Around every corner: tackling transactional risk

December 2023  |  COVER STORY | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

December 2023 Issue

We live today in a world awash with risks. Many we create ourselves, and many are new and emerging – continuously being revealed and inextricably linked to technological, biological, sociological and geopolitical evolutions. Such risks lurk around every corner.

According to the World Economic Forum’s (WEF’s) 2023 ‘Global Risks Perception Survey’, today’s risks feel both wholly new and eerily familiar. Familiar, in that there has been a return of ‘older’ risks such as inflation, cost-of-living crises, social unrest, geopolitical confrontation and the spectre of nuclear warfare, which few of this generation’s business leaders and public policymakers have experienced.

In terms of the new, the WEF observes that these are being amplified by comparatively new developments in the global risk landscape, including unsustainable levels of debt, rapid and unconstrained development of dual-use (civilian and military) technologies, and the growing pressure of climate change impacts and ambitions in an ever-shrinking window for transition to a 1.5 degree world.

“Economies and societies will not easily rebound from continued shocks,” states the WEF report. “The persistence of these crises is already reshaping the world that we live in, ushering in economic and technological fragmentation.

“A continued push for national resilience in strategic sectors will come at a cost – one that only a few economies can bear,” continues the report. “Geopolitical dynamics are also creating significant headwinds for global cooperation, which often acts as a guardrail to these global risks.”

Taken together, the risks outlined by the WEF are converging to shape a unique, uncertain and turbulent environment, and potentially for decades to come – a scenario that is causing ripple effects across a vast range of business activities.

Transactional risk

One arena continuously grappling with the volatile global risk landscape is the dynamic world of M&A transactions. As defined by the Corporate Finance Institute (CFI), ‘transactional risk’ for companies is the exposure to uncertain factors that may impact the expected return from a deal or transaction. Essentially, transactional risk encompasses all negative events that can prevent a deal from unfolding as expected.

These risks may relate to sustainability, environmental, social and governance (ESG), supply chain resilience and integrity, activism, cyber security or employee wellbeing – all issues high on the corporate agenda.

Data, regulation, operational resilience, geopolitical shocks and market and macroeconomic volatility are also key concerns. These challenges may distract companies from executing their strategies or, more seriously, result in them seeking, or being forced, to make wider strategic and operational changes and transformations that could lead to a crisis.

As a result, notes the CFI, a deal with a high transaction risk will typically require a higher expected return; therefore, it is important for dealmakers to consider such risk when evaluating a prospective investment. In some instances, contends the CFI, transaction risk can stop a deal from going through due to potentially negative outcomes associated with the transaction.

Identifying and managing

Every transaction is unique and carries its own blend of risks, so knowing how to tackle transactional risk is an essential part of the risk management process. The task begins with identifying what constitutes a transactional risk.

In the main, transactional risks are not simply commercial, financial or political in nature, but include a plethora of other inherent risks – technical, environmental, developmental and sociocultural. The most common risks affecting a deal and its value, according to the CFI, are outlined below.

First, foreign exchange risk. Also known as economic exposure, foreign exchange risk is the unforeseen fluctuation of foreign exchange, which can affect the expected transaction value. This risk is especially important to consider for cross-border transactions or deals with countries that have relatively high currency volatility.

Second, commodity risk. Similar to foreign exchange, commodity risk considers the unexpected fluctuation of commodity prices. While commodity fluctuation affects all sectors, it is a primary consideration in the oil & gas and mining sectors.

Third, interest rate risk. Interest rate risk examines how interest rate fluctuation can affect transaction value. Depending on the changes in rates, this risk can affect the ability of the purchasing party to raise the necessary capital for the transaction and can impact the debt obligations of the selling party. For companies that engage in debt covenant agreements with financial institutions, interest rate fluctuation can impact the company’s ability to meet its obligations established in the covenant.

Fourth, time risk. As market conditions and companies change with time, there is a higher probability that the initial transaction agreement conditions will become unfavourable the longer the negotiation process is extended. As a result, deals can fall through due to the favourable conditions no longer being present for both parties. The longer a deal takes to finalise, the longer the transaction is exposed to the other risks.

Lastly, counterparty risk. When engaging in transactions, there is a risk that the counterparty will not complete its contractual obligations agreed upon in the transaction. In instances where counterparties default on their contractual obligations, it is often due to the effects of the previously stated transaction risks.

The types of risks facing organisations also vary from jurisdiction to jurisdiction. “In the Australian M&A market, the key transactional risks relate to regulatory approvals, in particular foreign investment approvals,” says Con Boulougouris, a partner at MinterEllison. “Buyers are also trying to get their heads around ESG risks, and how to best diligence these risks and seek protections through representations and warranties (R&W) in transaction documents.

“We have also seen significant transactional risks arising from IT issues,” he continues. “Many businesses have a heightened focus on technology and digitalisation in recent years. Their customers are more reliant and more comfortable with digital transactions, largely accelerated by the pandemic. For many organisations, technology is now their central product, and IT risks should be front of mind during any deal.”

Once the potential risks associated with a transaction are identified, a company needs to assess the likelihood and severity of these risks in order to obtain an accurate risk assessment of a target or targets. This risk mosaic considers all the variables involved in a transaction.

