A favourable market for sellers
June 2014 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
It is a good time to be a seller. Increased deal activity has been spurred by a surplus of private equity and strategic capital poised for investment, generally supportive debt markets, buoyant public equity markets and a focus on roll-up and consolidation strategies as a means of driving growth and economies of scale. The increased market demand for acquisitions has, in turn, led to attractive deal terms, valuations and other market developments that have benefitted sellers.
Looking to recent empirical support, the Intralinks Deal Flow Indicator, which tracks due diligence on global M&A sell-side mandates and deals prior to public announcement, predicts a 16 percent increase in year-over-year global M&A activity. Intralinks’ March 2014 survey of a thousand global M&A professionals found 63 percent of them to be optimistic about the current deal environment, with 73 percent of them predicting an increase of M&A activity over the next six months. KPMG’s 2014 M&A Outlook Survey Report, which polled a thousand M&A professionals at US corporations, private equity firms and investment banks, found that 63 percent of them planned to make acquisitions in 2014.
This increased optimism and projected deal activity lines up with an upsurge of deal flow we have seen among both strategic and financial clients. Auctions for attractive assets have been extremely competitive, with seasoned investors often frustrated in processes where winning bids have defied risk factors and even the most creative financial modelling. With many buyers vying for the same assets in hot sectors such as financial services, healthcare, life sciences and technology, sellers have been able to harness these competitive dynamics to drive attractive valuations and limit their post-closing risk and obligations.
One key factor propelling this deal activity is the amount of cash that financial and strategic buyers have accumulated. Although the size of many mega-funds has decreased in connection with the most recent fundraising cycles, the private equity overhang remains substantial, with the Bain and Company 2014 Global Private Equity Report estimating that private equity firms had over $1 trillion in available capital at the end of 2013. Potential strategic buyers also are flush: according to Moody’s Investor Services, US strategics rated by Moody’s held $1.64 trillion in cash at the end of 2013.
In addition, banks have been actively looking to deploy capital and credit has been inexpensive, leading to low interest rates, flexible loan structures, and loan amounts at debt-to-EBITDA multiples that are reminiscent of the 2007 deal boom, although in recent months, we have seen a tightening of terms and increased pricing, particularly in the lower middle market. This general availability of credit has benefitted sellers looking to monetise their investments in a couple ways: (i) sellers not looking to relinquish control of their companies have achieved substantial liquidity through dividend recapitalisations (with significant spikes in such activity around the prospective tax rule changes in 2012 and again during the second half of 2013); and (ii) cheap debt and higher leverage multiples are allowing buyers to pay higher purchase prices in change of control transactions. At the same time, buoyant public equity markets have heightened private sellers’ valuation expectations, while limiting the number of attractive potential public-to-private acquisitions, due to the premiums typically paid for such businesses.
The active transactional market has fostered some key trends in deal terms involving private companies. Many private acquisition agreements contain indemnification provisions that enable buyers to recover from sellers certain post-closing losses sustained by the buyer due to a breach of the sellers’ representations and warranties within a specified period of time. These indemnifiable amounts often are subject to limitations, including: (i) a basket or deductible (a threshold loss amount that must be incurred before the buyer can collect losses against sellers or an escrow) and (ii) a cap on losses (the maximum amount of buyer recovery against sellers, often linked to whether a breach relates to a general rep, a fundamental rep – title, authority, organisation, capitalisation, etc., or a covenant). Parties often will set aside a certain portion of the purchase price in a third party escrow account for a period of time post-closing to cover such potential losses and mitigate collection risk.
The hot deal market has empowered sellers to become more aggressive in structuring indemnification obligations and escrows. According to the American Bar Association’s December 2013 Private Target M&A Deal Points Study, there has been an overall cutback in sellers’ indemnification obligations, and the median value of escrows as a percentage of transaction value fell from 9.93 percent in 2008 to 7.14 percent in 2012. In our experience representing both buyers and sellers in private transactions over the past 18 to 24 months, we have seen a continuation of this trend. For private deals with total enterprise values approaching or above $1bn, we have increasingly seen ‘public company’ style deals with no indemnity or escrow at all, or a minimal indemnity and escrow amount that serves as the sole post-closing recourse for the buyer, subject, of course, to the facts and circumstances of specific deals. In smaller middle market transactions, we have also seen indemnification caps on general representations and warranties and escrow amounts trend downwards, particularly in competitive auctions.
Faced with competitive auctions for attractive assets and less robust contractual protections, buyers have increasingly turned to representation and warranty (R&W) insurance to provide them with post-closing protection for potential losses. Once largely considered just a marketing tool for brokers and insurers, buyside R&W insurance has become increasingly popular among both buyers and sellers as a means of maximising closing proceeds to sellers, while giving buyers the post-closing protection that they desire. Attractive pricing (currently, premiums generally are around 2-4 percent of the covered amount) plus positive anecdotal feedback regarding claims experiences with certain insurers has helped to drive increased adoption of these policies, especially over the last year.
On sellside processes, there also has been a trend towards sellers offering up a ‘stapled’ R&W policy, which is presented to buyers together with an auction purchase agreement that contains reduced post-closing indemnity protections and little to no escrow. Sellers have used such a stapled policy, which is accompanied by firm pricing from the applicable insurer, to guide buyers towards bids that take into account the purchase of an R&W policy and a minimal escrow amount. This product has proven particularly attractive to financial sellers, as it enables them to distribute proceeds to their limited partners following a monetisation event, and it has been a useful means of enabling private equity funds in wind-down mode to distribute the bulk of their closing proceeds to their investors.
Signs point to an active 2014 for deal professionals with the private equity and strategic cash surplus, resilient debt markets and other industry trends supporting deal flow. We look forward to playing a part in the continued evolution of transactional terms, which, as always, will move in response to broader market trends and the overall health of the deal market.
Neill Jakobe is a partner and Jeffrey Koh is an associate at Ropes & Gray. Mr Jakobe can be contacted on +1 (312) 845 1260 or by email: firstname.lastname@example.org. Mr Koh can be contacted on +1 (312) 845 1386 or by email: email@example.com.
© Financier Worldwide
Neill Jakobe and Jeffrey Koh
Ropes & Gray