Beyond doing diligence and avoiding over-leverage, what information do you need to succeed as a business acquirer?
Two year-end studies give insights into the M&A market: Pitchbook’s “2018 Private Equity Outlook” and the ABA’s “Deal Points Study” of the private M&A market.
We start with Pitchbook’s 2018 predictions. Not surprisingly, all purchasers, not just PEs, will enjoy active years, given pressure to deploy funds and driven by booming public equity markets that, in turn, are highly correlated with purchase price multiples.
Since almost all the pundits in January were bullish on the equity markets, upward valuation pressures seem expectable. Pitchbook also references “relatively easy access to financing,” the accuracy of which prediction may be confused in the mid-term by projected fed actions and a possible burst of long-awaited inflation, but for the short term this prediction also seems plausible.
Del. Supreme Court issues
‘notable’ ruling in Dell case
In the November issue of New England In-House, I predicted that the Delaware Chancery Court decision — which held that the going private pricing of the Dell transaction was undervalued by $7 billion — would be reversed based on the trend in the Delaware courts to put heavier reliance on fully negotiated deal price accuracy notwithstanding shareholder claims of underpricing.
In December, the Delaware Supreme Court did just that, putting another nail in the coffin of appraisal claims of underpricing in M&A transactions.
True to emerging Delaware judicial thinking, the Supreme Court relied on the efficiency of the market in determining fair deal value. The court relied on the lower market value of the traded Dell shares and the fact that, after the actual deal was priced but before it was closed, the company had the opportunity to “go shop” and offered the deal to 67 other potential buyers.
The board’s special committee also had negotiated six price increases before signing the deal, and had been advised by its own law firm and two investment banks.
Notably, the court supported the deal price even though it involved an interested party in a management buy-out (Michael Dell was staying in the deal) and despite the court acknowledging that the deal price was likely fair even though not the “best” price.
The decision is notable as it now provides clear guidance to boards faced with M&A opportunities that must be priced. The growing legal practice of filing lawsuits in public acquisition deals almost automatically based on the appraisal statute appears dead and buried in Delaware, absent blatant board failure to follow common-sense valuation practices.
Valuations in all buy-outs, including but not limited to PE deals, in the first nine months of 2017 remained at the highest level since the 2008 market break. Notwithstanding, November 2017 saw the second greatest number of announced M&A deals in two decades. Why?
Part of the answer is the “dry powder” factor. Pitchbook credits strong PE fundraising, leading to such firms holding $65.9 billion in investable funds at the end of last March. That money needs to be deployed within each fund’s investment period.
Growing investment competition from family offices and likely from corporate acquirers (given tax reform and repatriation of offshore cash) will drive deal competition and thus valuation inflation, provided public equity markets do not surprise by an unexpected collapse.
There is lack of clarity relative to PE funds selling to other PE funds. You would think that the second fund, buying a prior fund’s company, might worry about how much more profit could be squeezed out of the investment. Nonetheless, per Pitchbook, a “secondary” purchase by a second fund represented 50 percent of all PE sales through December 2017, and 19 percent of all M&A.
Perhaps funds concentrated on a particular sector will be more willing to enter into secondary acquisitions, on the theory that their expertise in the vertical will uncover values that the prior PE fund missed.
Another Pitchbook prediction is the continued emergence of niche sector funds, because of LP desire to invest with sharp focus.
What will be the hottest investment areas? Software, which provides many targets with recurring revenue models “typical of a SaaS business model.” Proliferation of companies specializing in software solutions for non-high-tech businesses also promises further growth in this vertical.
Nonetheless, Pitchbook’s citation of this sole sector is interesting. Per the ABA study of private middle-market acquisitions, software is not the overwhelming acquisition category. While “technology,” the largest sector for the ABA (23.7 percent), likely contains some software companies, the health care category is almost equal (21.6 percent) and, even then, over half of the targets are not accounted for.
There is no separate target data in either report for the cutting-edge new economy darlings that futurists tell us are the businesses of the future: nanotech, AI, genetics, robotics.
Although no doubt some such companies are buried in other generically named categories, the absence of deal statistics for these narrow categories suggests that none make up a significant sector currently.
