As recently as March 15, 2017 (Financial Times), KPMG explained that total market capacity for M&A will increase by 17% in 2017 as companies continue to pay down debt and bolster cash reserves. As a result, sell-side valuations of assets look set to continue to increase. This article explores some of the tools being used by buyers to ‘bridge the gap’ between sell-side valuations and the amount of up-front cash buyers are willing to put at risk in acquiring assets.
The raft of private equity fundraisings over the last five years has typically led to intense competition for perceived trophy assets, pushing up valuations and sell-side expectations as to value. Recognition of the risk of over-payment for assets along with the hard-learned lessons of 2005-2007 has led to increasing sponsor creativity in methods of minimising up-front at risk cash consideration, particularly where an element of the value of a business is contingent on the occurrence of certain events.
In this article, we explore some of the key considerations regarding these arrangements from both a buy-side and sell-side perspective. Please note that this article does not consider the tax implications of these arrangements which are likely to vary from jurisdiction to jurisdiction but rather we have sought to explore the key commercial and legal concerns of a buyer or seller in respect of these arrangements.
Whilst we increasingly see multiple or hybrid forms of deferred consideration arrangements being proposed by buyers and increasing complexity of structures, it is usual for deferred consideration to take one of the following forms:
Vendor Loan Notes: In simple terms, notes issued to a seller from an entity within the buyer’s acquisition structure which obligate such entity to repay the face value of the notes (together with accrued but unpaid interest) at a future date or on the occurrence of a future event (e.g. a future sale or listing of the acquired company);
Earn-Outs: Whilst earn-outs may take multiple forms (e.g. being tied to the performance of a particular asset, contingent revenue stream or similar) a classic earn-out obligates an acquiring entity to make additional consideration payments to the seller in the event that the performance of an asset exceeds a particular floor; or
Rollover Investment: Increasingly, sellers are being offered the opportunity to rollover or re-invest a proportion of their proceeds into the buyer’s structure.
Key Sell-Side Considerations
On any deferred consideration structure, the first question any seller will typically ask is whether the buyer can be relied upon to make any deferred payment or whether the potential default risk makes a deferred consideration element to a proposed purchase price unpalatable (in an auction scenario this will often play out as a debate as to whether an all cash bid in a lower amount is preferable to a bid which has a lower ‘day 1’ cash element but the prospect of a greater overall return).
Whilst, to an extent, legal protections can be put in place to minimise default risk, a seller will ultimately have to make an overall assessment as to the creditworthiness of the buyer. Such an assessment will not purely be reputational but will also require an assessment of the level of leverage being put onto the target business, the amount of equity being put at risk by the buyer and the expected future financial performance of the target business. If, for example, a target business is being acquired at a high leverage multiple and the expected revenue of the target business is potentially inconsistent then a seller may be reticent in agreeing to deferred consideration arrangements, particularly if deferred consideration constitutes more than a de minimis proportion of the purchase price.
In such a scenario, a seller may consider requiring additional assurances to decrease the likelihood of default by the buyer (though, as is shown below, there is no single ‘silver bullet’ solution to entirely remove the risk of future default by the buyer and, given the constraints that such assurances may place upon the buyer, additional protections are likely to be resisted or heavily negotiated by any buyer).
Additional protections around deferred consideration arrangements would typically take the form of: (i) security over target assets (though such security is likely to rank behind any third party debt financing put in place by the buyer so may be of limited value); (ii) guarantees or equity commitments from the buyer which are capable of being called upon in the event of a default (increasingly however, sponsors have shown themselves as unwilling to give such commitments or may simply be prevented from doing so by fund constraints); (iii) call rights over shares or assets in the event of a default (though, as noted above, these structures are often impeded or prevented by the requirements of the buyer’s debt providers); and/or (iv) escrow arrangements (though typically escrows will be unpopular with buyer’s as an escrow requires the buyer to make available and set aside cash at the point of acquisition, which, particularly in a private equity sponsor context, will have a negative effect on the IRR performance of the asset unless an alternative source of escrow funds can be secured).
In addition, it may be possible for a seller to seek to insure against the default risk of the buyer in order to provide additional protection. However, the cost of such insurance may be prohibitive depending on underwriter attitudes to the risk of default.
Oversight and Protection
In the context of earn-out arrangements, sellers will be conscious of the fact that, once the keys to a business are handed over, a buyer may be able to run the acquired business in a way which minimises the risk of an earn-out threshold being met or exceeded (examples of methods which could be used to ‘game’ an earn-out in this way may include, holding back or deferring planned capex on the part(s) of the business which are the subject of the earn-out, transitioning customers onto alternative products or contracts which are not the subject of the earn-out, reducing marketing spend in order to suppress the performance of the relevant area of the target business or simply deferring customer payments until after the earn-out period has expired).
