Understanding the ‘why’ behind the deal

July 2023  |  SPECIAL REPORT: MERGERS & ACQUISITIONS

Financier Worldwide Magazine

July 2023 Issue

Never has managing transactional risk been more important than in today’s volatile economy. Interest rate increases, geopolitical uncertainty, continuing fallout from a global pandemic and changing demographics are just some of the forces roiling the transaction marketplace.

These forces have rippled through the economy and challenged our perception of ‘normal’ economic conditions. In this context, values are fluctuating and the risk inherent in each deal is magnified. Navigating this environment requires careful planning, familiarity with well-worn strategies and an openness to new solutions.

At the heart of every deal is an investment thesis that should answer the underlying question: why do this deal? An understanding of the answer from both the buyer and seller perspective is essential. The answer to the question can be many things, but it must be clear in the mind of the buyer and seller and understood throughout their respective deal teams.

Whatever the proposition is should inform all efforts around the transaction. For example, a common goal for buyers is simply to purchase a revenue stream. That objective leads to a focus on, among other things, quality of earnings, other deep financial diligence and an exploration of cost savings that may be available through the synergies between the target and the acquirer. In contrast, a deal that is fuelled by a desire to acquire intellectual property, regardless of revenue, would lead to very different diligence. A lack of clarity around the purpose of the deal threatens every aspect of deal execution and severely undermines the probability of success.

Seller goals should also not be assumed. While in many transactions sellers may simply want to maximise the return at closing, in other circumstances the goals may be more subtle. For example, some sellers may be eager to get access to additional capital to grow their business and to reduce the seller’s concentration of wealth around their business.

Such sellers may be excited by a larger rollover equity piece than those focused on cash at closing. Seller goals may also shift at various price points, becoming more conservative and focused on risk mitigation at some price points and being more focused on maximising value at others. Understanding seller goals is essential in understanding risk and how a seller defines risk.

Provided the ‘why’ is clear, a comprehensive diligence plan that is designed to ferret out facts and circumstances that could threaten the success of the transaction is important. Sellers should only start this process after carefully conducting diligence on their own business. Surprises during diligence can be deal killers. Recent events have made it both easier and harder to conduct thorough diligence. Data rooms and zoom calls have streamlined the process and made lengthy in-person exercises less essential.

Nonetheless, most continue to include some in-person component to their investigations reflecting an appreciation of the difference between being with someone in person and only being together via video. Attempting to normalise financial results during a time of dramatic fluctuation is a challenge for today’s dealmakers. Adjustments to financials to normalise earnings are always common. During times of unusual fluctuations, such adjustments that are highlighted in diligence can be significant and trigger differences of opinion between buyers and sellers.

In addition to thorough diligence, deal structure provides a risk mitigation tool. The simple distinction between an asset or stock transaction has profound implications for the risk assumed by the purchaser. To the extent the parties can agree on an asset sale, risk is, generally, reduced for the buyer. Mergers, if structured properly, may also provide opportunities to isolate risk. These structural strategies should be considered carefully in light of applicable successor liability caselaw, specific liability risks identified in diligence, and other factors, such as required approvals and tax considerations, that dictate how a deal is executed.

This is not the first time we have faced rising interest rates, geopolitical uncertainty or economic turmoil. During such times, deal terms have been used to bridge valuation gaps between buyers and sellers and to allocate risk created by the uncertainty. The most common strategies involve increasing the size of escrows and potentially embracing some form of contingent payments. Escrows in private company deals provide the assurance to buyers that resources will be available in the event indemnification is owed by the seller. At points in the economic cycle when indemnification claims may be more likely, escrow amounts typically grow. For example, one recent deal study found that median escrow holdbacks in all private company deals was more than 10 percent higher in 2022 than in 2021.

Contingent payments are a way to bridge valuation between buyer and seller and allocate risk. Whether an earn-out or some other form of payment that is only due from the buyer in the event certain post-closing events occur, such payments provide a framework through which risk can be mitigated for the buyer. The events that trigger a future payment obligation can be as varied as the imagination of the parties.

Regardless of the trigger, it should be subject to clear, objective measurement, time bound and provide for an efficient dispute resolution process. The longer the period for contingent payments and the greater the subjectivity around whether such payments are due, the greater the likelihood that a dispute will emerge. Parties should also consider a fee-shifting provision that provides reimbursement for all expenses relating to a dispute for the prevailing party if such disagreements emerge to discourage immaterial disputes.

Rollover equity provides another way through which sellers retain an interest in the post-closing performance of the business. This can reduce transactional risk for both buyers and sellers by helping to ensure post-closing alignment and providing a hedge on valuation. In the event, through the benefit of hindsight, it becomes clear the seller either over or underpaid, the rollover piece helps to mitigate that risk on both sides. Assuming the seller has been underpaid, the second bite at the apple through the subsequent sale of the business provides a chance to soften the impact of the initial sale.

The emergence of representation and warranty (R&W) insurance over the last decade changed the way risk is allocated in many transactions. The maturation of this insurance market has resulted in more efficient underwriting and reduced costs. Securing such a policy provides the parties with a way to fix the expense for most indemnification scenarios. In a very real sense, by fixing the cost of the risk, actors enjoy a greater level certainty. That confidence facilitates closing transactions. When, as now, risk profiles are evolving, this can be a valuable tool for buyers and sellers alike.

Regardless of whether insurance is used, limitations in the form of caps and baskets also impact transaction risks. Between 2019 and 2022, one recent study found that the number of deals without a basket of amounts of losses under which the buyer would not be obligated to pay indemnification increased from 11 to 19 percent. This reflects that nearly twice as many private company deals in 2022 had no basket at all compared to just three years before.

During the same period, there was a decrease of 6 percent (48 versus 42 percent) of deals where there was a deductible basket. Caps on indemnification liability have also moved up slightly. In 2020, 15 percent of transactions without R&W insurance involved a cap on liability of more than 15 percent of the transaction value. In 2023, that number had increased to 23 percent. The move toward greater risk allocation to sellers reflects the easing of the market and how exuberant markets were in 2019. Using caps and baskets to shape transaction risks for buyers and sellers will continue to be an important tool as we work through this economic cycle.

Fluctuating markets provide opportunities for counsel to add value in ways that more stable times do not. From the earliest days of a transaction in diligence, through structuring and careful consideration of post-closing scenarios, today’s market conditions reward careful lawyering. Those efforts should stem from a clear understanding of why the deal makes sense for both the buyer and seller.

 

Charles J. Morton, Jr. is a partner at Venable LLP. He can be contacted on +1 (410) 244 7716 or by email: cjmorton@venable.com.

© Financier Worldwide

BY

Charles J. Morton, Jr.

Venable LLP

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