Why do business like it is 2019?

10 May 2021

During the past year, most industries have adjusted to new ways of working to cater for an environment that has been transformed by Covid-19. Economic activity, including M&A activity, has been affected by the crisis, and we have been challenged to assist clients and businesses to find creative and innovative solutions to problems that they face in a post-pandemic world.

Many industries took a knock during 2020 as a result of Government shutdowns and are now experiencing increasing financial pressure as Government stimulus and relief packages are withdrawn. As a result, some companies are simply focused on survival and are forced to sell parts of their business to avoid the risk of insolvency. Consequently, there are deal making opportunities as businesses look to restructure and potentially sell non-core assets, divisions and subsidiaries. Additionally, many of the private equity firms that sat on cash during the non-acquisition friendly period and are now looking to catch-up on acquisitions. To this end, many buyers are optimistic about these opportunities as they foresee better transaction terms, attractive and well-priced targets and quicker completion times.

The use of innovative deal structures is an important aspect of helping buyers and sellers overcome barriers to M&A and empowering parties to pursue emerging opportunities. In the past few months, we have seen an upward turn in M&A activity and an increase in the creative deal strategies.

For parties who are exploring opportunities in the market, they may wish to consider some of the below strategies.

Joint ventures

A joint venture (“JV”) involves two (or more) parties pooling their assets and resources to achieve a particular objective, such as the acquisition of a target company. In our experience, one of the biggest aversions to M&A post-pandemic is access to financing and, relatedly, the inability to raise collateral for such funding. For this reason, a JV is an attractive work-around as it allows two parties to combine their resources. There are obvious drawbacks in teaming with another party, potentially a competitor, however, with the appropriate rights and obligations correctly documented, JVs offer the following advantages:

1. Access to markets that would otherwise be unavailable due to financing constraints;
2. Sharing of risk between the JV parties; and
3. Lessening of competition and regulating the potentially inflated acquisition price, particularly in circumstances where competing buyers form a JV or special purpose vehicle to acquire the target company.

Anti-embarrassment clauses

Due to the downturn in revenue, many sellers are reflecting a non-profitable business, resulting in lower valuations and a buyer friendly market. In these situations, sellers are reluctant to sell as, pre-pandemic, the company had a profitable track-record and with sufficient access to capital, it is likely that the business will have a prosperous future.

To solve this issue, we have explored the use of an anti-embarrassment clause. This seeks to provide a seller with a purchase consideration percentage claw back in circumstances where there is an onward sale of the company or business unit by the initial purchaser for a consideration which exceeds the initial purchase consideration paid. The seller can then avoid the “embarrassment” of having sold too soon.

As potential buyers and sellers adapt to the changing market post-Covid19, the inclusion of anti-embarrassment clause protects against the the risk of uncertain valuations at the time of the sale and enables the seller to share in any future uplift in value.

An anti-embarrassment clause is usually limited to a certain period, for example 18 months from the closing date, and is prescriptive in terms of what events trigger the clause. It is important that the terms of the clause are carefully negotiated as there is a delicate balance in ensuring that the seller is fairly compensated whilst not deterring a purchaser from the transaction.

Earn-outs/contingent payment mechanisms

An earnout is a mechanism often used in management buy-outs and can be explored as an alternative to, or in conjunction with, an anti-embarrassment clause for buyers who are reluctant to sell due to low valuations but are forced to sell due to financial pressure.

An earnout contemplates a purchase consideration that is comprised of an initial payment on closing, plus future payments which are contingent upon the business achieving certain targets post-closing. Traditionally, the earnout mechanism has been a bridging solution between what a seller seeks as total consideration for the target, and what the purchaser (often a management team) is willing or able to pay for the target.

This mechanism provides benefits for both buyers and sellers. For the buyer, it is attractive to have a longer period of time to pay out the increased purchase consideration for a business meeting growth or sales targets. For the seller, the earnout mechanism allows the seller to share in the actual growth of the business post sale and might alleviate the seller’s concern of having sold too soon.

Warranty and indemnity insurance

Risk allocation is contentious in all M&A transactions and is the subject of ongoing negotiation. In many jurisdictions such as the UK, US and Australia, warranty and indemnity (“W&I”) insurance is a commonly used solution to cover some of the risk of a transaction.

In essence, W&I insurance prices the risk of the transaction and passes it on to an underwriter. For the seller, it can mitigate the risk of liability that the seller retains under warranties and indemnities given to the buyer. For the buyer, W&I insurance provides certainty that any warranty claim will be paid by the insurer instead of having to claim against the seller thereby increasing the scope of warranty coverage.

W&I insurance is not new in South Africa, however, due to the cost of the insurance product and delays caused by the insurer’s due diligence investigation, traditionally parties have opted to use an escrow account and holdback/retention amount to decrease the risk of the transaction.

An escrow mechanism contemplates a portion of the purchase consideration being held in a third-party account for a period of time after closing. The escrow acts as security for the buyer as it allows the buyer to make claims against the seller, including warranty claims, which are paid out of the escrow account.

Whilst the escrow mechanism has been effective in the past, it is not necessarily the best fit for a post-pandemic market. Cash strapped sellers are unwilling to agree to a portion of the purchase consideration being inaccessible for a long period of time after closing.

Accordingly, W&I insurance is increasingly being explored as alternative security for damages resulting from breaches of warranties. It has become an emerging trend for buyers to prefer buy-side policies over sell-side policies as the buyer’s recourse is directly against the insurer. To this end, it is important that the price of the buy-side policy is factored into the purchase consideration.

W&I insurance has many benefits to both buyers and sellers, particular in a post-pandemic market, which includes:

1. Clean exit for sellers – the seller is able to access the full purchase consideration without the need for additional security and with no exposure to liability in the future;
2. Attractive financial security for potential buyers – the buyer has certainty that it can recover a warranty or indemnity claim as it arises;
3. Advisable in cross-border M&A – enforcement of a claim in a foreign jurisdiction can be difficult and costly, which is eliminated by buy-side W&I policies;
4. No escrow – this is attractive to a seller as it means immediate access to the purchase consideration; and
5. Apportionment of risk – W&I insurance effectively prices the risk of the transaction, by charging a premium to parties for the insurer accepting the risk on the seller’s behalf. Parties can commercially negotiate how such premiums are factored into the purchase consideration, which allows the parties to accurately apportion the risk.

In summary, the above mentioned tools are only a few ways in which potential buyers and sellers can overcome the barriers to M&A activity after the Covid-19 crisis. Whilst we have highlighted some of the advantages of these mechanisms, not every solution will be the perfect fit for a specific transaction. Nonetheless, it is certainly worth considering implementing creative deal structures in any M&A transaction.

See also:

• Remote due diligence investigations and unique considerations for mergers and acquisitions during the ‘new normal’.
• Warranties and indemnities in your merger and acquisition agreement
• So, you want to sell your business?
• Due diligence in Intellectual Property acquisitions

(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)