Allen & Overy's annual study of the private M&A market - based on in-depth analysis of more than 1,000 deals we've advised on over the last seven years - showed growing levels of auction activity in 2018, with confident sellers gaining the upper hand on deal terms.
Increase in auction activity
Auction activity has increased steadily over recent years. But in 2018, for the first time, more than half the private M&A deals we advised on were conducted as auctions, with the figure rising sharply from 41% in 2017 to 53% last year. Sellers will only contemplate an auction if they believe they can attract significant competition for their assets, so this was a strong indicator of market confidence.
PE funds continued to win a high proportion of auctions some 46% of those in our sample. Part of this success comes from a continuation of strategies that emerged a number of years ago. Buy and build, for example, means that many sponsors already have large portfolio companies they can merge targets into, achieving synergies that allow them to compete with strategic bidders on price. Last year, 60% of the auctions in our sample that were won by a PE bidder were bolt-on transactions of this type. Many more represented the first stage of a buy and build strategy an initial investment to which further businesses would be added.
Despite their dominance, PE funds are now facing greater competition for assets as the universe of potential buyers expands. While sovereign wealth and pension funds were once happy to invest through, or alongside, PE, some have now established teams to source and execute deals in their own right.
Execution risk rises
Our analysis over recent years has shown the deal environment becoming riskier, with transactions more likely to require antitrust, foreign investment or regulatory clearance. This is mostly down to merger control regimes becoming stricter and more numerous, foreign investment regimes getting tougher, and regulators becoming more active. However, it may also indicate that buyers are receptive to doing riskier deals something that typically happens in a maturing M&A cycle.
Execution risk continued to rise in 2018, with 85% of our deals worth more than USD250 million requiring some form of clearance an increase of 8% on the previous year.
This means that, in reality, most sellers now have to accept some conditionality. Last year, they seemed willing to do so where the substantive risk of a failed deal was low, particularly if the buyer backed its `low risk' assessment with an element of deal protection.
Protections are typically either financial or behavioural, with a reverse break fee payable by the buyer to the seller the primary example of the former. Last year, 13% of our conditional deals provided for one of these, with the average fee some 6% of deal value.
On the behavioural side, "hell or high water" commitments are increasingly common. These require a buyer to take all necessary action to get clearance, and last year 26% of the deals in our sample with an antitrust condition included one. PE sellers, in particular, insisted on them.
Digital transformation leads to more earn-outs
Companies across sectors are increasingly using transactions to speed their digital transformation programmes or to `acquihire' talented individuals with important digital skills. As a by-product of this we saw a rise in the use of earn-outs, designed to retain and incentivise founders and management shareholders or to share risk and reward in a new technology.
Sellers gained an increasing upper hand in the private M&A market in 2018, but that only becomes truly apparent when you look closely at changes in deal terms.
These include mechanisms designed to delay the passing of risk to the buyer ahead of closing such as material adverse change provisions, pre-closing termination rights for material breach of warranty, and warranty repetition (giving a buyer the right to claim damages if a warranty is incorrect at closing). Globally, we saw a sharp decline in the use of the first two mechanisms and a slight decrease in warranty repetition during the year.
We've also seen warranty cover diluted (including by more data room disclosure and consequential loss exclusions, and high levels of materiality and knowledge qualifiers), lower financial caps on the seller's liability, and shorter terms for transitional services arrangements.
Taking a global view ignores the inevitable differences between market practice in different regions, but it does show the balance swinging in favour of sellers. As we move through a potentially far more uncertain M&A market in 2019, it remains to be seen whether that advantage will hold or if buyers will begin to push harder on deal terms in the months ahead.
W&I insurance continues to grow
Over the last few years, we have seen an explosion in the use of warranty and indemnity (W&I) insurance in PE exits. This trend continued in 2018, with the product used in some 70% of the PE exits we advised on globally.
W&I insurance started in Australia, but quickly caught on in the UK and Western Europe the regions where it remains most popular. Although later to the party, the U.S. is now seeing greater use of W&I insurance though premiums tend to be considerably higher. Even in markets where it remains a newer phenomenon, like MENA and Asia, the product was used in around half of our PE exits last year.
All around the world, parties take a more selective approach to W&I insurance outside of PE exits. In 2018, it was used in just 16% of our deals with non-PE sellers.
We're seeing interesting innovations in the W&I market. Some of these like movement on previously standard exclusions, and synthetic elements of cover are largely driven by increasing competition between insurers. But the biggest change has been the move towards so-called "stapled W&I", with sellers going to market with a 100% insurable sale and purchase agreement, underwritten on the basis of vendor due diligence and on condition that specified checks are carried out on the buy-side.