Private M&A in uncertain times

1. Exclusivity: Not for the tyre kickers

It is now more common for buyers to seek exclusivity before committing substantial time and expense to a sale process. Before granting exclusivity, sellers need to consider what they can do to avoid locking themselves out of a wider buyer universe for too long. Limiting the period of exclusivity is an obvious option but not always acceptable to a buyer in a soft market. Requiring buyers to submit a reasonably firm proposal before going exclusive is another option – but of questionable benefit in circumstances where an indicative proposal is non-binding in any event.

One method we have seen put to good use is where a seller requires the buyer to regularly confirm their offer price and that they have not identified any material issues in their due diligence that would impact the valuations provided in their initial offer. If the buyer does not want to confirm their offer price, the exclusivity arrangement terminates. This method avoids an excessive lock up period, but also gives the buyer the certainty it needs to invest in the process. It can also help a seller manage any doubts it has about a buyer’s ongoing conviction.

To reduce the need for extensions to exclusivity arrangements, sellers may be well served to front-end some internal “vendor” due diligence to ensure it can provide material information about their assets at an earlier stage in an M&A process, and invest effort into how this information is presented. A well-organised data room is a given, but management presentations and vendor diligence reports can also expedite the buyer’s price discovery process.

2. Deal conditions: There’s no free lunch

Sellers will always want to minimise the pre-completion conditions that must be satisfied post-signing. For sellers, deal certainty is key, particularly in a volatile market. But it is that same market that spooks buyers into wanting a gold plated deal with as many “outs” as they can negotiate. Sellers should carefully consider the language of any conditions to ensure that they are specific, objectively measurable, and appropriate to address the buyer’s concerns. Sellers may need to push buyers to be very clear about their concerns, and negotiate conditions that are proportionate. A general concern about the state of the world should not become the seller’s problem.

Wherever possible the seller should push for objective tests for satisfaction of conditions, rather than accepting a requirement that the buyer is satisfied with a particular outcome or circumstance.

However, due diligence conditions often have an unavoidable element of subjectivity. Therefore a seller should accept such conditions only on the basis that they relate to specific residual items identified in due diligence, or they are required to underpin the valuation (for instance, change of control consents or specific counterparty approvals).

Regulatory approval conditions are featuring more often due to greater cross-border M&A activity and oversight from the Australian competition regulator. Sellers should resist a general “obtaining all necessary regulatory approvals” condition, and seek a robust “hell or highwater” requirement on the buyer to avoid handing the buyer a “free-option” on the transaction.

3. Big MACs: Might be tough to swallow

On the subject of conditions, buyers are increasingly pressing for no material adverse change (MAC) rights. These provisions usually allow the buyer to terminate the sale agreement if the target business suffers a material adverse change between signing and completion. Where the buyer is financing the deal, a MAC is hard to avoid as it is generally required by the financiers. MACs vary across markets and are more common in some – as a result, some foreign buyers may expect that a MAC will be included as a matter of course.

Sellers compelled to accept a MAC should seek to narrow the scope of the MAC as much as possible. MACs that are triggered on the basis of market or industry changes should be resisted, especially in turbulent markets where, for example, tariff rates could be double overnight. MACs should also be tightly drafted to ensure their triggers are easily assessed, and forward-looking impacts should be avoided on the basis they are more likely subjective.

4. Mind the (valuation) gap

Dynamic market conditions can lead to valuation challenges. The parties may have to share that risk (beyond simply negotiating the purchase price) in order to strike a deal.

A common approach is to defer payment of part of the purchase price, depending on the performance of the business over a certain period (generally 1 – 2 years post-completion). The founders or key personnel are generally kept on during this time so they can continue to drive earnings – and they are incentivised to do so to protect their ‘earn-out’ payment.

Some sellers are more open to an earn-out than others. Founders are often more understanding of a buyer’s desire to incentivise a smooth transition. Conversely, certain kinds of sellers, such as private equity sellers who want a ‘clean exit’, will not value an ‘earn-out’ highly or at all.

If the parties agree that an earn-out is appropriate, they will each want to negotiate terms to ensure that the earn-out metrics are not artificially inflated or depressed, and that the buyer has sufficient flexibility to operate and integrate the business.

The actual earn-out targets are also critical. Simpler targets are less likely to lead to a dispute than more complex ones, but too much simplicity can create other issues. For example, sales revenue is the simplest financial target, but sales can be prioritised to the detriment of profit. While profitability metrics are preferred because they may more accurately indicate the value of the business, time needs to be spent on agreeing the methodology for calculating those metrics.

5. Post completion claims: What if the seller has gone fishing?

What if a seller disappears with its cash and the buyer is left with a business different to what was promised? Warranty and indemnity (W&I) insurance can provide some insulation. This is particularly the case for larger (>$100 million) transactions that can justify the costs involved and for deals involving private equity sellers who demand a ‘clean exit’. Other than a few specific exceptions (for example, businesses in sanctioned countries), it is now possible to obtain W&I insurance coverage for most if not all the key warranties that a buyer will seek to negotiate. However, insurers do require evidence that sufficient due diligence has been done before policy inception.

A contractual performance guarantee could also be sought. This could be a personal guarantee from the founders, a parent company guarantee (if the seller is not an ‘entity of substance’), or even a bank guarantee. However, most sellers will strongly resist providing personal guarantees or bank guarantees, as they put the personal wealth or balance sheet of the sellers at risk.

‘Retention’ arrangements, where the buyer holds part of the purchase price back or in escrow used to be popular but have become less common in recent times – they generally only appear in very one-sided deals.

Conclusion

If you are about to embark on a private sale process (on either the buy or sell side), we expect some or all the above may be relevant issues that you will encounter over the process. If we can assist you or you would just like to discuss, please contact us.

Norton Rose Fulbright’s in-depth M&A Deal Trends report for Australia’s public and private markets will be released in April. If you would like to receive a copy, subscribe to our corporate mailing list.