Although 2010 commenced with somewhat lacklustre M&A activity, with activity in the June 2010 quarter being lower than in the December 2009 quarter, a late flurry of transactions in the second half of 2010 resulted in a record-breaking year in which Australian M&A exceeded US$100 billion for the first time.
Private equity stages a slow return
Private equity deals comprised a significant portion of Australian M&A activity, with the number of exits and trade sales increasing from the previous year.2 In particular, the number of trade sales more than doubled from 9 in 2009 to 22 in 2010 – this was the most popular exit mechanism for 2010.3 Fundraising remained relatively flat in 2010 and for the first time since the 2003 financial year, capital invested by private equity and venture capital funds exceeded the total funds raised by these categories in the same year.4
In terms of key industries, the consumer goods and retail industries received a large portion of private equity investment, with energy and environment also being heavily invested in.5 This focus on the energy and environment industry was reflective of a global trend of significant investments in the energy and resources sector.6
Key drivers of increased M&A activity
A large force behind the increased M&A activity in 2010 was the general view held by private companies that the Australian economy is well into recovery mode and is, in fact, on the upward curve of the economic cycle.7 Medium and long-term business prospects for Australian private companies are considered to be good or very good, and the proportion of private company owners considering an exit over the next 3 years has doubled from the previous year.8
Private M&A deal trends emerging from 2010
Steadier and stronger valuation multiples
Business valuation multiples are now considered to be around long-term averages,9 particularly in relation to targets in the mid-market (with a turnover of $5 to $15 million).10 However, the table below indicates that in the wider Australian M&A market, multiples have varied widely in the period from December 2009 to September 2010, although high multiples have consistently been paid in the energy and materials sectors.
No significant change in access to funding
Despite the lower interest rates following the global financial crisis, funding in Australia remains difficult to access and is still a significant restraint on M&A activity as many lenders are still operating with tougher lending standards and higher risk margins. In the UK, the certainty of funding has risen to some degree and banks seem to be more willing to lend. There were also some significant loans in the UK in 2010, including a recent €2 billion loan to CVC to finance its acquisition of Sunrise, a Swiss-based mobile phone operator.11
Risk management remains a top priority
With the global economy still on the mend, comprehensive risk management is top priority, as reflected in the following trends:
- (Warranty claim periods) warranty claim periods remain higher than those prevalent prior to the global financial crisis, with the majority of warranty claim periods ranging from 18 months to 5 years. It is rare for warranty claim periods (other than in relation to tax warranties) to extend beyond 5 years. In American private company M&A transactions completed between July 2007 and July 2010, warranty claim periods were generally between 12 to 18 months and only about 15 per cent of deals had claim periods over 18 months. In recent years, warranty claim periods in European private target transactions have generally been between 12 months to 24 months. Only a very small percentage of warranty claim periods in European private target transactions were over 24 months
- (Warranty claim periods – carve-outs) common carve-outs which survive or have extended warranty claim periods have not materially changed and continue to relate to tax, title, authority, fraud and breach by the seller. These carve-outs were also common in US deals between 2008 and 2010 and reflect the general trend in European private target deals (Monetary caps on warranty claims) in the majority of Australian deals completed in 2010, caps on warranty claims were equivalent to the purchase price or a significant percentage of it. In contrast, only about 5 to 10 per cent of American private target deals completed between 2008 and 2010 involved a warranty cap equal to or greater than 50 per cent of the purchase price. Caps on warranty claims in UK deals were historically equal or close to the full purchase price, however, these have recently followed the US trend with claims for warranties other than title and other fundamental warranties being capped at around 50 per cent of the purchase price in most cases.12 It has also been recently noted in UK deals that there is an increasing use of different caps for different areas of risk, such as tax, environmental or regulatory13. In the broader European market, warranty claim caps are smaller and are generally between 10 to 50 per cent of the purchase price
- (Warranty baskets) the trend of lower baskets (being the threshold for aggregate claims before a warranty claim can be made) we previously identified14 remains applicable in Australia and America, with baskets between 0 to 1 per cent of the purchase price being favoured. In the UK, baskets are generally between 0.5 per cent and 1.5 per cent of the purchase price
- (Specific indemnities) in Australian deals, the most common specific indemnity is in relation to tax liabilities. However, in American deals, the trend appears to be that specific indemnities are given with respect to payments to dissenting shareholders (78 per cent), tax liabilities (61 per cent) and transaction expenses or change in control payments (55 per cent)
