M&A Negotiating Trends: M&A Buyers Respond to Seller- Friendly Market

Transcription

1 Special Report M&A Negotiating Trends: M&A Buyers Respond to Seller- Friendly Market By: Sean Arend and Andrew Hubley

2 M&A Negotiating Trends: M&A Buyers Respond to Seller-Friendly Market By: Sean Arend and Andrew Hubley Over the past few years, several practitioners and banks have observed that the mergers and acquisitions (M&A) market in the United States favors the seller. 1 To evaluate how buyers are reacting to this trend, we analyzed deal terms contained in 795 private-target M&A agreements concluded between 2013 and 2016 and included in the SRS Acquiom MarketStandard database. 2 Additionally, we analyzed data concerning approximately 42,600 private-target M&A deals contained in the Bloomberg Law Deal Analytics database to understand general market trends and provide context for our review of the substantive deal terms. 3 Our main goal was to determine how certain terms in M&A agreements have shifted in recent periods and to offer context for why the changes may have been occurring. 2

3 June SRS Acquiom M&A Deal Terms Study 2017 SRS Acquiom Inc. All rights reserved. / An analysis of deal terms in private-target M&A transactions that closed between POWERED BY Our analysis identified shifts in a number of deal terms to a more seller-friendly formulation. These shifts coincided with market trends that have generally favored sellers, suggesting that sellers exercised greater leverage in negotiations. However, our analysis also showed that buyers are devising creative provisions that limit or curb the effects of seller-friendly terms. In this article, we first discuss factors that may have contributed to the rise of more seller-friendly terms. We then review five M&A terms that have become more seller-friendly during the past several years, and we identify the tactics buyers have used to limit or curb the increasingly seller-friendly terms. More Auction Sales and Private Buyers Mean More Seller-Friendly Terms The shift toward more seller-friendly terms is likely due to several factors, including the increased use of auctions to market and sell target companies and an increase in the numbers of private buyers participating in the market. Recently, sellers have increasingly relied on auctions, rather than negotiated sales, to market target companies to buyers. 4 In an auction, the seller typically dictates the initial sale terms. For example, an auctioning seller typically prepares the initial draft of the purchase agreement, while in a negotiated sale the buyer typically prepares the first draft of the sale agreement. By controlling the process and initial document drafting, the auction gives a seller a stronger negotiating position, from which it can focus on ensuring potential buyers do not modify terms that it considers critical to the deal. Additionally, auctions facilitate competition, as the seller s financial advisers often identify several interested parties to bid against one another in competition for the target company. The presence of more than one bidder may mean that the seller can retain its control over the bidding process beyond the initial bids and can play bidders off of one another in negotiations. This leverage may permit a seller to extract additional submissions and drive deal terms that favor its interests in ways that are not typically possible in a one-on-one negotiated sale. Another factor contributing to sellers market strength is the increasing number of private buyers, both private companies and private equity funds, participating in the M&A market. According to Bloomberg Law data, the percentage of private buyers, including private equity buyers, jumped from 53.4 percent in 2014 to 64.5 percent of buyers in Private Deals as % of Total Deals Source: Bloomberg Law Private Deals as % of Total Deals Total Deals % Private Acquirers The larger number of private buyers has changed the personality of the M&A market. Large public companies often have significant financial resources and market 2018 by The Bureau of National Affairs, Inc. 3

