Volatile economic markets in 2009 were a key contributing factor to the decline in size and number of M&A deals completed during the year. These market conditions influenced deal tactics and structuring, with reduced appetite for risk on the part of buyers and the far greater potential for systematic underlying risks being reflected in a renewed focus on integrated and risk sensitive due diligence and some refinement and adaptation in the approach taken to documenting and structuring acquisitions.
The effects of the Global Financial Crisis have not been uniform and whilst no region has been immune to these economic pressures, the Asia-Pacific region (due largely to the moderating climate provided by China’s influence) has fared better than the rest. However, given the increasing integration of economies and growing number of cross border acquisitions, market trends from other regions are worthy of consideration.
Calendar Year 2009 saw the number and size of M&A transactions shrink globally with total M&A activity down by over 25 per cent in volume and value terms when measured against 2008 levels.
The realisation by buyers that they could inherit risk far greater than the perceived upside on a transaction made them more cautious, with a renewed focus on integrated legal and financial due diligence investigations of targets.
The nature of the active buyers has also changed dramatically. Private equity firms were in retreat and sovereign wealth funds (SWFs) and state owned enterprises (SOEs) were mandated to acquire assets globally. However, many of these new investors lacked the experience and evaluation techniques which had been developed by the private equity firms over the period before the crisis.
M&A statistics in 2009
In 2009, aggregate European M&A deal value was in the region of US$474 billion, a 35 per cent decrease in value and volume terms from 2008. Tellingly, these European deals made up only 27 per cent of global activity by value and 37 per cent by volume, down from the 43 per cent share the region enjoyed in 2008 according to both measurements.
The Asia-Pacific region by comparison held relatively steady, with 2009 seeing in excess of 2,200 deals announced representing a modest 5 per cent decline in volume terms from 2008 but a 6 per cent rise when measured by value, a sharp contrast to the global falls of 27 per cent.
The increasing importance of Asia-Pacific to global deal making also continued to accelerate in 2009 with the region contributing some 24 per cent of worldwide M&A activity during 2009 compared to just 16 per cent in value and 18 per cent in volume terms in 2008.
M&A transactions over the past year
To a varying extent, 2009 saw a continued shift across the global M&A market away from the distinctly seller-friendly market of the pre-crisis, 2006-2008 period. As they have become increasingly risk averse, the changing landscape has afforded acquirers a more favourable environment in which to push for greater deal protection and certainty because of the decreased level of competition for assets.
How has this been reflected in the way transactions are being done?
SOEs, SWFs and the need for experience
Many of the new sources of capital may have little or no previous experience in running the types of operations they have been acquiring. In addition, many of the target assets require significant capital expenditure on infrastructure and deep capital commitments over a long period of time.
These factors have led to some transactions being structured as partial acquisitions with joint venture or placement and offtake arrangements and accompanying board representation and finance arrangements. Experienced staff can be seconded into the joint venture while the joint venture partners can structure capital requirements to fit their own structures while retaining some of the likely capital upside of the deal.
Price, price adjustments and deferring the purchase price
In European transactions, with fewer buyers in the current market with access to credit, sellers are faced with receiving lower prices for their assets, with buyers increasingly concerned to avoid paying “over the odds” in markets where the success of an investment can not be assumed. By using an earn-out or deferred/contingent payment mechanisms in the calculation of the purchase price, buyers seek comfort that assets are realistically priced. Such mechanisms are being used with greater frequency in European M&A transactions.
In a shift back to pre-boom deal features, European buyers are increasingly insisting on the preparation of completion accounts rather than submitting to the more seller-friendly ‘locked box’ mechanism, which became a tool popular in many European and US private equity driven sale processes.
The locked box is a mechanism through which the parties agree a price payable for the target company based on accounts (often unaudited) drawn up to a date prior to signing. The “box” is then locked by the seller giving indemnities or undertakings not to extract dividends or any other form of value from the target group prior to completion of the deal.
The advantage for the seller of this mechanism is that it gives certainty as to the determination of the price, with little ability for the buyer to reclaim value after completion. It also leads to a quicker process of execution, with no necessity to draw up and agree completion accounts. However, such a mechanism places the onus firmly on the buyer to conduct detailed financial due diligence in advance of signing.
Even during the headier seller-friendly times, the ‘locked box’ approach was not something widely used in M&A deals in Asia. However, the use of completion accounts to verify assumptions underpinning the pricing of deals is becoming increasingly prevalent.
In Europe, reflecting the “distressed” nature of some sellers, there has been a rise in the use of retention or escrow accounts for safeguarding money in case of a claim under the warranties or other parts of the sale documentation. In that context, the retention account route has brought new concerns, these being that the escrow money will usually only attract very low interest rates and parties have had to consider the risk of bank default as a real possibility rather than a theoretical risk.