- (W&I Insurance) the use of warranty and indemnity insurance (W&I Insurance) in Australia continues to increase.15 Some attribute the increased interest in W&I Insurance to UK-based insurers having a greater appetite for Australia/New Zealand risks, which has resulted in pricing and coverage offered in Australia which is in line with the UK terms.16 In particular, premiums have reduced from approximately 3 to 5 per cent of the insured limit to approximately 1 to 2 per cent of the insured limit. The increased use of W&I Insurance has seen the creation of more innovative insurance structures to meet the wide range of insurance demands17
- (Tax Insurance) tax insurance is slowly being introduced into Australian transactions, with global premiums decreasing as expertise in this field has improved. Insurance policies of this nature, which cover tax liabilities, have primarily only been placed for UK, US, European and Australian risks to date
- (Material adverse change) a condition precedent involving no “material adverse change” is now the norm in Australian transactions. The typical definition of “material adverse change” in Australian deals includes a forward-looking element, generally by reference to the prospects of the target. In contrast, only about half of American private target transactions in 2008 to 2010 included a “material adverse change” condition precedent, and only about 25 per cent of these incorporated a forward-looking element in the definition of a “material adverse change”. The position in Europe is in between the Australian and American positions, with the material adverse change condition used in about half of European private target deals and a forward-looking element included in the definition of material adverse change in about half of these deals.
Earnouts continue to be employed quite often in private M&A transactions, particularly as there is a lack of publicly available information regarding private targets and uncertainty around valuations. Accordingly, buyers are keen to see evidence of the performance promised by the seller and/or the achievement of key milestones. In America, however, only 25 per cent of private M&A deals in 2008 to 2010 employed an earnout mechanism.
Earnout periods in Australian private M&A deals are commonly greater than 12 months, with an earnout period of more than 5 years being quite rare. In comparison, the most common earnout period in American private M&A deals is greater than 5 years (about 30 per cent), with the second most common earnout period being between 12 and 24 months.
Deals appear to be on longer timetables in Australia, with the typical deal timetable extending from about 8 to 12 weeks to 16 to 20 weeks. This is indicative of buyers being more cautious and completing more thorough due diligence.
Buyers still too cautious for locked-box mechanisms
The cautious approach of buyers is also evident in the regular use of completion accounts, as opposed to locked-box mechanisms.
The locked-box mechanism involves fixing the purchase price based on accounts as at a date prior to the execution date. The sellers must then covenant that no “leakage” of value from the target will occur from the accounts date. Broadly speaking, “leakage” refers to cash flows or other value transfers to the benefit of the seller, such as dividends. The locked-box mechanism favours the seller by providing price certainty – the buyer, on the other hand, must rely on accounts which are often unaudited and must ensure that the accounts date is sufficiently reliable and that “leakages” are comprehensively identified, defined and warranted. Completion accounts, however, are a buyer-friendly mechanism and permits the buyer to review the accounts in the period after completion. Fluctuations in working capital or other parts of the balance sheet are generally addressed by post-completion adjustments to the purchase price or a claim made by the buyer.
The preferred exit strategy employed by private equity funds in 2010 was by trade sales,18 however, secondary sales were also popular, particularly in the latter part of the year. Looking forward, the exit strategy most likely to be pursued by private companies is a sale to an independent third party (22 per cent), closely followed by sale to a competitor (20 per cent).19
M&A sentiment for 2011
There appears to be a general consensus in the Australian private company arena that M&A activity is expected to increase in 2011, however, it appears that there was more optimism around M&A market growth at the conclusion of 2009 than at the end of 2010. Energy and resources is widely tipped to be the sector of choice in 2011, with a diverse range of acquirers being expected.
Private equity activity has been the subject of particular recent interest, with the big private equity bids by TPG and Carlyle for Healthscope and KKR for Perpetual in 2010 being lauded as the start of a flood of private equity activity. Significant sell-side activity by private equity funds is also expected, as funds look to exit portfolio investments held through the global financial crisis.
There appears to be a renewed confidence in the Australian M&A market and it will be interesting to see the multiples paid in this optimistic period, given the wide variation evident in the period from the end of 2009 to September 2010.
Notwithstanding the positive sentiment about the Australian market, it is still advisable to proceed with caution, given that the economy is still in the recovery phase. Tough warranty regimes are likely to be sought by buyers and W&I Insurance may be a valuable tool for sellers looking for a clean exit and buyers seeking protection in an uncertain environment.