4 power that provide leverage in negotiations that private companies or private equity funds may lack. Conversely, private buyers may be more attractive than public buyers, since they may be more amenable to accepting seller-friendly terms. In addition, private buyers and particularly private equity buyers are more likely to maintain a post-closing relationship with sellers. In fact, private buyers often rely on the seller or the target s existing management to continue operating the business after the sale or, at a minimum, to assist with an extended transition. As a result, a private buyer may be incentivized to ensure that the sellers do not feel taken advantage of during negotiations. Comparatively, large public buyers are more likely to have the resources and experience to conduct post-closing integration without assistance from the seller or pre-closing target management. Lastly, in order to compete with public strategic buyers, private equity buyers have increasingly used representation and warranty insurance (discussed below in the section entitled Limiting the Duration of Escrows) to sweeten the deal for sellers. By insuring a portion of the liabilities that may result from the sale, buyers limit their post-closing exposure extra-contractually and therefore do not need the same range of protections in the contract itself. This risk-shifting is important for private equity buyers. They typically must generate post-closing returns within a limited time frame, and unexpected post-closing liabilities may affect the ability to deliver post-closing returns to investors. Average Deal Size on the Rise (but Limitation of Potential Damages) Purchase price is possibly the most critical negotiating point for most M&A transactions. If the market and negotiating leverage are shifting in a more sellerfavorable direction, one would expect average deal values to rise. Our analysis tends to confirm that prediction. According to Bloomberg Law data, between 2015 and 2017, average deal size has grown over 4 percent. This jump is a sign that sellers may be negotiating higher deal prices than they were a few years ago. Additionally, our analysis of SRS Acquiom data showed that the median multiple of return on investment (transaction values as multiples of total equity capital invested in the target company) was higher for 2016 deals at 4.6x, compared to 3.9x and 3.7x in 2015 and 2013, respectively, also implying higher valuations. Average Deal Size $ $ $ $ $ $ $ $110.0 Source: Bloomberg Law Average Deal Size $ $ Median Multiple of Return Year Median Multiple of Return x 3.9x 4.6x Note: 2014 data is unavailable. Prior to 2015, this data was compiled on a biannual basis. Several market factors may have facilitated the rise in average deal size and valuations, including: (1) the relative ease of obtaining financing for M&A deals; (2) the increased competitiveness of the M&A market; and (3) the participation of more private equity buyers, which tend to offer higher prices to compete with public strategic buyers in certain market segments. Although buyers have been willing and able to pay higher prices, they are increasingly negotiating for the express allowance of so-called diminution in value damages in M&A agreements. Diminution in 4

5 value damages provide the buyer a right to claim damages if a seller s misrepresentation led the buyer to negotiate a different purchase price than it would have otherwise. In 2016, express inclusion of diminution in value damages increased to 23 percent, up from 18 percent the year before. Additionally, the express exclusion of such damages declined to 10 percent in 2016, down from 12 percent in The rise in the express inclusion of such damages is notable given that a New York federal court recently found that diminution in value damages are general in nature and therefore must be expressly excluded for a seller to avoid liability. 5 Taken together, these two trends the increase in average deal size and the inclusion of provisions expressly granting buyers the right to diminution in value damages show that while sellers have been successful at obtaining higher prices, buyers are responding by seeking assurances that they are receiving the benefit of their bargain. Increased Seller Negotiation of Earnout Parameters Earnouts are generally buyer-friendly provisions. They make payment of a portion of the purchase price contingent upon the achievement of postclosing financial milestones. Typically, parties actively negotiate the specific milestones (e.g., revenue or income level targets) and standards for operating the business, and they often prove to be significant points of contention. Sellers worry that the buyer may intentionally operate the target business in a manner that causes the target to miss the milestones in order to avoid paying an earnout. business were essentially nonexistent in our analysis of 2015 deals, appearing in just 5 percent of agreements. In 2016, the number of agreements containing such covenants jumped to 20 percent. This is a win for sellers that agree to earnouts, as it provides some comfort that the full purchase price will eventually be paid. One reason for the jump in the post-closing operation covenants may relate to the larger number of private equity buyers currently in the market. After closing, private equity buyers typically do not combine the target business with a pre-existing business. In contrast, public and private strategic buyers combine the target s operations with their existing business, eliminating redundancies and duplicative roles, which allows them to reduce overall costs while growing revenue. Thus, private equity buyers may be more likely to agree to such a covenant, as they do not face the same integration issues that strategic acquirers often face. A major concern for buyers regarding the earnout provision is that a buyer may be obligated to make earnout payments while simultaneously being forced to engage in arbitration or litigation to recover for a seller s breach. To address this mismatch, buyers have increasingly sought to offset any outstanding indemnity claims against amounts due under an earnout. In 2016, the use of these offsetting provisions jumped over 10 percent from the previous year, appearing in 88 percent of agreements in 2016 compared with 76 percent in With the jump in covenants limiting the buyer s post-closing operation of the business and the tightening of escrow terms (discussed below), it is likely that buyers will continue to push for such offsetting provisions in the future. Sellers appear to have taken a two-pronged approach to addressing their concerns. First, they have had some success at excluding this obligation altogether: earnouts appeared in 20 percent of deals in 2016 compared with 23 percent during the prior year. Additionally, sellers have increasingly negotiated covenants to ensure that the buyer does not try to avoid making earnout payments. This type of covenant might obligate the buyer to operate the business consistently with the seller s past practice or it might require the buyer to operate the business so as to maximize the earnout payments, for example. Buyers covenants regarding operation of the post-closing 2018 by The Bureau of National Affairs, Inc. 5

