Strategies and best practices for managing transactional risk: a legal perspective

July 2023  | SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2023 Issue

Managing transactional risk is the central piece of every deal involving the transfer of equity, quasi-equity or assets in any transaction, from the acquisition of real estate to a large-cap M&A. The success of any such transaction depends heavily on the ability of the parties to manage transactional risk so that the gaps in valuation are, to the fullest extent possible, bridged.

Risks can arise from a wide range of sources, including financial uncertainties, regulatory issues, technological complexities and, especially in deals involving developing countries, cultural differences. The risks encompass a vast array of legal, operational and financial challenges that can have a profound impact on the success or failure of a deal.

In this article we will explore the key strategies and best practices for managing transactional risk in M&A transactions strictly from a legal perspective. From due diligence to the closing of the transaction, we will examine the essential steps that every organisation must take on the path toward successful M&A dealmaking. With the right preparation, planning and execution, it is possible to navigate the complexities of transactional risk and achieve a successful outcome that benefits both parties involved.

The management of transactional risk generally involves a multifaceted approach that combines various strategies and tactics. In Brazil, in general, transactional risks are addressed by breaking the process down into four distinct steps: data room due diligence, independent searches, representations and warranties (R&W)/specific indemnities and guarantees.

The first two steps are focused mainly on identifying the potential risks to the transaction; the second two, on addressing the identified (and unknown) risks. In the middle is one of the most important elements of a transaction: identifying and separating risks that are material from risks that are acceptable and generally spread across the relevant market. After all, doing transactions is not about avoiding all risks, but rather knowing what risks to accept and what to avoid.

We will also address some strategies to protect buyers and sellers against risks in the interim period (between signing and closing).

Data room due diligence

Data room due diligence refers to the process of conducting a detailed review of the target company’s financial, legal and operational records, as made available by the sellers or the target company in an organised fashion. A large array of advisers is involved in the process, which entails examining legal and regulatory compliance, financial and operational records to identify any areas of risk or concern. By conducting a thorough review of the information made available through the data room, the buyer can gain a deep understanding of the target company’s operations and assess potential liabilities or contingencies (materialised or contingent).

Independent searches

One must always remember that, ultimately, information provided in a data room is fundamentally information that was treated and cleansed by the seller – it is information that the seller wants the buyer to know. While we would always recommend to any seller to provide as much raw information as possible, to avoid any future claims for breach of representations, contractual warranties or even fraudulent misrepresentation, if the virtual data room (VDR) is incomplete, the buyer may miss any potential risks or liabilities that could impact the value or viability of the target company.

This is why we believe that making thorough independent searches of public databases (and of market peers) is something crucial to every deal (albeit often a step ignored by buyers). Public sources such as industry publications, news articles and regulatory filings can provide additional insights that may not be included in the VDR. This is especially important in jurisdictions where the rule of law is not thoroughly enforced or for non-recourse deal structures, without indemnification obligations.

Performing due diligence in public sources (i.e., outside the VDR) allows the buyer to gather a more complete picture of the target company’s business, including any potential red flags that may have been omitted from the VDR. By researching public sources, the buyer can discover these issues and factor them into their decision-making process.

While it is true that performing due diligence using public sources may be more expensive than relying solely on a VDR, depending on the seller or the jurisdiction the additional cost may be well worth it. This can ultimately save money in the long run by avoiding potentially costly mistakes. In our experience, due diligence costs are usually immaterial in the context of an M&A transaction.

Business judgement

After conducting thorough due diligence, one of the most important phases in any deal starts – separating material issues from non-material or, even, from industry risks. Although advisers might be helpful in guiding decision makers through market-specific risks, in particular for countries with which the client is not very familiar, ultimately this is a business decision.

This is often a critical decision for the success or failure of any deal. It is not uncommon to see negotiations become protracted because parties choose to fight over non-material issues, while material risk may be left aside. Also, inexperienced dealmakers may try to protect against all possible risk in any potential scenario (which usually creates huge difficulty in more seller-friendly markets), or failing to attain enough protection (in particular in developing countries and jurisdictions which carry a higher systemic and country risk).

Ultimately, there is no magical rule to define risk allocation, but having experienced advisers and dealmakers, as well as leveraging the parties’ knowledge of their industry, is critical to achieving a successful and fruitful deal for all parties – one that can find the right balance of risk protection and risk assumption.

R&W

At a contractual level, R&W are critical clauses in any M&A transaction, as they serve to allocate risk between the buyer and the seller. Their purpose is to ensure that the buyer is acquiring the assets or shares they expect with adequate protection against undisclosed liabilities. Also, by obtaining representations from the seller, the buyer can hold the seller accountable for providing a complete VDR and avoid any potential legal disputes or surprises after closing.

We usually divide R&W into two categories: fundamental and operational.

Fundamental R&W are those that relate to the core aspects of the business. These would include matters such as the ownership of the company’s shares, its capitalisation structure, authority of the seller to enter the transaction and, most recently, compliance with sanctions, anti-corruption and anti-money laundering regulations (the US Foreign Corrupt Practices Act (FCPA), UK Bribery Act and others).

Operational R&W, on the other hand, relate to the more day-to-day aspects of a business, such as its financial statements, litigation matters, and compliance with laws and regulations.

A typical set of R&W in an M&A transaction might cover matters such as: (i) ownership and title to the shares or assets being sold; (ii) capacity and power of the seller to enter into the transaction; (iii) compliance with laws and regulations; (iv) financial statements and results; (v) taxes and filings; (vi) information technology systems; (vii) intellectual property and proprietary rights; (viii) employees and benefits; (ix) litigation and disputes; and (x) real estate.

