Take decreasing deal volumes, add in hundreds of billions of dry powder and mix it all into an economy finally showing signs of strength and you find yourself with a market much more friendly to sellers. Corporate lawyers say the trend is only set to continue and that private fund managers are already witnessing its effects when negotiating M&A agreements. But what terms specifically are experiencing the most movement? And what types of negotiations are taking place around them?
For starters, the current M&A environment is catching some by surprise. It wasn’t long ago some European M&A experts were telling pfm that lessons learned from the 2008 crisis would force buyers to invariably negotiate Material Adverse Change (MAC) clauses – which are a way for buyer and seller to allocate risk between signing and closing in an acquisition – and escrows long into the future.
Recent research from law firm Latham & Watkins proved the prediction wrong. True, during the immediate post-crisis years of 2009 and 2011, around 30 percent of deals included a MAC; but between January 2012 and July 2014, only 10 percent of private equity deals (either as a buyer or seller) contained a MAC.
“That is a reflection that there is a huge amount of money chasing few deals,” says David Walker, partner and global co-chair of Latham & Watkins private equity practice. “Many auctions have been so ferocious that you persuade yourself to get comfortable with the risks and not include those in your SPA [sale and purchase agreement] mark-up because you know there will be a long queue of other potential buyers prepared to take a view.”
Geography is a factor during negotiations too. In the US, the use of MAC clauses has never really gone away. But what’s changing now is that some M&A lawyers are beginning to wonder if the terms popularity in the US will cause a ripple effect across the Atlantic. Amid Europe’s improving economic conditions, more and more US GPs are making bids for European assets, but may be less willing to sacrifice their love for MACs.
The counter effect may be European and Asian GPs (that are investing in the US) being able to negotiate their own MAC clauses, says Nick Rainsford, corporate partner at law firm Ashurst. “There would be an appetite to follow what the market is doing in a particular jurisdiction, so a European buyer would be happy to take the extra protections and follow the US-style deal.”
However, M&A lawyers in Australia and Asia say MAC clauses aren’t all that important to their clients because they tend to agree what King & Wood Mallesons M&A partner Andrew Wingfield calls a “backdoor MAC.” Using this “backdoor MAC,” the seller agrees, that as a condition of the deal closing, all representations and warranties are accurate; plus make another representation that “since the balance sheet date there has not been any material adverse change affecting the business,” he explains.
But as mentioned, it is a seller’s market, meaning sellers aren’t necessarily offering an abundance of representations and warranties. And when reps and warranties are being made, they usually have a shorter time period for a claim to be made too, says Rainsford.
“On almost all private equity deals, particularly those deals involving the European based funds, the fund will only give title and capacity warranties on an exit,” adds Richard Bull, corporate partner at law firm Norton Rose. In layman’s terms, a title and capacity warranties guarantee that the seller owns the business and is allowed to sell it.
As an alternative, sometimes GPs will look for comfort from warranties by asking the target’s management team to sign them. However, legal sources say that portfolio executives, especially those who’ve previously partnered with a private equity sponsor, are becoming more hesitant about what types of warranties they agree.
Closing the locked-box
Another seller-friendly deal terms that are becoming more prevalent, certainly in Europe, is the locked-box mechanism approach to determine the price for a target business. A locked-box mechanism involves the parties agreeing a fixed equity price, calculated using a recent historical balance sheet of the target, prepared before the date of signing of the sale and purchase agreement. Cash, debt and working capital as at the date of the locked-box reference accounts are therefore known by the parties at the time of signing and there is no post-completion adjustment. The economic risk and benefits of the business pass to the buyer from the date of the locked box reference accounts.
Latham & Watkins’ data shows that in Europe nearly 70 percent of private equity deals between January 2012 and July 2014 included a locked-box pricing mechanism.
“The private equity seller will be interested in repatriating cash to investors as quickly as possible to stop the IRR clock which drives their returns,” says Tom Evans, corporate partner at Latham & Watkins. “Deals transacted on a locked-box basis means that once you close there’s no adjustment to the purchase price. The PE funds can repatriate the vast majority of proceeds to its investors and people move on.”
At the negotiating table, GPs agreeing a locked-box mechanism say they must feel more comfortable about their due diligence of the target before ultimately agreeing a purchase price. This is because the buyer effectively takes over “economic ownership” of the target from the locked-box date, which is before it legally owns the business. The profits or losses made by the target after the locked-box balance sheet date will arise to the benefit/detriment of the buyer.
Not that this has been much of an issue for most private equity bidders, say legal sources. “Locked-boxes are now routinely used to value businesses, particularly where an asset is being sold by a private equity house through a competitive auction,” says Bull. “This trend has largely been driven by the increase in secondary and tertiary transactions (as opposed to primary deals) in the market and the private equity houses’ desire to have value certainty at completion.”
Consequently the level of due diligence GPs now require to feel comfortable about a deal is causing final signings to stretch out. More than half (55 percent) of the 75 private equity executive respondents to a July Duff & Phelps survey indicated that the median time to complete a transaction from start to finish takes about seven to nine months these days. Figures from “Big Four” audit firm EY also found that all mergers and acquisitions (including buyouts) took on average 52 days in 2012 compared to 48 days in 2011 and 47 days in 2010.
GPs need to get used to this however, as legal sources say the evidence points to seller-friendly terms being a continuing trend. Latham & Watkins research showing European private equity “as we don’t use” up 13 percent in a year (from 2012 to 2013) and buyout activity in 2014 down 7 percent on last year. Add to that the increasing competition from sovereign wealth funds and large public pension plans, and seller-power looks set to continue creating more interesting negotiations for GPs.