6 Earnouts (Non-Life Sciences Deals*): Covenants, Acceleration, and Offsets Subset: 2015 & 2016 deals with earnouts, excluding life sciences deals 8% 18% 4% 100% 84% 95% 80% 76% 80% 6% 16% 5% 20% 24% 20% 76% 88% Covenant to run business in accordance with seller s past practices Covenant to run business to maximize earnout payments Earnout accelerates (fully or partially) on change in control of earnout assets Buyer can offset indemnity claims against future earnout payments Included Not included Express yes Express no Silent * For a more detailed analysis of SRS Acquiom s life sciences deals, please see the 2016 SRS Acquiom Life Sciences M&A Update. ** Generally subject to exceptions, such as if the subsequent buyer assumes the earnout obligations. Limiting the Duration of Escrows Unlike earnout provisions, escrow provisions are included in most M&A agreements, appearing in 86 percent of 2016 agreements. Sellers are increasingly focused on reducing the time that funds are held in escrow. Our analysis showed that the median duration for general escrows declined from 18 months in 2014 and 2015 to 16 months in Of course, the seller is without full benefit of the consideration for as long as the purchase price remains in escrow. This decline is also significant because the longer funds remain in escrow, the more likely they may be used to satisfy indemnification claims. In addition to being able to reduce escrow durations, sellers have also been able to avoid an increase in the size of escrows. Over the past four years, the median size of general escrows has remained flat at roughly 10 percent. 6

7 14% 12% 10% 8% 6% 4% 2% Median indemnification escrow/holdback size recently, however, buyers appear willing to give some ground when negotiating general escrows. Two major factors have contributed to this trend: (i) the increase in specialty escrows; and (ii) an increase in the use of representation and warranty insurance. The use of a specialty, or separate, escrow for purchase price adjustments jumped to 39 percent in 2016, up from only 27 percent the previous year. This trend indicates that while buyers may be willing to give ground on terms relating to general indemnification escrows, they still seek protection for areas of special concern (e.g., purchase price adjustments). 0% As % of transaction value Many buyers consider escrows important because they provide protection against the risk that they are dealing with sellers that may not have the funds available to indemnify the buyer if a breach occurred. More The second key factor impacting escrow negotiations is the rise of representation and warranty insurance. According to data from one insurer, the number of representation and warranty policies underwritten between 2013 and 2016 jumped over 200 percent. 6 If this trend continues, we may see the size and duration of general indemnification escrows continue to decline. In fact, there has already been a significant impact: some M&A parties skip a general indemnity escrow, and the buyer instead relies on the insurance policy as its sole recourse. Post-Closing Purchase Price Adjustments: Thresholds and Separate Escrows Subset: 2015 & 2016 deals with post-closing purchase price adjustments in the consideration mechanics section of the acquisition agreement (as opposed to the indemnification section only) Adjustment only if threshold exceeded Source of payment if buyer-favorable adjustment Yes 13% Yes 13% Inner circle = 2015 Outer circle = 2016 No 87% No 87% Generally, payment out-of-pocket from securityholders Separate escrow 39% 2015 Separate escrow 27% No separate escrow 61% No separate escrow 73% Payment not from indemnity escrow 7% Payment from indemnity escrow 93% Payment not from indemnity escrow 7% Payment from indemnity escrow 93% 2018 by The Bureau of National Affairs, Inc. 7

