Coronavirus - Private equity and the pandemic: Future of M&A Part 2 - Global

As we move into peak holiday season (if you can call it that this year!), we continue to gaze into the crystal ball and consider how deal-making is likely to change in the post-COVID 19 environment.

Following Ceri-Ann McGraa’s excellent article on deal origination, deal process and the growth of opportunistic M&A last week, we now turn our attention to valuation and pricing mechanisms, with a particular focus on the ways that parties to M&A transactions can bridge the valuation gap. We look at the lessons learned from previous economic downturns as well as trends that are starting to emerge from the transactions we are seeing. Hopefully this provides some food for thought as you enjoy your staycation, socially-distanced pub trip or even a surprise quarantine on returning from Malta (or whichever other Country is added to the quarantine list on 24 hours’ notice).

For the purposes of this article we will be looking at solvent assets, however Ceri-Ann will be back later in the series taking a look at accelerated M&A involving distressed assets.

Disclaimer out of the way, it will not come as a surprise to hear that the overarching expectation is a re-balance in the market following a decade of sellers being able to largely dictate terms. Some of the macro factors still favour sellers (many sponsors, for example, are still well-funded and so will continue to chase quality assets), so we probably won’t see buyer domination, rather a move towards the middle of the terms spectrum.

So, what changes do we expect the “new normal” in terms of M&A to bring about?

Completion Accounts v Locked Box

As those of you that are familiar with our industry-leading Market Monitor tool will be aware (shameless plug #1), locked box has become the common valuation mechanism over the past decade in private equity transactions in the UK.

By way of a brief recap, a completion accounts mechanism sees the parties close on an estimated position with the purchase price adjusted (upwards or downwards) after completion to reflect the actual financial position of the target company or business at completion (typically a true up of cash/debt and net working capital).

A locked box mechanism on the other hand fixes the purchase price ahead of completion by reference to the target’s balance sheet position at an agreed point in the past (the “locked box date”). After the locked box date no value (other than permitted leakage negotiated and listed in the sale and purchase agreement) is permitted to leave the target before completion – the “box” is “locked”.

Sellers typically prefer the price certainty afforded by locked box, particularly sponsors who will be obliged to distribute funds to their investors - potentially having to “refund” part of the consideration a number of months after completion really isn’t that attractive! Furthermore, even the most carefully considered and drafted completion accounts mechanism can give rise to dispute (which can be both costly and time consuming), as the accounting policies are often complex and open to a degree of interpretation. By this point, sellers have also lost the leverage of competitive tension as the transaction has completed and is in the rear view mirror.

As we embark on the journey into the “new normal”, one shift we are likely to see is a re-emergence of completion accounts mechanisms, particularly in Europe. This provides buyers with the opportunity to 'test' the balance sheet at completion (rather than the earlier locked box date) and it ensures the risks and rewards of the business only pass at or near legal completion. In the US, locked box has never really taken off and the majority of deals were concluded with a completion accounts mechanism even before the pandemic.

That said, we are unlikely to see a complete shift. Sponsors will still favour locked-box processes and attractive assets - particularly in sectors that have flourished as a result of the pandemic - will still be highly sought after and generate competitive processes.

How else can buyers plug the valuation gap and minimise risk in order for parties to strike deals? The most obvious answer is to pay the right price. Valuations for most sectors may be lower than those discussed based on specific multiples at the beginning of the year, as buyers likely price in more downside sensitivity. That may not be palatable to sellers on its own and so for deals to be made, we are likely to see a resurgence of a key tool to navigate this tension…earn out mechanisms.

Earn Outs

Whilst there are other forms of deferred or contingent consideration, an earn-out mechanism is different to others as it involves at least part of the purchase consideration being calculated by reference to the future performance of the target business.

Given the shift of power to sellers over the past decade, the use of earn outs has declined, however lessons from previous downturns suggest that earn-outs become a more prominent feature of M&A transactions during periods of economic uncertainty. In our view, the era of coronavirus will prove to be no exception and we can expect an increase in the use of earn-out mechanisms to bridge the valuation gap between sellers who are keen to sell and buyers who are unwilling to over-pay.

