Risk sharing in European M&A: is normal service resumed? — Financier Worldwide – Financier Worldwide

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July 2022  |  SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
July 2022 Issue
2021 saw European M&A booming, with a confident return to pre-pandemic levels and normal deal behaviour resuming in the majority of transactions, according to our latest annual M&A study.
In an analysis of the key legal provisions within nearly 500 M&A agreements on which the firm advised in Europe in 2021, we observed that ‘normal’ deal metrics applied in most transactions, with a retreat from the ‘buyer-friendly’ approach observed in 2020 and a return to the more standard approach to risk sharing that was observed before the pandemic.
In many ways, ‘normal’ service resumed in 2021, with more familiar patterns in deal metrics. An increase in the use of locked boxes and a decrease in liability caps might appear to reflect a move toward a more ‘seller-friendly’ environment, but this was counterbalanced by continued ‘buyer-friendly’ positions still trending in certain areas.
Earn-out structures
One notable feature was a significant increase in the use of earn-out structures in 2021.
An earn-out provides for an additional amount of purchase price to be paid after completion, typically by reference to the performance of the acquired business over an agreed period after completion. By doing this, the seller and buyer share the risks and rewards of how the target business performs following completion. A seller may receive a higher overall price than on a deal where all the proceeds are paid on completion, but is likely to be required to remain engaged with the business and must wait to receive that enhanced value. Buyers get to ensure the final overall purchase price is linked both to historic and present financial performance and may well be able to insist on the continued engagement with the business of key sellers.
According to the study, the use of these structures jumped from 5 percent in 2020 to 26 percent in 2021, indicating a general move to ensure that the price paid for a business is measured over a longer period than purely by reference to the financial years dominated by the pandemic and to justify a pre-pandemic pricing. The increase in their use was repeated across almost all jurisdictions, and levels are now higher even than the most recent US statistics, where earn-outs typically have been more popular than in Europe.
There was also an increase in applying earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortisation (EBITDA) as the earn-out criterion instead of turnover, perhaps showing that more stable economic conditions are in place. Earn-outs are also now generally measured over a period of up to 24 months, with a drop in longer time periods.
Purchase price adjustments and ‘locked box’ provisions
Purchase price adjustment (PPA) clauses are designed to ensure the correct amount is finally payable by the buyer for the target business. Adjustments can arise by reference to the target company’s debt and cash position or to its working capital or overall net asset position at completion. Parties to the M&A agreement thereby achieve certainty that the final purchase price reflects the actual debt, cash, working capital or net asset position.
PPA provisions can, however, result in uncertainty as to the final purchase price at the time of signing. Several months, or in extreme cases even years, may elapse before the price is agreed or determined. Some may feel this is impractical and excessive and therefore prefer ‘locked box’ provisions. In such cases, the seller warrants the accuracy of an agreed balance sheet and covenants that there are no leakage payments (e.g., dividends and management charges) from the target.
In 2021, PPA provisions returned to pre-pandemic levels. The number of transactions featuring PPA provisions returned to 47 percent, just above the 2010-20 average of 45 percent, suggesting that a greater proportion of buyers are able to insist on them.
In contrast, the use of a locked box structure in non-PPA transactions increased significantly. This is probably symptomatic of a wider acceptance of locked box provisions once it is agreed that a PPA provision will not apply.
Limitation periods for warranty claims
Sellers and buyers typically agree to reduce the statutory limitation period for warranty claims under a sale and purchase agreement by choosing shorter limitation periods than applies in the relevant statute. This is favourable to sellers because buyers have less time to bring claims.
In contrast to previous years, the former ‘seller-friendly’ trend of shorter periods has shifted, and in 2021 limitation periods tended to be longer. The frequency of limitation periods of more than 24 months was 25 percent of deals in 2021, above the 11-year average of 22 percent.