8 Increase in Deductible Baskets but More Limitations on Material Breaches Number of RWI Policies Number of RWI Policies 350 Sellers are also succeeding at negotiating the inclusion of limiting payments of buyer claims through the use of deductible baskets. Under a deductible basket, which is considered a seller-friendly term, the buyer receives payment for only those claims above the negotiated threshold; the threshold thus operates as a deductible. From the seller s point of view, a deductible basket prevents the buyer from nickel-anddiming the seller for every insignificant breach. In 2016, the use of deductible baskets jumped to 42 percent, up from 30 percent the previous year Source: Aon and Winston & Strawn In addition to successfully pushing for the use of deductible baskets, sellers have also successfully negotiated increases in the average size of both deductible and tipping baskets. With a tipping or first dollar basket, the buyer receives payment for all claims, not just those in excess of the threshold, but only once the value of claims exceeds the threshold amount. In 2016, the average threshold for deductible baskets increased to 1.21 percent of the transaction value, up from 0.73 percent in During the same time period, the average threshold for tipping baskets increased to 0.70 percent from 0.64 percent. This combination means that buyers are receiving smaller payouts for indemnification claims while also needing to incur greater damages to be eligible for reimbursement. As sellers squeeze indemnification rights, buyers agreeing to deductible baskets have increasingly negotiated for the inclusion of a double materiality scrape. Materiality scrapes instruct the reader when to ignore materiality qualifiers found in the representations and warranties (e.g., for determining whether a breach has occurred, in the calculation of damages or in both instances). If the agreement instructs the reader to ignore materiality qualifiers in both the determination of breach and for the calculation of damages, it is commonly referred to as a double materiality scrape. Buyers agreeing to a deductible basket often prefer inclusion of a double materiality scrape because, from its perspective, the seller already has protection from immaterial claims through the use of baskets, and it can eliminate postclosing disputes over what is and is not material. Our analysis indicates that agreements containing a double materiality scrape nearly doubled from 2015 to 2016 (increasing from 19 percent to 34 percent). Baskets as a Percentage of Transaction Value Subset: 2015 & 2016 deals with baskets Basket type Deductible First dollar 2015 Average 0.74% 0.64% 2016 Average 1.21% 0.70% 2015 Median 0.71% 0.54% 2016 Median 0.75% 0.54% 8

9 Materiality Scrape Inclusion 2016 Deals Materiality qualifiers not disregarded 16% Materiality qualifiers disregarded 84% For determining data breach only 20% For determining damages only 46% For determining breach and damages 34% 2015 Deals Materiality qualifiers not disregarded 16% Materiality qualifiers disregarded 84% For determining data breach only 23% For determining damages only 58% For determining breach and damages 19% With increasing use of deductible baskets, coupled with rising basket thresholds, we expect buyers to continue to negotiate materiality scrapes or pursue other methods (e.g., representation and warranty insurance) that ensure they have recourse in the event of seller breaches. Accuracy of Representations at Closing Becoming More Seller Friendly Another shift in favor of sellers is a rise in the inclusion of a material adverse effect ( MAE ) standard in the requirement that representations and warranties be accurate as of the closing date in order for the closing to occur. This provision is a closing condition often referred to as an accuracy of representations condition. The use of such MAE qualifications jumped 12 percent to 43 percent in 2016 (compared to 31 percent in 2015 agreements). The change is significant. We are unaware of any court that has found that a buyer has established an MAE, essentially prohibiting the buyer from walking away from the transaction even if the seller s representations and warranties are inaccurate by The Bureau of National Affairs, Inc. 9

10 Accuracy: Materiality (2015/2016 deals) 9% 28% 11% 37% Year-Over-Year Trend Year-Over-Year Trend 5% 31% 5% 63% 52% 64% 52% 2015 At signing MAE 2016 At signing In all material respects 2015 At closing 43% In all respects 2016 At closing With the increased use of MAE in this closing condition, buyers are responding by seeking the inclusion of a sandbagging provision. Sandbagging provisions permit buyers to seek post-closing indemnifications for breaches that it was aware of at or prior to closing. In 2016, pro-sandbagging provisions appeared in 58 percent of the agreements analyzed, up from 52 percent the prior year. Buyers seeking sandbagging provisions would likely argue that if they are being forced to close their transaction despite known seller breaches, that decision should not prejudice their right to seek postclosing indemnification for those breaches. Those not familiar with M&A agreements may consider sandbagging provisions a gotcha game in which buyers knowingly bait sellers into breaches and then elect to close over them so as to clawback a portion of the purchase price. However, until courts change their views on what constitutes an MAE, sandbagging provisions may be the only effective method for buyers to counter the inclusion of an MAE in the accuracy of representations closing condition. 54% 52% 52% 58% 1% 1% 3% 0% 45% 47% 45% 42% Pro-sandbagging provision included Anti-sandbagging provision included Silent 10

