There are few deals nowadays that do not have a private equity component. With the recent return of trade buyers to the market and private equity houses increasingly turning to trade sales rather than initial public offerings (IPOs), tensions have developed between private equity sellers and trade buyers.
For the trade buyer, making a major acquisition will require a significant due diligence effort involving all functions of management to assess the legal, accounting and regulatory risk as well as planning for integration and the consequences of acquisition.
By contrast, private equity houses generally acquire businesses on a standalone basis, and their concerns on acquisition involve a narrower assessment of liabilities and financial performance. As a consequence, the difference in perspective can lead to a private equity seller’s impatience at the pace of a trade buyer’s review and a reluctance to permit an invasive, drawn-out diligence review.
The increasing use by private equity sellers of “vendor” due diligence reports, in which the seller commissions a firm of accountants to prepare a commercial, financial and legal report on the target, has gone a long way to accelerate the due diligence process. There will, however, always be a residual concern over the report’s objectivity and the limited liability of the accounting firm to the buyer for omissions in the report.
Early and full access to target management is the best way to clarify due diligence queries and avoid misunderstandings that can otherwise get out of proportion later in the process. For the trade buyer, a small and more focussed team with the ability to respond and make decisions quickly will be a much more attractive counterparty to a private equity seller.
Some private equity houses take an extreme position on warranty cover, offering nothing beyond capacity to transact, title to shares and no encumbrances. However, some private equity sellers are willing to offer limited business warranties to facilitate the deal in acknowledgment that trade buyers often cannot, as a matter of internal compliance, accept no or minimal business warranties. Where offered warranties are limited, we recommend to trade buyers a “bring down” due diligence meeting shortly before signing. During the meeting, representatives of the seller and target management orally respond to a standard list of warranties by reference to a set of the data room documents.
Once the scope of warranty cover has been agreed, the quantum of liability—in value and time—is inevitably an issue. On the one hand, the private equity seller cannot offer future recourse against the fund since it will not want to fetter its ability to close the fund or distribute the proceeds of sale. On the other hand, the trade buyer needs to be able to recover on a warranty claim. In our experience, provided the sums are reasonable—typically 5 to 10 per cent of the purchase price—private equity sellers are often willing to entertain the idea of holding it back in escrow for a year or so, especially if they perceive the likelihood of paying out to be low.
However, where the size of an escrow is perceived by the trade buyer to be too low, parties are increasingly turning to warranty and indemnity insurance. It is usual for the seller to bear the cost of the premium. It is worth remembering that the policy only covers undisclosed liabilities— not existing liability or unexpected increased liability. Insurers generally require sight of the buyer’s due diligence report to determine the extent of due diligence, so often a buyer has to commission a more in-depth report than it would normally consider necessary. The warranties in the sale agreement often themselves become renegotiated as the insurer may refuse to cover certain warranties to reduce its exposure.
The seller will naturally try to have as many of the warranties as possible covered by the policy in order to limit its own exposure.
The introduction of warranty and indemnity insurance dramatically increases cost and management time. However, if there is otherwise limited recourse, it is often the only means by which a trade buyer can complete the deal. In these circumstances, keeping a policy restricted to discrete areas of concern is the most effective route.
Post-closing pricing adjustment tends to fall into two categories:
- Full closing accounts: A full balance sheet is prepared to test net assets on closing. Private equity sellers often resist this on grounds of uncertainty of price based on the potential for a buyer to review accounting policies, asset valuations and the adequacy of provisions post closing.
- A reduced set of closing accounts: Only certain assets or liabilities (like working capital) are examined, generally involving a buyer taking on more risk.
There is now an increased use of a third method called the “locked box” whereby the parties fix the purchase price based on a balance sheet agreed before exchange. This allows the buyer to carry out due diligence on the price before the acquisition is consummated, with the intention that disputes after closing are avoided.
To protect the buyer against the seller manipulating working capital in the period from the balance sheet date to closing, the seller will usually agree to repay to the buyer any cash it receives during this period from the company outside the normal course of trading. A lock-box mechanism can only work if a balance sheet has been prepared and approved by both parties. It therefore underlines the onus on the buyer to conduct full financial due diligence, but will give the seller greater certainty about the price it receives as the only adjustment against the seller is if it has extracted cash after the balance sheet date. The process for agreeing the balance sheet and lock-box protections can be long and involved and can bring to light issues that can give a buyer ammunition to reduce the price. However, the benefit for both parties is that the issue of price adjustment is addressed before exchange of contracts.
If a seller is proposing to adopt the lock-box approach, it is essential that the process is very carefully explained to the prospective buyer at the beginning of the negotiation process. A thorough set of accounts must be prepared with supporting data, and the prospective buyer given ample opportunity to test the quality of the data and representative nature of the date on which the accounts are struck.
It is essential for the trade buyer that the target management is involved in the sale process, especially if management is to remain with the business following sale. Interest in the price paid and choice of buyer may not be aligned as ongoing management will want the best possible packages and will not want the buyer to pay too much. In these circumstances, the trade buyer needs to take into account the environment under which management has been operating and be prepared, if possible, to offer equity-style incentives. Similarly, the private equity seller should ensure that the draft sale contract includes suitable provisions preventing (in the event of a warranty claim) a buyer from taking action against a manager on whom the seller may have relied in making warranties in the sale agreement and in preparing data and forecasts of the company’s performance.