operators during 2023, with strong potential for the year to match and even rebound to outstrip 2022 in deal numbers and total value transacted.

Also read:
2023: Mergers & acquisitions outlook including developing trends
Finding M&A value in an economic downturn

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