As far as end-of-year stats go—2015 blew 2014 out of the water. An all-time record was set last year for the highest value of merger and acquisition transactions in the United States with $1.97 trillion—that’s 40 percent higher than the total deal value in 2014.* Mega deals were announced showing industry giants consolidating with other industry giants—Pfizer and Allergan, Dell and EMC, Anheuser-Busch InBev and SABMiller—and setting a string of records for the second-biggest health care deal, the biggest tech deal, the biggest beer deal and the biggest year for overall deal value. Yes, the M&A momentum continued last year in full force, gained strength and barreled right up until the end of December. So now the question is: how long can this deal flow last? There’s no way to know for sure, but there are some factors to consider.
We at Katten—through deals we’ve done and discussions we’ve had with clients—have noticed some interesting behavior, a few possible trends, and several ways M&A participants are getting ahead. Highlighted below are some thoughts on how dealmakers are approaching deals and some trends to watch.
- Owners/operators may be waiting for higher multiples on their assets that may not come. Throughout the past few years, buyers, strategics and private equity funds alike aggressively pursued high-quality assets with clean balance sheets and provable levels of historical EBITDA. Riskier assets—perhaps with historical issues such as regulatory matters, customer turnover and leadership changes—that could be turned around relatively easily with solid management oversight and effective strategic plans also have been scooped up. 2016 looks to be the year of dealing with what’s left. Perhaps there are assets in industries in transition or where there are complex ownership scenarios—qualities that make deals more complicated than normal. Buyers will be less likely to pay high valuations for these assets when leverage is no longer as cheap as it’s been. Owners/operators may need to take a hard look in the mirror and face these realities before continuing to hold out for high multiples that may never materialize.
- Representations and warranties (R&W) insurance policies have become more expensive as the demand for them has grown. Insurance companies may have aggressively priced these policies in the past in order to increase demand in the market, but now that there’s demand for them, we’ve seen premium rates, risk retention and diligence costs go up. The policies are more expensive and in some industries they are becoming harder to obtain. Take the health care industry as an example: risk retention is greater in health care deals, and premiums are going to be greater than in most other industries because insurers do not like insuring against Medicare/Medicaid fraud risk and will price accordingly. Buyers need to prepare for these increased costs.
- Delaware court provides clarity on damage claims from busted M&A deals. The Delaware Supreme Court recently affirmed a trial court breach of contract decision imposing liability for failing to negotiate in good faith and awarding “expectation damages” for the breach. In its holding, the Court made clear that an injured party seeking damages for breach of contract need only prove the existence of the breach with specificity; claims for damages may be made based on estimates. This presumably reduces the burden of proof on plaintiffs, and therefore the cost, making litigation for, among other things, indemnification in an M&A agreement incrementally more likely. A potential ripple effect from this ruling may be that the cost of R&W policy premiums go up as insurers price that incremental risk into their policies.
- Engagement letters between investment bankers and their clients for public company deals may be getting a re-write given recent shareholder litigation. The Delaware Supreme Court recently upheld a shareholder lawsuit ruling that found an investment bank had aided and abetted breaches of fiduciary duty by former directors in a buyout deal, thus potentially increasing the risk for investment banks to be held liable in M&A deals. While shareholder lawsuits against boards of selling companies are commonplace in Delaware courts, deal advisers generally have averted financial sanctions—until now. This ruling, while carefully drafted to be very narrow in its holding, may still serve as a wake-up call for investment bankers that they will be held accountable for knowingly giving conflicted advice. Given the holding, bankers and boards should consider how to redraft the language in engagement letters to better address potential conflicts of interest before putting deals together.
- More family offices are co-investing with private equity firms. In the past, a family office may have snatched a good investment away from a private equity firm (and vice versa), but now they’re joining forces. Family offices typically don’t have as deep of pockets as private equity firms do. At the same time, many family offices have hired former private equity executives who are familiar with the landscape and the personalities of the middle market. As a result, many family offices are realizing the benefits of combining their capital with traditional funds to acquire a minority stake in higher grade assets than what might ordinarily be available to them if they invested by themselves. On the other side of the coin, private equity funds may find real value in working with family offices as they often tend to stay close to home in familiar industries where they retain keen insight, making them potentially valuable board partners. Symbiotic friendships may continue to blossom between these two classes of investors.
- Closer scrutiny of settlements of frivolous strike suit claims by the Delaware Court of Chancery may result in more claims being thrown out and more narrowly tailored releases for claims that settle. Corporations have bemoaned the virtually automatic filing of strike suits after M&A deals are announced, and the subsequent settlement of these lawsuits for attorneys’ fees and additional disclosure with no economic recovery for stockholders. Last year the Delaware Court of Chancery began rejecting such settlements and dismissing cases. In the case of one recent rejected settlement, Vice Chancellor Laster stated: “We have reached a point where we have to acknowledge that settling for disclosure only and giving the type of expansive release that has been given has created a real systemic problem.” While this pushback against “deal tax” litigation is generally beneficial to corporations, it also has a downside. Defendant corporations understand that the Delaware Court of Chancery is increasingly focusing upon settlement releases tied to claims that have been adequately alleged and thus should no longer expect to receive broad “intergalactic releases.” For companies that have adopted a Delaware exclusive forum bylaw, the willingness of some members of the Delaware Court of Chancery to reject “fee-only” settlements increases the potential for frivolous claims to be thrown out or not filed. For companies that do not have such a provision, plaintiffs may push for settlements outside Delaware in order to avoid scrutiny from the Court of Chancery.
Based on lessons learned from economic patterns in 2001 and 2008, the question that now hangs in the air like an ominous storm cloud is: does this zenith spike in M&A deals signal an impending correction in the M&A markets like it did in the past? And if so, how big and how long? Or will we have another momentous year of deal flow before any sort of tapering off begins? Will this be the year that strategics pull back and consolidate their recent activity, leaving a more wide-open playing field for funds and fundless sponsors? Or will they continue to deploy their still record-level cash balances on M&A strategies? If fundamentals are weak and costs have already been cut, in what direction will companies turn for profitability? Or does the Fed’s interest rate increase signal a positive economic outlook where corporate earnings will grow stronger?
Whatever happens, those that have best prepared in advance for possible shifts in the M&A landscape will be best positioned to succeed—remaining nimble in order to buy, sell, merge or hold. We understand that acting instead of reacting in the face of change can create new opportunities and we can help you successfully navigate them.