Four ways M&A deals are changing
This article was originally published by Law360 on 11 July 2022 and has been reproduced with permission from the publisher.
The M&A market in 2021 was extremely buoyant with a record number of transactions, due to large amounts of private equity dry powder, pent-up deal demand from the first half of 2020 when the COVID-19 pandemic hit deal flows, and a need for businesses to adapt to the new normal, to bolster their supply chains and to adjust their business models.
The M&A market has remained strong in the first half of 2022, but there are signs that, in part due to rising inflation and the rising cost of debt, the market may cool slightly in the second half of 2022.1
More General Changes in Deal Approach?
When an M&A market is buoyant, deal terms are unsurprisingly seller friendly. Many potential buyers are often competing for the same target company and need to offer the best possible deal terms, including price, to win the deal.
However, there have been changes in how M&A transactions are effected over recent years, which are down to more than just a hot or cold market and appear to reflect a more general change in deal approach.
There are a number of areas where deal approach has changed. These include:
U.S. Bidders Increasingly Willing to Transact on U.K. Deal Terms
Historically, there has been a significant divergence between deal terms on U.S. and U.K. transactions. The most seller-friendly deal terms are generally found in the U.K. market, which are broadly reflective of the European market, whereas the approach on U.S. transactions is more balanced. This remains 1 today.
As a result, U.S. bidders in U.K. transactions are at a competitive disadvantage, especially in auction processes, if they seek to transact, which they often have done, on the basis of U.S. market standard deal terms.
However, data shows that U.S. bidders have shown an increased willingness to adapt to the U.K. market and have accepted that to be competitive on U.K. transactions they will need to be willing to transact on U.K. deal terms. It is, therefore, hugely important that a U.S. bidder's lawyers educate them on U.K. market practice and ensure that the bidder is aware where they are diverging from market norms.
A good example of U.S. bidders adapting to U.K. terms is of their increased acceptance of locked-box pricing mechanisms. Based on available data, virtually all private U.S. deals have a completion accounts mechanism.
By contrast, in the U.K., locked-box mechanisms, widely perceived to be seller friendly, prevail with completion accounts found in just under a half of majority share deals.
What the data shows is that U.S. buyers have more recently been willing to accept a locked-box mechanism when acquiring in the U.K. and Europe. In the deals surveyed, a locked-box mechanism was used in over 40% of these trans-Atlantic deals.
It is not only locked-box pricing mechanisms that U.S. bidders are accepting on U.K. transactions. Other examples of deal terms that U.S. bidders are willing to accept, include:
- General disclosure of the data room. This is standard on U.K. deals but is seen on less than half of U.S. transactions; although, interestingly, general disclosure of the data room has been increasingly seen in U.S. deals over the last two years;
- Fewer termination rights on deals where there is a gap between signing and completion. It is common for U.S. deals to have a number of termination rights, including material adverse change clauses, as standard — although interestingly termination rights do not seem to be exercised much more frequently on U.S. transactions compared to U.K. deals. On U.K. deals, any termination rights other than for mandatory and suspensory regulatory or shareholder approvals are generally strongly resisted by sellers, with "hell or high water" provisions commonly requested on auction processes for such mandatory and suspensory approvals; and
- No escrow or holdback from the consideration to provide security for claims. It is standard practice in the U.S. for there to be an escrow or holdback, which is typically around 10% of the purchase price for 12 to 18 months. By contrast, security for claims is generally successfully resisted in the U.K. unless there is a specific identified risk that has been uncovered during due diligence or there are concerns about the seller's financial covenant strength.
The Development of Warranty and Indemnity Insurance
Buy-side warranty and indemnity insurance is now an integral part of many M&A transactions in the U.S., Europe and Asia Pacific. There has been significant growth in the usage of insurance in deals over the last five years, as obtaining insurance successfully facilitates a smooth-running transaction, reduces time spent negotiating warranties and limitations of a seller's liability and offers sellers a clean exit. For example, in our own experience, 42% of the M&A transactions that we acted on in 2021 utilized buy-side warranty and indemnity insurance.
Private equity, as both a seller and a buyer class, have long utilized buy-side insurance on their transactions and continue to use insurance more often than trade sellers and buyers. However, in recent years buy-side insurance has been used more frequently by trade buyers, particularly repeat trade buyers.
Historically, the liability cap for sellers in U.K. and European insured deals was set at the amount of the policy retention, i.e., the amount of loss that must be exceeded before the policy will respond.