11 Conclusion Our analysis has shown that sellers have succeeded in leveraging a favorable market environment to push certain terms in their favor. In other words, perception is, to some extent, reality. However, M&A negotiations have not become one-sided, and buyers still exercise significant power. For each shift in sellers favor, buyers have pushed back, with some effect. Unless general market trends change, we would expect sellers and buyers to engage in a continuing game of whack-a-mole, with buyers continuing to search for ways to limit sellerfavorable provisions as they pop up. About the authors Sean Arend is Managing Director, Corporate Development and General Counsel, for SRS Acquiom. He manages all company legal, risk, and compliance matters and assists with strategic alliances and early stage product development. Prior to SRS Acquiom, Sean served as General Counsel in a venture-backed technology company, Senior Counsel in an industry-leading public company, and an attorney at Cooley LLP. Andrew Hubley is a Senior Legal Editor at Bloomberg Law focused on M&A and private equity. Prior to Bloomberg Law, Andrew was a Corporate Associate with an Am Law 100 law firm. Prior to practicing law, Andrew was a strategy consultant advising Fortune 500 clients on business and strategic decisions. 1 See William Blair, Merger Tracker Q (noting that sellers are seeking to take advantage of the seller-friendly M&A market by accelerating the sale process); see also, Oliver Brahmst & Carolyn J. Vardi, Private Equity Adapts in a Seller s Market, White & Case Jul. 31, 2017 (noting that PE firms are under pressure to deploy capital in a market that has favored sellers in recent years ); Gibson Dunn, M&A Report How Representations and Warranties Insurance is Transforming Risk Allocation in M&A transactions, Nov. 27, 2017 (stating that buyers are relying on rep & warranty insurance more frequently due to, among other things, an increasingly competitive, sellerfriendly deal climate... ). 2 SRS Acquiom maintains a proprietary database of M&A agreements, most of which are not publicly available. The database includes statistics on drafting points for selected provisions in the agreements. As part of our analysis, we analyzed drafting trends in the 795 M&A agreements included in the SRS Acquiom database for deals occurring between 2013 and We reviewed data concerning the approximately 42,561 M&A deals announced between January 2013 and October 2017, valued at less than $1 billion U.S., involving a U.S. private target company and contained in the Bloomberg Law Deal Analytics database. 4 See, e.g., How to Navigate and be Successful During the Investment Banker-Led Auction Process, Pepper Hamilton LLP (Nov. 3, 2017), podcasts/how-to-navigate-and-be-successful-during-the-investment-banker-led-auctionprocess /. 5 Powers v. Stanley Black & Decker, Inc., 137 F. Supp. 3d (S.D.N.Y. 2015) ( Where, as here, a party purchased a company on the basis of inaccurate warranties, the injured party is normally entitled to the benefit of its bargain... That is sensible because general damages include those damages that are the natural and probable consequence of the breach. Therefore, where the seller makes representations about the business he is selling, the natural and probable result is that the business is actually worth less than the buyer paid, and diminution in value damages therefore compensate the buyer for the value of the promised performance. ). 6 See, Oscar A. David, et al., The Real Deal Webinar Series: Negotiating Favorable Representation and Warranty Insurance Policies Lessons Learned from Litigating Claims at *5, WINSTON & STRAWN LLP, (May 11, 2017), content/1/2/v2/123093/real-deal-webinar pdf (listing market statistics from Aon for the years of 2013 through 2016). 7 Although we are unaware of any cases finding an MAE, it is possible (and indeed likely) that buyers have used seller breaches that may rise to the level of an MAE to negotiate favorable revisions to the agreement in lieu of seeking litigation by The Bureau of National Affairs, Inc. 11

12 2018 The Bureau of National Affairs, Inc JO