Whilst it is rare that gaming mechanisms are exploited to extremes, any combination of such factors may reduce or even prevent the seller being paid the deferred consideration to which it is due.
As a result, a seller’s legal advisers should consider including some of the following earn-out protections:
(i) Oversight by the seller on the acquired business/the relevant party of the business which is the subject matter of the earn-out. This would usually include an obligation on the buyer to deliver regular financial information (the extent of which should be specified by the seller taking into account the subject matter of the earn-out as this provides a seller with an early warning system for any potential issues and can assist seller in verifying buyer’s earn-out obligations).
(ii) Obligations and parameters on the buyer and the target group regarding its conduct towards the subject matter of the earn-out (e.g. minimum capex, maintenance of marketing spend, obligations not to terminate or materially vary the terms of key customer contracts, restrictions on disposals etc.).
(iii) Consistent financial treatment. Care needs to be taken to avoid different accounting treatment of the subject matter of the earn-out in order to ensure consistency of the treatment of the subject matter of the earn-out throughout the transition of the target group from the seller’s ownership to the buyer’s ownership.
(iv) Appropriate testing/dispute resolution procedures: Whilst it is typical for dispute resolution mechanisms to be included around financial performance and testing, a buyer should consider whether (especially in the context of a bespoke earn-out arrangement) additional ‘external audit’ parameters are included to ensure compliance with the buyer’s post-closing obligations.
This is by no means exhaustive and additional items may well need to be considered depending on the subject matter of the earn-out (for example an earn out relating to a royalty stream on a pharmaceutical product may well require the buyer to maintain patent protection and restrict the buyer from developing similar generic products).
In any minority co-investment or re-investment scenario, a minority investor will require certain protections from the buyer in order to protect the value of its investment. Key amongst these protections will be veto rights on changes to the governance documents of the target (in particular, as regards the economic rights of the investors), anti-dilution and related party transaction protections together with information and board/observer rights in respect of the target group.
Depending on the relative bargaining power of a buyer and seller, a seller may be able to obtain certain veto protections in a vendor loan note or earn-out scenario (i.e. on material business disposals, upstreaming of cash, mandatory payment protections etc.). Such protections are helpful in giving an extra layer of assurance to the seller that there will not be a material leakage of value from the target business until the buyer’s obligations to the seller have been discharged.
Generally a seller will seek to include certain acceleration events as a term of any vendor loan or earn-out in order to ensure that the deferred consideration will be paid on the occurrence of an exit from the target business by the buyer. Whilst these arrangements are relatively straightforward in a vendor loan scenario through prepayment mechanisms, acceleration of an earn-out is likely to require detailed consideration as to the potential effect of an exit throughout the life of the earn-out in order to ensure appropriate testing thresholds for the earn-out as at the date of the exit event (indeed in certain scenarios, the recipient of the earn-out may ultimately determine that it is most appropriate for the earn-out to transfer with the target with the relevant earn-out obligations being transferred to the new buyer).
Key Buy-Side Considerations
In general a buyer will be the first party to put the concept of deferred consideration on the table in any negotiations. Regardless however, once the concept is accepted and the key commercial parameters of the deferred consideration mechanism are agreed, a buyer will likely have two principal concerns around the deferred consideration arrangements:
Structuring: In simple terms, the buyer will need to ask if its acquisition structure is suitable for implementing the proposed deferred consideration mechanism and whether any amendments are required. Whilst this can be simple (e.g. introducing a new vehicle to issue vendor loan notes and to give security) it is often the case where the buyer is using leverage to acquire the target asset that particular carve-outs will be required (e.g. to introduce permitted payments into finance documents to allow for the servicing of earn-out payments or vendor loan interest) and the buyer will need to ensure at the outset that appropriate arrangements are put in place).
Ongoing operational considerations: To some degree, any ongoing involvement of the seller is likely to have an impact on the operations of the target. Such impact may be limited (e.g. where the seller just holds subordinate loan notes in the acquisition structure with limited covenants) but could potentially become disruptive (e.g. in a minority investor scenario where the relationship between the buyer and seller deteriorates following the initial transaction). Whilst the buyer should be careful to ensure that operational control of the target is never impacted by the deferred consideration arrangements, they may also seek certain additional ‘belt and braces’ protections (e.g. buy-out or early redemption rights) in order to preserve flexibility in case the deferred consideration arrangements begin to become a roadblock to the buyer’s strategy for the target business.
With valuations for European trophy assets continuing to rise and European debt markets (other than HY) remaining very liquid, it is likely that the use of deferred consideration structures will continue to grow. While the type of deferred consideration structure will vary from deal to deal, it is clear that, whilst we remain in a seller’s market, sellers will often be able to seek enhanced terms to protect the value of such arrangements.