However, there are now a significant number of insured deals in the U.K. and Europe, particularly auctions, where the sellers agree a nominal cap of GBP1 or EUR1 (USD1) in the share purchase agreement, meaning that the buyer's sole recourse is against the insurer under the warranty and indemnity policy for any commercial warranty breaches and, as such, the policy retention is not recoverable.
The concept of insurance being the buyer's sole recourse, subject to any known risks that are the subject of specific indemnities, is also now market-standard in Asia Pacific. The position is different in the U.S., where the liability cap for sellers is typically 50% of the retention under the insurance policy.
Trade sellers have also become more sophisticated in their use of buy-side insurance. An increasing number of trade sellers, particularly on auctions, make clear to potential buyers, including trade buyers, that the use of insurance is non-negotiable. Also, trade sellers are becoming increasingly aware of their ability to cap their liability under the warranties at GBP1 or EUR1 and to qualify all of the warranties by actual awareness, with an awareness scrape being purchased by the buyer under the insurance policy.
On the flip side, in bilateral transactions, there is an increasing trend for buyers, including trade buyers, to stipulate at term sheet stage that the seller must cover gaps or specific exclusions in the insurance coverage.
Risk allocation negotiations in the context of the acquisition agreement therefore focus on the distinction between insured and uninsured claims.
Underwriters have also become more sophisticated and in recent years have introduced a range of deal enhancements that are available to buyers for an additional premium, together with more sophisticated insurance products. These include:
- Deemed nondisclosure of the data room and due diligence reports;
- Knowledge scrapes;
- Materiality scrapes;
- An indemnity basis of recovery;
- Synthetic warranty packages and tax deeds; and
- Known risk policies.
Increased Use of Auction Processes
In recent years, the use of auctions has continued to spread. However, what has remained consistent, given the high upfront costs of auction processes, is that they remain significantly more common in transactions higher up the value chain. For example, on average in the last three years auctions have been used in less than 10% of transactions with a value of 50 million euros or below.
Private equity sellers and buyers are most likely to be involved in auctions and in 2021 private equity sellers comprised 39% of sellers in auctions globally, an increase from 24% in 2020. Trade sellers made up only 29% of sellers, down from 50% in 2020. This change is perhaps a reflection of private equity owners' preoccupation with their portfolios in at least the first half of 2020 and then a very hot market in 2021.
Notwithstanding that private equity make up a larger percentage of sellers in auctions than trade sellers, over recent years we have seen trade sellers increasingly look to take the same approach to deal terms as private equity sellers. There is an ever-increasing convergence in the deal terms obtained on auction processes by private equity sellers and trade sellers.
Private equity bidders are also more likely to succeed in auction processes — up until 2019 the proportion of successful private equity buyers in auctions steadily increased. This reversed in 2020 when trade buyers were successful in nearly three quarters of auctions. In 2021, however, private equity buyers made up around 50% of auction buyers.
Again, 2020 appears to be an outlier, as in the early stages of the pandemic private equity concentrated on existing investments with less appetite for M&A.
Where there is private equity interest in an asset, unless there are significant synergy opportunities for trade buyers, it has historically been, and remains, difficult for trade buyers to compete with the speed of execution and price offered by private equity. However, we have seen in recent years trade bidders become more sophisticated in their approach and more willing to engage in auction processes.
They have looked to move quickly and have been willing to accept the deal terms routinely agreed to by private equity bidders, e.g., buy-side warranty and indemnity insurance, locked-box pricing mechanisms and limited walkaway rights in deals where there is a gap between signing and completion.
Increased Use of Locked-Box Pricing Mechanisms in Europe But Rare in U.S. Deals
European private equity uses locked-box far more frequently than European trade when it sells. In 2021 just under 70% of private equity exits used locked-box pricing mechanisms while it was 40% when trade were selling. That was pretty much at the top of the normal range for private equity — the data fluctuates between 60% and 70% — only in 2019 did it dip beneath 50% due to the outbreak of coronavirus.
However, for trade sellers that 40% is a continuation of a now steady trend, up from 30% in 2017. There remains a marked difference between the use of locked-box pricing mechanisms by European private equity and trade sellers. However, this difference does appear to be narrowing.
As noted, the prevalence of locked-box pricing mechanisms in Europe has not found its way to the U.S. and there are no signs that it will do so.
This article is for general information purposes and is not intended to be and should not be taken as legal advice.
1 The data contained in this article is taken from DLA Piper's Global M&A Intelligence Report 2022