There has also been a return to ‘Clawback’ and ‘Put Options’ in the event that the fundamental terms of the deal are not fulfilled.
Focus on warranty protection - restricting claims
Historically, the cap on the seller’s liability for breach of warranty claims was usually equivalent to the consideration paid (and in some cases could even extend to the value of target group debt assumed or refinanced by the buyer). In the strong seller market, these caps became a percentage of the consideration paid. However, these percentages have been creeping upwards in recent transactions, reflecting the increased deal risk being perceived by buyers. Warranties addressing title to shares and other fundamental concerns such as capacity and authority to sell continue to remain subject to the highest cap (usually 100 per cent. of consideration received). Perceptions of deal risk have also seen buyers reducing the level at which small claims can be brought (so called “de minimis claims”) as well as the aggregate thresholds for bringing claims (the so called “basket”).
European transactions are also witnessing a re-appearance of the tax deed on most transactions, reversing the trend which saw them frequently specifically excluded in seller driven auction processes. Whilst not traditionally as widely used in Asian transactions, tax indemnities are increasingly becoming a feature of cross border deals in this region particularly where the transaction includes European parties on the buy or sell side.
Is the auction route still a popular choice?
The seller-driven auction sale process evolved in a market where there was a proliferation of buyers and no liquidity problems. Despite the reversal of these market conditions, auctions remain the preferred method of sale for sellers globally. However, in both the European and Asian markets, whilst these processes continue to be competitively run, sellers can expect to be required to be more generous with the documentation and the process.
A seller contemplating using this process is now more likely to have to be more realistic and flexible in terms of the timetable; it must test the “deliverability” of the buyer carefully, particularly on financing aspects, and expect that the documentation will end up reflecting a more level playing field. With the number of buyers decreasing, sellers need to maintain their flexibility to ensure the competitive tension remains in the process.
Buyers are clearly less prepared to accept the high levels of risk that were necessary to succeed in the previous seller friendly environment and whilst they may have little choice but to participate in an auction process if a seller elects to run one, they have shown a greater willingness to walk away from a process if their concerns are not resolved prior to signing.
Will alternative processes to auction sales emerge?
In 2009, the “go shop” clause (a US private equity invention) came to the notice of the European market by virtue of the press coverage surrounding the sale by Barclays Bank of iShares. The Barclays “go shop” model followed that used in the high-profile sale of La Salle Bank Corporation by ABN Amro to Bank of America in 2007. A “go shop” clause effectively permits a seller, once it has broadly reached agreement with a buyer, to try and identify, within a prescribed time frame, any other parties who might be prepared to enter into a transaction on similar or preferred terms.
In the iShares deal, once a binding £3 billion bid by CVC had been agreed, Barclays had a further 45 day period in which to find another bidder who would offer more than CVC. For CVC, the advantage was the negotiation of a deal on its own terms (rather than those dictated by an auction), with the relative “luxury” of following a competitive auction from the sidelines. For Barclays, it had the opportunity to confirm whether the price struck with CVC represented the maximum it could achieve for its shareholders.
The creation of such mechanisms is, in part, a reaction to the expense and time involved in running or participating for an auction transaction and so it remains to be seen whether “go-shop” provisions will catch on more in European acquisitions in 2010 and/or see their use in the Asia-Pacific market or indeed whether other devices such as matching rights or topping up mechanisms will increase in popularity.
Will the market for warranty insurance develop?
In Europe, sellers have increasingly been turning to insurance brokers for cover specifically designed to deal with warranty claims. The European market for specialised insurance has seen an increase in enquiries and of insurance cover being put in place, particularly in respect of transactions where non-core assets are being disposed of or in distressed sale situations. Separately, buyers have themselves been looking to obtain cover against less financially reliable sellers and to supplement the scope of the warranties being obtained.
Whilst the market for specialist warranty insurance in the Asia-Pacific region is not currently as developed as in Europe, the sector has been expanding in recent years in response to a growing demand triggered by the current economic climate. Insurance providers in the region have responded to the increasing number of queries being received from interested parties by making available a greater variety of tailored products and there is increased take up of such products.
Finally - ability to walk away?
In the uncertain European market, buyers have become more likely to seek widely drafted material adverse change clauses addressing market disruptions rather than defined events specific to the target group. This is a trend which has emerged particularly in the context of termination rights used in acquisitions in the financial institutions sector. In addition, to the extent that any external financing is obtained in relation to an acquisition, buyers require this protection so they can provide the lending banks with a similar MAC style clause as a condition precedent to drawdown. In the previous benevolent lending environment, buyers were invariably required to take “financing” risk with sellers unwilling to accept any execution risk around the buyer’s ability to finance the transaction.
This trend is very much in the same direction in the Asia-Pacific region with the long waiting periods which may be required between signing and completion for receipt of regulatory or anti-trust approvals, making binding finance increasingly difficult and expensive to secure.