When there is unpredictability in the air, risk allocation is the name of the game when it comes to negotiating M&A transactions. While the market for M&A has been record-breaking on most accounts in recent years, geopolitical turmoil, increased inflation, the stock market turning bearish, and rising regulatory enforcement all contribute to an atmosphere of growing uncertainty. A landscape of uncertainty does not mean that buyers’ appetite for strategic acquisitions will dry up entirely, but rather that buyers will look for techniques to employ to allocate risk and increase their scrutiny of target companies. This article will discuss the current legal and deal landscape and discuss a potential shift in the market. This article will then analyze potential techniques and deal terms that may become more popular as we enter an unknown future regarding mergers and acquisitions.
Legal and Economic Landscape
For dealmakers (and their attorneys) 2021 was the best year on record for global M&A, with more than 60,000 publicly disclosed deals and the aggregate deal value breaking $5 trillion for the first time. Since then, M&A activity in 2022 has slowed from its rapid pace in 2021. The value of the global M&A market fell by nearly 20% to $2 trillion in the first half of 2022 compared to the same period in 2021. The total deal market is likely to fall further as economic fallout is reflected in global markets, according to PwC’s “Global M&A Industry Trends: 2022 Mid-Year Update” report. Looking forward, M&A deals are facing the most uncertain and complex environments in recent memory.
We have already seen in 2022 that certain headwinds will have some tempering impact on deal activity—rising inflation and interest rates, once-in-a-lifetime supply chain and labor challenges, the war in Ukraine, and Russian sanctions, to name a few. Adding speed to the headwinds, the Biden administration has indicated that it expects to pursue and adopt policies that could impact M&A in certain sectors of the economy (e.g., new pro-enforcement approaches to antitrust, increase in infrastructure spending, and adoption of laws to address climate change, such as the newly minted Inflation Reduction Act).
But as the year progresses and worries about a recession grow, the appetite for deal-making has hardly disappeared. One driving force is that private equity firms still have large amounts of dry powder. According to the PwC report, lower company valuations will provide investment openings for both strategic and private equity players to generate desired returns in an unpredictable market. There is an enormous amount of economic incentive to acquire the right kind of target on the right terms. Instead of a stark overall decline in the M&A market, we expect buyers to hedge their bets and shift risk away from their investment using some old and newer techniques.
More Earnouts
An earnout is a contractual provision that provides for contingent future payments to the seller if the business achieves certain performance or financial goals after closing, i.e., sellers must “earn” part of the purchase price. Earnouts can be a useful tool for buyers and sellers with different views on the value of the business, expected growth or future performance, as it allows them to avoid difficult purchase price negotiations at the time of closing. Ultimately, an earnout is an allocation of risk that is borne by the seller who expects to achieve the earnout.
According to the American Bar Association’s Business Law Section 2021 Private Target Deal Points Study (the Study), in 2021, earnouts appeared in only 20% of post-pandemic transactions, the lowest percentage in the past decade. It is worth noting, that deals with earnouts increased in 2008-2010 (occurring on average in 33-34% of deals), and then decreased in popularity from 2012-2019 (occurring on average in 26-27% of deals). In deals that did use earnouts in 2021, parties were more likely to use revenue, as opposed to earnings or EBITDA, as a metric to determine an earnout payment. Sellers will often push for a revenue-based earnout as it is simpler to calculate and avoids the issue that arises when buyers take post-closing actions that adversely affect the net profitability of the business. The use of earnings or EBITDA, typically a more buyer-friendly metric that takes into account operating costs and expenses associated with the business, substantially decreased in 2021 according to the Study.
As the hot seller’s market shifts to a market with more cautious buyers, the use of earnouts may grow in popularity and buyer-favorable earnouts based on EBITDA or earnings may become more common. At the very least, in my own practice, they are being more frequently proposed. First, the effects of inflation may give buyers additional reasons to ensure that their purchase is properly valued. Second, implementing a buyer-friendly earnout will eliminate some risk in circumstances where the target company is experiencing a supply chain issue, a temporary drop in earnings, facing rising costs or labor shortages, entering into a new market or has limited access to financing—all of which may be more prevalent in the aftermath of COVID-19. Finally and relatedly, sellers may be more likely to agree to an earnout believing that buyers are undervaluing their company in an uncertain economy. Deal-makers will rely on earnouts to bridge the valuation gap to get deals done.
Earnout provisions are often heavily negotiated and fact‐specific. In addition, there are tax, accounting, and employment‐related issues that need careful navigation. Earnouts, when not carefully designed (and even when they are), can easily become the subject of disputes, so earnout‐related litigation may well be a new trend to look out for.
Representation and Warranties Insurance
The allocation of risk shapes every merger and acquisition. Representations and warranties insurance (RWI) has been a game changer in the world of M&A transactions, and it is not going anywhere. The Study shows an increasing growth in the use of RWI with nearly two-thirds of the deals referencing RWI in 2021. Allocation of post-closing risk, including the right of the buyer to be indemnified for losses resulting from seller’s breaches of representations and warranties and the scope of those representations and warranties, is one of the most heavily negotiated aspects of a deal. RWI, which generally covers these potential losses, shifts much of this post-closing indemnification risk to a third-party insurer. RWI protects a buyer from a loss related to an unknown breach of a representation or warranty, and any allocation of risk of a known breach remains the subject of tough negotiations. Sellers push for RWI, oftentimes paid for by the buyer, as it allows sellers to receive all or most of the funds at closing that would otherwise be at risk in escrow. A buyer, in turn, might push for a broader set of seller representations and warranties than the seller would normally accept, to obtain the most coverage from RWI. Insurers do not directly dictate the wording of representations and warranties, but they can limit coverage by either excluding certain known risk areas or certain representations altogether that they believe fall outside of what is “market.”
As the demand for RWI grows, we expect RWI to adapt and introduce new product offerings to capture an increased share of the M&A market. Traditionally, insurers have minimum premiums and high underwriting costs, making smaller transactions (less than $50 million) difficult to insure. For all the reasons noted above, we anticipate that small and mid-market deal participants will continue to jump on the bandwagon and insist that their deals be RWI-backed. We might begin to see insurers willing to provide coverage for certain “boilerplate” representations or a pre-determined list of risks to fit the RWI demands of a smaller-sized deal. We might also begin to see more automation in the world of RWI (see, e.g., io.insure) as well as more segmentation by market or industry in RWI offerings.
Increasing Diligence
The M&A market for attractive assets has been so competitive that acquirers are frequently forced to accept less-than-perfect deal protections. With the changing headwinds in the economic and legal landscape, buyers will take their time and do their diligence on acquisition targets to seek additional warranties, indemnities, and post-closing price adjustments to mitigate the uncertainties (including regulatory risks). Buyers will take longer and harder looks at potential targets and become more selective in the companies they pursue. We will continue to see a robust legal due diligence process as buyers attempt to forecast targets’ futures and avoid pitfalls. In addition, we predict continuing innovation and automation this area as deal-makers continue to find ways to make the due diligence phase of M&A transactions as efficient as possible.
As we sit with our crystal ball and gaze fixedly into an unpredictable landscape, we remain cautiously optimistic. While the shifting landscape of M&A presents hurdles and opportunities for buyers, sellers, deal-makers and their attorneys, deal terms will adapt to the economic and legal changes. Buyers’ demand for new opportunities and more attractive acquisitions will not falter, and deal-makers will utilize different methods of risk allocation to shape their transactions.
Reprinted with permission from the October 17, 2022 edition of the “New York Law Journal”© 202X ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or reprints@alm.com.