De minimis, baskets and liability caps
De minimis levels (the minimum amount for which certain warranty claims can be brought by a buyer) and basket provisions (which prevent warranty claims from being made where the total amount claimed in respect of all warranties is less than an agreed ‘basket’ amount) also decreased in size. A significant proportion of baskets are now at less than 0.5 percent of the purchase price. This drop perhaps indicates a more ‘buyer-friendly’ approach and may also result from the wider use of warranty & indemnity (W&I) insurance.
In most M&A transactions it is usually accepted that sellers expect that their liability in respect of warranty claims will not exceed a pre-agreed capped amount. This amount is often simply the purchase price, so the buyer cannot recover more than it has paid. However, the liability cap might be hotly debated, and can vary significantly from deal to deal, particularly in larger deals. For deals with full W&I insurance cover, the liability cap is often a nominal amount.
In 2021 there was a big increase in the number of deals with liability caps of less than 50 percent of the purchase price, reflecting a return to the levels of liability caps prevailing before the pandemic. In particular, those deals with a cap of less than 10 percent of the purchase price increased significantly to 22 percent from 16 percent in 2020. The proportion of deals with liability caps equal to the purchase price remained constant at 30 percent.
It seems likely that the greater use of W&I has resulted in sellers being able to command lower liability caps as buyers seek cover from the W&I insurance market.
W&I insurance
Where there is no obvious warrantor to stand behind the warranties (e.g., private equity sellers) or there is an insufficient amount of coverage provided by the warrantors, W&I insurance offers an elegant solution.
Our data demonstrates that the drop-off in W&I insurance policies seen in 2020 was a one-off and that W&I made a return in 2021, significantly so in the UK and Germany, and particularly on transactions with higher values. Overall, 19 percent of European deals used W&I cover in 2021, however nearly half of larger transactions now have W&I cover as standard.
The application of W&I insurance is giving rise to significant benefits to sellers, with lower basket thresholds and lower liability caps, even though the buyer is apparently paying the premium in most cases.
Arbitration as a dispute resolution mechanism
The effect of an arbitration clause is to require all disputes arising out of the deal to be decided before a private tribunal instead of a public court (e.g., litigation). Reasons for agreeing on arbitration include the desire to avoid courts in jurisdictions where proceedings are time consuming and the outcome is highly unpredictable, as well as the desire to avoid a public process.
There are perceived downsides, such as the relatively high costs of arbitrations administered by well-known arbitration institutions and the concern that potential efficiencies are not actually achieved in practice. However, since the enforcement of foreign judgments may still be difficult in some jurisdictions, the need to obtain an award that can be enforced in multiple jurisdictions is probably the strongest driving force for choosing arbitration.
Arbitration was used as the dispute resolution mechanism in 33 percent of deals reviewed in 2021. This marks a slight increase compared to 2020 but continues a steady increase in recent years (up from 25 percent in 2016). The overall trend shows that arbitration is less popular in certain regions (UK, France and Benelux) than others (Central and Eastern Europe, German-speaking and Southern European countries).
Deal drivers
The study also sought to identify the main deal drivers for each relevant transaction. Entry into new markets was the leading deal driver at 43 percent of deals.
There was a significant increase in deals comprising the acquisition of a competitor (from 22 to 32 percent), perhaps representative of post-pandemic opportunism as buyers seek consolidation.
A rise in the proportion of acquisitions concerning know-how and digitalisation from 19 to 26 percent is also perhaps reflective of the M&A market generally and the opportunities which have arisen as a result of pandemic-driven technology changes. Overall, 36 percent of all deals were either the acquisition of know-how or acqui-hire transactions.
The future
While 2022 has started very strongly, the war in Ukraine as well as energy price increases, certain supply shortages and inflationary pressures across Europe may well impact on European M&A as the year proceeds. If that is the case, we anticipate that more buyer-friendly clauses will re-emerge in M&A transactions in 2022.
 
Louise Wallace is head of the Corporate/M&A group at CMS. She can be contacted on +44 (0)20 7367 2181 or by email: louise.wallace@cms-cmno.com.
© Financier Worldwide
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Louise Wallace
CMS
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