“Excellent”, I hear you say, “let’s just drop an earn-out into the term sheet, and leave the rest to the lawyers, simple”. Unfortunately it is not quite that simple. Competing commercial interests can mean a conceptual tension in approach to earn-outs: buyers will view future payments as highly contingent (‘if, not when’), while sellers may feel some entitlement to payments which are merely deferred. This variance has implications for the (often fraught) negotiation and drafting process that surrounds an earn-out. Significant and frequently recurring questions and issues that need to be considered include:

• Performance targets - what should the triggers for earn-out payments be? Typically, this will be tied to profits or turnover of the target business during relevant periods. A common compromise between a buyer favouring higher thresholds and sellers wary of “all or nothing” situations is to see a waterfall or sliding scale approach, whereby performance targets are split periodically through the earnout period. In the context of unusual circumstances such as the coronavirus pandemic, we may also see the rise of other specifically focused trigger events (for example, the non-termination of a key commercial agreement).
• Conduct of Business - regardless of whether an earn-out is profit or turnover driven, the question of how the target business is run during the earn-out period will be highly relevant. Conduct of business covenants are often heavily negotiated due to the competing objectives of the parties. While sellers will want to impose restrictions to protect and maximise their earn-out in the short-term, this must be balanced with the buyer’s business plans and expectations, which are often linked to business synergies and other integration benefits. Commonly accepted restrictions (or seller approval rights) include material non-ordinary course transactions, group reorganisations, ‘leakage’ of value to the buyer group, changes in key personnel, material changes in the nature of the business, and restrictions on competition with other buyer group entities.
• Relationship to the other transaction terms – the earn out provisions will also need to be cohesive with the rest of the transaction documents. For example, sellers should consider whether all or part of the potential earn out payment should be held in escrow or otherwise secured (absent this, the seller would be an unsecured creditor of the buyer in respect of its earn-out entitlements). On the other hand, buyers will be keen for the warranty ‘jeopardy’ period to be no shorter than the earn-out period and that the earn-out provisions allow for set-off against warranty or indemnity claims by the buyer.
• Taxation – it won’t come as a surprise that earn-outs are complex and tax advice should always be taken early. Stamp duty (applicable to the total consideration for shares, including earn-outs in certain circumstances) and capital gains tax (where proceeds will generally be deemed to comprise any initial payment and the market value of the earn-out at the point of sale) should always be considered to ensure that the full tax impacts of the earn-out mechanism are clearly understood. Further tax issues may arise if any consideration is in non-cash form (such as shares or loan notes). Where the seller is a director or employee of the target it will also be important to consider the rules around employment related securities, particularly where (as is often the case) the earn-out terms are different for shareholders continuing in the business.

The issues above are far from exhaustive, and it is important to recognise that there is no “right” or “wrong” answer. As always, final deal terms will depend on the bargaining position of the parties, as well as the specific fact pattern of the transaction in question.

This does however highlight that while earn-out mechanisms are extremely useful tools, particularly in the current deal making environment and for the foreseeable future, they are complex and require careful strategic and technical advice from the outset.

Put and call option structures

Another tool which may also become more prevalent in M&A transactions to bridge the valuation gaps in the context of the Covid-19 pandemic are partial acquisitions coupled with put/call options. Under such structures the seller is left with a (usually minority) equity stake, typically with the parties each having the benefit of an option to require the sale of that stake to the buyer at a later date at a price usually based on a metric such as multiple of earnings or revenue (and possibly subject to certain conditions). Such structures are less common – and arguably more complex - than earn outs, and could command an entire article of their own.

Doing Deals in Different Times

Shameless plug #2 - our global corporate partnership have joined together to produce a presentation, ‘Doing Deals in Different Times’, which looks at how M&A transactions will be completed in a post-COVID world and what new trends may arise as a result of the pandemic. It is a genuine piece of thought leadership that builds on some of the trends discussed in this and last week’s bitesize articles, and much more.

To ask us to deliver this presentation to you and your team, or if you have any questions about trends in M&A or the issues discussed in this article, please contact Chris Archer or your usual Eversheds Sutherland lawyer.

Next week, as part of our on-going series, Chris Hastings will consider the future of debt funding for private equity-backed buyouts and portfolio companies.