Executing well – managing legal transaction risk in M&A
June 2018 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2018 Issue
M&A transactions are designed to serve a strategy of generating value, whether as part of a growth or exit plan. Managing transaction risks in these types of transactions is key to successfully executing that strategy.
Attitudes of buyers and sellers on how they manage and allocate risk have shifted over time, due to market, regulatory and other drivers. This article provides a high level summary of tools – some of which have been traditionally favoured, and some newer trends that are emerging. This article focuses on the New Zealand market in private M&A deals.
It is widely recognised that a successful M&A transaction begins with high-quality due diligence. Due diligence is conducted by sellers, to ensure the target business is in order, and to identify and address risk areas in advance of a sale. Buyers see it as part of their core assessment of risk and value. While the purpose of due diligence has not changed, technology has added sophistication in parties’ control (and management) of the quality of due diligence. Virtual data rooms are the norm in sophisticated transactions, and allow the sharing and controlled disclosure of large volumes of information securely (which is especially useful in staged disclosure of sensitive information or to manage multiple bidders at once).
Firms are also looking to leverage the power of AI to automate reviews and improve accuracy and efficiency in due diligence.
In terms of risks assessed, increasing global focus on cyber security, data privacy and IT risks have become key, irrespective of business type.
Conditions continue to be a useful tool to protect both buyers and sellers from specific and significant risks. Common conditions include antitrust clearance or approval of the New Zealand Overseas Investment Office, financing, consent to change of control under key contracts and there being no material adverse change in the target business before completion.
Whereas completion accounts and locked box mechanisms are used to manage the risk of loss of value to the extent caused by a seller, a no MAC condition is useful for unforeseen events and events outside of the control of the parties (such as market conditions or regulatory changes). Buyers are more likely to insist on a no MAC condition the longer the period of time between signing and completion.
Sale agreements usually include a ‘drop dead’ date, by which all the conditions must be satisfied or waived, and failing satisfaction or waiver by that date, the sale agreement will usually provide for termination.
Earnouts are structured so that the buyer pays a portion of the purchase price at closing, and the remainder is paid at a future date if certain conditions are met. It incentivises sellers to continue to have the best interests of the business they just sold in mind.
Earnouts can also bridge critical gaps in valuation between buyers and sellers. They manage the buyer’s risk of overpayment (this is particularly useful if the business is difficult to value, or has a limited track record of performance, for example high-growth start-up businesses).
Sellers are unlikely to back an earnout structure that does not support their view of the business’ value and their view of credible post-closing performance. In this way, earnouts encourage sellers to make credible statements about future performance that they are willing to back.
Earnouts need to be structured carefully to mitigate the risk of dispute or manipulation of performance results. A well-structured earnout will set out clear, objective mechanisms to measure performance and for preparing the metrics on which the earnout is to be calculated.
Completion accounts vs. locked box
Completion accounts provide a mechanism to ‘true-up’ the headline price paid at completion, by adjusting that price against actual accounts of the business prepared as at the completion date. While completion accounts have long been preferred for managing pricing risk (its key benefit being that it establishes the ‘true’ value of the business at completion), preparing and finalising completion adjustments can be complex, and both parties face the risk of uncertain adjustments.
As an alternative, the fixed price approach of a locked-box mechanism has proved popular in certain cases as a simpler alternative. A locked box fixes the purchase price at a specific point in time, and shifts the economic risks (and rewards) of the business to the buyer as of that time. Accordingly, quality due diligence is key, as the price will be fixed on the basis of that due diligence. In return for this price certainty, sellers undertake that there will be no leakage of value from the locked box time to completion.
Warranties and indemnities and the rise of insurance
Warranties and indemnities remain the core contractual tools by which buyers and sellers allocate specific risks relating to the target business. Warranties are factual statements made by the sellers about the sellers, the target and the target business. The usual remedy for breach of warranties is damages, which will require the buyer to have suffered loss.
Sale agreements will usually contain negotiated provisions limiting the buyer’s ability to claim for loss under the warranties, including: (i) a financial cap on the maximum amount that may be claimed; (ii) de minimis of individual loss and ‘basket’ of total aggregate losses; (iii) time limits; and (iv) qualification for matters disclosed.
It is becoming common for buyers to identify fundamental warranties that they want carved out of (some or all of) these limitations. These are typically warranties around the seller’s authority, capacity and title, but can also include other matters that are of particular concern to buyers.
Indemnities, on the other hand, cover specific risks. Tax indemnities are standard practice, but buyers also seek additional indemnities for specific risks that are yet to be quantified.
Warranty and indemnity (W&I) insurance is gaining popularity as a way to reallocate risk by transferring the risk of breaches of warranties and indemnities to an insurer. Premiums remain relatively low in New Zealand (around 1 to 5 percent of the liability limit) which has made W&I insurance more economically viable for many transactions.
W&I insurance policies can be ‘buy side’ (to allow the buyer to make any claims against the insurer) or ‘sell side’ (to insure the sellers in the event a claim is made against them). Buy-side policies make up the vast majority of W&I policies in New Zealand. The key benefit to a buy-side policy is that the buyer does not need to make a claim against the sellers directly. Instead, the buyer only needs to seek recovery for a claim from the insurer.
With a buy-side policy, sale agreements often provide that the buyer’s only recourse is limited to the W&I policy (subject to certain exceptions, such as fraud). As it benefits both parties, it is common for them to share the cost of the premium. This has obvious appeal to a seller, who can be assured of retaining their full purchase price.
W&I insurance is a useful solution to an otherwise deadlocked position, or to give a bidder a competitive edge in an auction process. W&I insurance also avoids the need to address risk through purchase price mechanisms, for example by splitting the consideration in an earnout or by retaining funds in escrow (both of which options diminish the clean exit desired by sellers). At the same time, W&I insurance also addresses concerns that a buyer may have as to the sellers’ ability to meet claims.
Another common situation where W&I insurance has proven useful is where the transaction is a strategic partnership. By taking out W&I insurance, the parties avoid the risk of souring the strategic relationship with warranty and indemnity claims.
While W&I insurance can bridge conflicts between buyers and sellers in negotiating warranties and indemnities, it does not replace quality due diligence. Especially where there is nil recourse against sellers, insurers will expect high-quality disclosure by sellers and robust due diligence by buyers. Parties should also factor in the time frames required to put W&I insurance in place – insurers need time to review the transaction, including due diligence, and negotiate the insurance package with the insured.
Market practice has given rise to a number of common exclusions to W&I insurance cover (for example around transfer pricing, consolidated tax groups and forward-looking warranties). However, insurers will review individual warranties and indemnities and determine the extent to which they are willing to cover the specific risks in the context of each transaction. Accordingly, buyers should be wary of any inadvertent ‘gaps’ in cover – particularly where there is nil recourse against the sellers.
Elena Kim is a senior associate at MinterEllisonRuddWatts. She can be contacted on +64 9 353 9705 or by email: firstname.lastname@example.org.
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