What are the fundamentals of deferred consideration on bolt-on acquisitions from a legal, non-accounting perspective?
Backing a private equity sponsor in the leveraged finance market does not mean solely supporting the upfront, headline acquisition. Very often, a great deal of attention is rightly focused on how the lenders will support buy-and-build strategies by way of large, uncommitted lines of debt, known as "accordion", "additional" and "incremental" facilities.
An important aspect of supporting these strategies is to understand the position and treatment of deferred consideration on each and every permitted bolt-on acquisition.
What is deferred consideration in the context of loan agreements? Deferred consideration is the amount of the consideration for an acquisition that is not paid upfront but, instead, delayed to a later specified date or until the occurrence of a particular trigger, milestone or target.
A later specified date may be selected in order to ensure the vendor or management has "skin in the game", or because of the funding pressures on the buyer such that they want to spread the cost of the acquisition.
A trigger, milestone or target may be selected as part of an incentivisation tool for rollover management such that, if the business improves measurable performance on a pre-determined model, then further consideration is unlocked and becomes payable as a kind of reward.
Broadly – and solely as it features in UK mid-market acquisition finance documentation – there are three types of deferred consideration: contingent, non-contingent and crystallised:
- Contingent – the deferred consideration is only payable if specified triggers, milestones or targets occur and, therefore, the amount is not known at the time of the relevant acquisition.
- Non-contingent – the deferred consideration is payable irrespective of conditionality, and is known on completion of the acquisition or is otherwise determinable and measurable.
- Crystallised – the contingent deferred consideration which has become quantifiable and measurable due to the trigger, milestone or target having been satisfied and, therefore, crystallises ahead of its upcoming payment.
Having an uncapped amount of deferred consideration for each permitted bolt-on acquisition is very often not palatable to lenders, as it can distort the accuracy of indebtedness measurements during the life of the agreement, lead to large amounts of outgoings in quick succession if similar quantifiable metrics for unlocking such consideration are met, and potentially encourage less scrutiny on acquisitions due to a "buy now, pay later" mindset.
Due to these well-established lender concerns, it is very common to see restrictions apply in respect of deferred consideration such as:
- A percentage restriction on the amount of deferred consideration as against the total consideration or enterprise value payable in respect of any permitted bolt-on acquisition. This is often focused on controlling the amount of contingent deferred consideration, rather than non-contingent deferred consideration. This is because the latter is quantifiable and accountable upfront and so the forthcoming financial impact is known by all parties concerned.
- An aggregated limit on all deferred consideration outstanding at any time not exceeding x% of earnings before interest, taxes, depreciation, and amortisation or other set amount.
- An obligation that all deferred consideration must be on an arm's length basis, which should go some way to encourage independence of commerce and deter related party acts or other unfavourable outcomes.
- Deferred consideration can be expressly restricted from having a preferred claim on any assets of the business in a downside scenario such as insolvency; sometimes this is qualified to only bite on assets within the lender recourse net or limited to certain amounts sitting in specified escrow accounts. The thrust of this point is to ensure that any third party with a right to receive monies by way of a non-contingent or crystallised deferred consideration payment, is only ever treated as an unsecured and unpreferred creditor of the business, and so, pursuant to the customary intercreditor agreement waterfall of proceeds, will sit lower than the senior secured creditors.
- For permitted payments out of the group to fund such deferred consideration, certification that the group has sufficient cash on balance sheet to meet all contingent and non-contingent deferred consideration payments falling due within the next 12 months following, and pro forma for, the current proposed payment.
- Familiar leakage conditions to be met ahead of payment often include: no event of default at the time of payment or resulting from the payment, and certification of maintenance of financial covenant compliance pro forma for payment of deferred consideration.
These are in addition to any conditions required to be met pursuant to the permitted acquisitions provisions and the incremental, additional and accordion facility provisions.
Treatment in financial covenants
Parties should be careful to ensure that deferred consideration is properly reflected when it comes to the terms "financial indebtedness" and "borrowings" (or their equivalent). The frequently taken positions are non-contingent deferred consideration and contingent deferred consideration which has crystallised. The focus is to ensure that these should constitute group debt when it comes to deferred consideration:
When calculating deferred consideration as debt owed by group members, anything that is contingent and unquantifiable should not be included.
The difference, in this regard, between financial indebtedness and borrowings is that the former only bites on deferred consideration that has become due and payable whereas the latter bites on deferred consideration as soon as it has crystallised which will very often be before it is due and payable.
Financial Indebtedness includes: "any deferred consideration (but excluding any contingent deferred consideration), and for the avoidance of doubt, any earn out liabilities in connection with a Permitted Acquisition and any deferred payment liabilities shall only be counted towards Financial Indebtedness when they become due and payable"
Borrowings include: "any non-contingent deferred consideration (excluding, for the avoidance of doubt, any contingent deferred consideration or any contingent earn-out payment to the extent that the value of such consideration is not capable of being quantified as its value is linked to a pre-determined and targeted level of future growth as measured in revenue generated and/or EBITDA in relation to the main acquisition and any permitted acquisition)".