While for some years, profitable and market leading private equity backed companies pro-actively pursued acquisition opportunities in the U.S., U.S. buyers are increasingly looking to Germany and other parts of Western Europe for deal opportunities. Deal appetite of U.S. strategic and financial buyers has significantly increased in Germany in the last two years and as a result the German market for M&A and leveraged buy-outs has become increasingly vibrant and competitive. This article discusses these trends, reasons and associated deal terms.
The business and legal environment for eyeing German M&A and PE target companies
Increased participation of U.S. buyers in the German M&A markets has resulted in several deal trends. German market players in PE and M&A have reported this year less deal flow and a shortfall of real opportunities to close deals due to very high price expectations from sellers across all industries. Nevertheless, capital markets continue to apply different valuation metrics when comparing U.S. and European peer companies. This valuation difference affects the private M&A market and its dynamics across the Atlantic. With PE backed businesses in the U.S. enjoying fairly superior acquisition financing terms, this valuation arbitrage gives U.S. buyers a notably strong competitive advantage when bidding for German or European enterprises, whether acquired stand alone or as part of a buy and build strategy.
German management teams have taken note of these factors. While the German market has always been a good source of know-how and management capability, the top talented German teams now often pro-actively reach out to U.S. funds to team-up on transactions, whether primary or secondary leveraged buy-outs or add-on acquisitions. Further, even exits of small to mid-cap German companies are increasingly marketed through structured auctions, so bidders can be approached on a more international level. Depending on the industry of the target, a strong U.S. presence and network is often crucial for the selection of the corporate finance advisor running the auction as sellers want to make sure that U.S. parties know what is up for sale.
The flip-side of asking bidders to pay at the top end of the price range is that the buyer may need better contract terms. This might sometimes require a potential buyer to walk away from so called “market” legal terms since for the bidder with the best pricing there is a need to fairly balance the deal risks versus the offer. Top line prices might therefore come at a rather intangible cost for sellers, e.g. accepting broader sets of reps and warranties, higher caps and lower baskets, longer periods of limitation, bigger escrows with a longer duration and other buyer friendly terms. As always in business, the principle of “quid pro quo” applies. On the other hand, in very competitive deal markets, buyers that are tapped out on price can seek to compete by offering better contract terms.
Mitigating the risk of cash and working capital shortfall post acquisition
A common practice during the hot deal market before the financial crisis in 2007, in particular in German or European deals, was the use of a fixed purchase price based on historic accounts and financial data, also called “locked-box deals.” This pricing structure is still often claimed as market practice by sellers irrespective of deal size. Whether or not the revenue of the target company experiences seasonality, buyers want certainty as to cash and working capital levels when paying top end prices. Even when leveraging smaller add-on acquisitions, the financial covenants of the acquiring group are often fairly tight, increasing the need for certainty as to working capital levels at close. That is why we have seen in most M&A transactions in the last two years the “classic” closing balance sheet with a comprehensive adjustment mechanism post-closing dealing with cash and working capital items forming the closing balance sheet. A fixed purchase price, even with a satisfactory leakage clause, puts the burden of initial cash funding on the buyer, which may turn into an unforeseeable and material risk of underfunding. It will be interesting to see if a continuing strong M&A market will result in a return to aggressive locked-box pricing structures, or if the more balanced current practice prevails.
Bridging valuation gaps – vendor loan, equity roll-over, earn-out
Differing views of sellers and buyers on price can be bridged by various deal strategies. In “all equity” deals, a subordinated loan granted by the seller or even by the target company to the acquisition vehicle/purchaser can bridge a price gap. Often, such vendor loans also contain an acceleration clause that requires prepayment of the loan in case the buyer sells its new asset quickly. In typical leveraged PE deals, however, a vendor loan is often an issue since the third party lenders will require it to be strictly subordinated and unsecured. To accept those terms, sellers may demand a high interest rate. Unless interest is accrued or paid in kind, this reduces cash flows which would otherwise be available to service the senior debt. Financing banks will take these issues into account in their financing models, so sometimes it might be more advisable to increase the equity component or senior debt than using a vendor loan.
Price gaps can also be bridged by offering an equity roll over to the seller. Whilst the typical equity roll over is commonly used to retain top management after the sale of a company, this structure can also be used for selling majority shareholders, if the control over the target company will remain with the new owner.
Earn outs are also sometimes used to bridge a price gap. The typical earn out clause obliges the acquirer to pay one or more deferred purchase price installments in case the target company reaches certain milestones. Such milestones are mostly financial targets, which are material for the pricing in the first place, i.e. reaching certain revenues, EBITDA etc., or even continued service of a key selling shareholder as a manager. In negotiations about price, earn outs often appear as the “magic bullet”, seemingly providing a great win-win solution for buy and sell side to bridge a price gap. The serious consequences of such a “perfect” compromise often show only later. Understandingly, the seller will ask for a broad set of covenants to ensure that the buyer will not manipulate the results of the target after taking control of the business and ensure that the business continues to be operated in the ordinary course as conducted in the past. This might hinder the buyer from properly integrating the newly purchased business leading to a potential underperformance of the acquired asset and result in a failure to meet the earn out targets. In particular, earn out periods that run longer than a short period after closing can be dangerous territory for both parties. Buyers and seller must carefully consider whether a proposed earn out structure is the best way to bridge a price gap.
Price Component “Cash at Closing” – where cash might be no king but only a ghost
Companies in particular sectors enjoy business models where customers allow them to collect cash up-front but the business will only need to pay its suppliers much later (negative working capital). Working capital adjustment formulas and respective peg amounts must be set up accordingly to reflect such models. In these situations, parties will always need to discuss how to deal with cash in the business at closing that was received as pre-payments from customers before signing/closing. As many business models from internet trading companies are based on such pre-payments from customers, these issues now increasingly arise in M&A deals. Sellers of such companies may also be motivated to increase sales and pre-payments by special offers in the hope that such cash received will be treated as collected in the ordinary course of business when computing the equity value of a business. Buyers have to check carefully if cash and prepayment levels are excessive and out of the ordinary and agree with the seller how such cash shall be treated. The main issue is that cash from prepayments has not been properly “earned” yet since the delivery of the goods or services is still outstanding. After closing, the buyer as the new owner of the target company will be responsible for the delivery of the prepaid goods and also for potential warranty claims of the customer. Depending on the business to be sold, pre-paid cash could be considered as cash only partly or not at all. It is advisable for each buyer of an internet revenue based company to investigate the topic in its financial due diligence. Buyers will look in particular at current trading and compare it to historic financial data. They will also ask for frequent updates of this data before signing to mitigate the risk that cash paid to the seller as part of the purchase price later turns out not to be free cash but only a ghost.
U.S. based PE funds and companies leveraged under U.S. senior debt terms might look at a bullish forthcoming year 2016 to pursue M&A opportunities in Germany, if not Europe. Based on the stock market valuation arbitrage and better financing terms they benefit from a continued competitive advantage on pricing terms. Nevertheless, the key business and related legal terms require a most diligent and careful handling towards completion. Sellers in Europe might need to accept less advantageous deal terms when seeking high valuations.