Such an assessment requires specialised knowledge and skills, including financial, legal and technological expertise. Those companies that engage and harness experts will be better equipped to manage the transactional risks they face and achieve their goals.

“Dealmakers need to obtain a full, early understanding of how transactional risks can impact deals and the additional risks and costs that may emerge and add significant management costs,” advises Mr Boulougouris. “For example, in relation to IT transactional risks, without proper planning and due diligence between dealmakers and those operating the business, the acquirer could buy a service that looks great on paper but will cost a lot to fix or replace the moment it falls over.

But with careful planning, this risk can be managed. “In order to overcome inflexible mindsets, it needs to be recognised that transactional risks cannot be managed solely through transaction documents,” says Mr Boulougouris. “The post-closing integration process, in particular in relation to technology and people, can be more critical than the transaction documents. Taking technology as an example, one of the most difficult factors is integrating the ‘target’ entity and its associated enabling technology into the purchaser’s IT systems.”

Unfortunately, however, companies often underestimate the time and cost involved in integrating such systems, as well as customer data and managing agreements with IT vendors. “If handled well, however, the process offers an opportunity to shed legacy technology and rationalise infrastructure and software to better fit the new business,” adds Mr Boulougouris.

Insurance options

Among the options for addressing and mitigating the key risks inherent in a transaction is to procure appropriate insurance coverage, aligned with the specific characteristics of the transaction. There are several types for companies to choose from.

Thus, with sellers looking for certainty and an accelerated closing process, it is essential that buyers not only undertake a robust due diligence process, but also consider a range of insurance options to help them successfully close a deal and mitigate certain exposures. According to the Risk Management Society (RIMS), key points to consider are outlined below.

First, warranties & indemnities (W&I). W&I insurance provides cover for losses arising from a breach of a warranty and claims under a tax indemnity, and, in certain cases, other equivalent provisions, in connection with an M&A transaction. The warranties given in the sale and purchase agreement play an important role in the transaction. Properly drafted, they assist the information-gathering process and clarify the position of the target company by requiring disclosure of certain key characteristics and issues.

Second, representations & warranties (R&W). R&W insurance helps facilitate M&A by reducing the need for protracted negotiations of certain indemnity provisions between buyers and sellers and protects participants from risks that arise in connection with the underlying transaction. Specifically, R&W insurance is designed to provide protection against financial losses arising from breaches of a seller’s representations and warranties made in the acquisition or merger agreement, including costs associated with defending claims.

Third, tax liability. Tax liability insurance is designed to transfer a known, but uncertain, tax liability from a company’s balance sheet to an insurance company. This type of insurance indemnifies the policyholder for financial loss arising from a successful challenge from a tax authority, removing uncertainty around potential tax liabilities. For M&A transactions, policies are available either pre- or post-transaction. Tax liability insurance is also available on a standalone basis.

Lastly, contingent risk. Contingent risk insurance for M&A, and other investment or financing transactions, offers insurance for a broad range of contingent risks for which neither party to the transaction will accept financial responsibility. Usually, the insurance transfers a known or uncertain contingent liability from a buyer’s balance sheet to an insurance company. This type of insurance can cover a very broad range of contingent risks, which may be identified during due diligence conducted as part of the transaction process.

“Transactional risk insurance has a special role in mitigating transactional risks,” notes Mr Boulougouris. “Risk managers need to ensure there is appropriate coverage under R&W insurance relating to warranties and representations under the transaction documents, with limited exclusions and qualifications.

“They also need to integrate the target business into group insurance policies with effect from closing,” he continues. “This includes ensuring there is appropriate coverage under directors’ and officers’ insurance and cyber policies which provide protection for any new directors or management taking on a new role in the target business post-closing.”

Regulatory spheres

As a company’s transaction operations take shape, it is important to integrate and tailor regulatory compliance policies and controls to the new company’s risk profile. This process involves testing and reassessing as the target company’s operations become clear, with the compliance team assigning actions to an agreed timeline.

For Mr Boulougouris, an increasing area of transactional risk in the regulatory sphere is foreign investment approvals – a risk that most foreign buyers should be able to manage, but which calls for an early start to the engagement process.

“Many foreign investment approvals now have conditions attached, such as tax conditions, which may need to be monitored post-closing for a number of years and may require annual confirmation of compliance,” he explains. “It is critical that boards have appropriate procedures in place to ensure compliance with these conditions and reporting requirements.”

Reactive to proactive

With headwinds such as geopolitical unrest, looming recession and rising interest rates slow to abate, the likelihood is that transacting companies will not have transactional risk troubles to seek in the months ahead. For some, the key to success is the application of a proactive rather than reactive approach to transactions and their associated risks.

“It is critical that the deal team engages proactively with transactional risks and does not wait until closing approaches or until closing happens,” concludes Mr Boulougouris. “Transactional risks need to be considered at every stage in a deal’s lifecycle, including pre-deal planning, pre-deal assessment, due diligence, transition and post-deal operations. And as technology becomes more significant in every organisation, the costs associated with ignoring IT in transactions, for example, will become greater and the risks more significant.”

© Financier Worldwide

BY

Fraser Tennant