In practice, different transactions may involve different R&W, which may be specific to the industry in which the target business operates. It is important to understand the specific needs and circumstances of the deal, as well as the risk allocation mechanisms, to create a set of appropriate and reasonable R&W.

Specific indemnities

In addition to R&W, parties commonly use specific indemnities to cover for material risks that are known and were already identified during due diligence. The negotiation of specific indemnities is a key aspect of any M&A negotiation, as most often these debates are around indemnities with specific (or no) caps or limitations, and address risks identified as ‘dealbreakers’ or material risks for the future of the deal.

Guarantees

From a liability management standpoint, the use of guarantees is an important mechanism for backing the indemnification obligations in an M&A agreement. In practical terms, if an R&W breach occurs and results in a loss to the buyer (or a specific indemnity is triggered), the guarantee provides a creditworthy source of recovery for the buyer.

While R&W and specific indemnities help to protect the buyer against known and unknown liabilities, the use of guarantees protects the buyer from the credit risk of the sellers.

In M&A transactions, there are several types of guarantees that may be used to back the indemnification obligations assumed by the sellers. These include holdbacks, escrows, real guarantees (such as guarantees over real estate and machinery) and personal guarantees. Each of these has its own advantages and disadvantages for both the buyer and the seller.

Holdbacks are a type of guarantee in which a portion of the purchase price is held back by the buyer to cover any potential liability arising from a breach of R&W. Holdbacks are better from a buyer’s perspective because they provide a direct source of funds to cover any liability that may arise and allow the buyer to take advantage of the liquidity of having these funds at hand.

Escrows are another type of guarantee that is commonly used in M&A transactions. In an escrow arrangement, a portion of the purchase price is deposited with a neutral third party, normally a bank, to be held in trust for a specified period of time. If a claim is made against the seller for a breach of R&W, the funds held in escrow can be used to cover the cost and any losses associated with the claim.

Personal guarantees are a third type of guarantee that can be used in M&A transactions. These are guarantees made by entities associated with the seller, such as parent companies, or by banks or financial institutions. Personal guarantees are typically used in situations where the seller is not able to (or does not wish to, from a negotiation perspective) provide a hold-back or escrow and wants to provide a level of comfort to the buyer.

Escrows, real guarantees and certain types of personal guarantees (parent company guarantee) are better from a seller’s perspective because they do not tie up a portion of the purchase price and do not require the seller to provide direct sources of funds upfront. Usually, sellers look to avoid bank guarantees and guarantees over real assets, as these usually come at a high cost or affect the ability of the seller to obtain further financing giving its assets as collateral.

The type of guarantee used in any given M&A transaction will depend on the specific needs of the buyer and seller and should be carefully considered as part of the negotiation process. A crucial issue to consider when choosing a guarantee is the treatment of this type of collateral in bankruptcy scenarios.

As guarantees are fundamentally given to protect the buyer against the credit risk of the seller, buyers usually prefer instruments that are bankruptcy remote (which may vary depending on the regulations of each country).

On the other hand, sellers usually try to avoid this type of guarantee, as it can increase systemic risks for the selling entity. Distressed M&A is a good example of this situation.

Interim period protections

For deals with a separate signing and closing and, most importantly, where the interim period might be long due to specific conditions precedent (such as antitrust and other regulatory approvals), parties should look to protect against unknown market fluctuations which may materially affect the economic assumptions of a transaction. This is also of particular concern in emerging markets or industries, where market fluctuations may be high over a certain period of time.

There are three main conditions precedent used to protect the parties during the interim period. First, a material adverse change (MAC) condition. Second, the bringdown of R&W at closing date. Third, ordinary course of business obligations. All of these conditions are usually heavily negotiated in M&A transactions.

A MAC clause is usually a condition precedent establishing certain events or facts that, if implemented or reasonably expected to be implemented, would cause hardship for one of the parties or render null the valuation of the transaction. Negotiations usually revolve around determining what level of change would be material enough to allow the buyer to walk away from the transaction or reopen price discussions (usually a reduction in revenues or similar criteria, which could also include divestments required by antitrust authorities), and situations which could lead to the non-application of the MAC clause (such as pandemics, wars, acts of God, etc.).

We also often see the bringdown of R&W at closing being included as a condition precedent. In this case, discussions revolve around the extent of additional disclosures that would be allowed to the seller – which means, fundamentally, that any new liabilities identified in the interim period and exceeding pre-contracted thresholds would effectively give a walk-away right to the buyer.

Finally, most M&A deals with a separate signing and closing also have a series of obligations for the seller to conduct the target business in the ordinary course during the interim period, which may or may not include negative covenants (an obligation not to implement certain changes or carry out certain acts without the buyer’s prior approval). Oftentimes a breach of such obligations may also lead to a right of the buyer to walk away from the deal.

Conclusion

In conclusion, managing transactional risk in M&A transactions is an essential aspect of successful dealmaking. Just as essential as identifying the risks to which one is exposed and applying the correct protective instruments, the key aspect of any negotiation is to properly judge which risks to assume and which to protect against. For that, having experienced advisers and dealmakers will always be the best choice for any company venturing into the cross-border M&A world.

 

Thiago Sandim is a partner and Marcelo Peloso is a lawyer at Demarest Advogados. Mr Sandim can be contacted on +55 (11) 3356 2085 or by email: tsandim@demarest.com.br. Mr Peloso can be contacted on +55 (11) 3356 1529 or by email: mpeloso@demarest.com.br.

© Financier Worldwide

BY

Thiago Sandim and Marcelo Peloso

Demarest Advogados

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