Perhaps these companies are not so numerous, at least at the stage to be acquired (as opposed to being VC targets). But the growth of specific sector PE funds that focus on these verticals must at some point encourage acquisitions.
Lastly, the Pitchbook report suggests reshaping of the PE landscape. Liquidity has been falling in given funds even while aggregate dry powder has been growing. The absolute number of LPs in PE funds fell in 2017 for the first time since at least 2000, perhaps reflecting more active direct investments by historical LPs such as family offices, sovereign wealth funds and pension plans.
Pitchbook predicts a continued decline in the total number of PE firms during 2018.
The ABA’s annual study of private acquisitions sampled acquisitions not by PE firms but rather by public companies (where disclosure of contracts is legally required).
The study covers major negotiated aspects of M&A transactions: purchase price adjustments, earn-outs, MAC, warranties, closing conditions, indemnity, rep insurance and dispute resolution, among others. Below are two issues that call for careful client focus.
One part of the M&A process that is vexatious, expensive and exasperating: post-closing adjustments. Disputes might arise over alleged misrepresentations, which may or may not either be insured or fall into a de minimus “basket.”
But even without any claim of misrepresentation, deals typically require “post-closing purchase price adjustments.” The operation of the business between signing and closing may change the economic value of the target. Since the deal price was struck based on financial statements at a prior date, how do you compensate the buyer for any economic deterioration, or compensate the seller for any improvement?
The classic manner, embodied in the ABA Model Asset Purchase Agreement, is to adjust based on changes in working capital. If it increased, the buyer pays more. If it decreased, the seller refunds the decrease.
For the last decade, over 80 percent of transactions have included some adjustment either based on a single factor or (in 73 percent of the cases) in tandem with other adjustments.
And of these adjustment provisions, last year 89 percent relied on working capital measures either alone or together with an added metric (debt level and cash on hand are typical).
In most cases, the target will make a pre-closing estimate of this adjustment, and the closing payment will reflect this estimate. Only 16 percent of deals gave the buyer the right to question the closing estimate presented by the target even if it increased the closing payment, which is surprising since less than half the sellers were required to escrow funds to secure a negative adjustment when post-closing working capital is calculated.
Acquisition agreements provide in 95 percent of all deals that the post-closing working capital calculation be prepared by the buyer. And in the vast majority of cases, this adjustment is paid from the first dollar. There is no threshold, for example, of working capital deficiency before adjustment is made (unlike the typical “basket” for misrepresentations so that sellers are “not nickeled and dimed to death”).
These adjustments depend on the definition of working capital, for which there is no universal formulation. Counsel is often ill-prepared to negotiate, and the discussion falls on the seller’s CFO and accountants. The seller’s senior management needs to be deeply involved.
Different results in different companies can be driven by excluding one or more often-excluded items from current assets or liabilities: debt, net debt, cash and equivalents, transaction expense, tax attributes, employee liabilities, and — in 52 percent of deals — “other” unspecified items.
Management will be unable to get granular guidance from counsel on this matter, and must be intimately involved in understanding the target’s particular working capital cycles.
Another post-closing economic problem is the “earn-out.” When there is debate as to the value of a target, one solution is to fix closing valuation at what the buyer believes, but also to provide that the seller will be paid more if future performance exceeds buyer expectation. An accounting is kept of post-closing performance, often measured by revenue or EBITDA although sometimes based on other specific criteria.
Seller’s counsel often may advise the seller “don’t take the risk, rather try to negotiate even a modest increment of closing cash in lieu of accepting the earn-out because you never know how it is going to work out and you will end up fighting with the new owner.”
The key to protecting the seller in these cases is to gain control of post-closing operations, to be sure that actual business decisions align with the criteria by which success in earn-out is achieved.
Will the new owners allow management to pursue a goal of increased EBITDA, or of higher gross volume, and (whatever their goal) will they measure earn-out on that metric?
Who controls the budget and CapX? What happens if the acquirer is acquired? Will the seller’s management be in charge of the business during the earn-out period?
Will the seller be protected by obtaining a covenant that the buyer will operate the business as in the past? Is the seller protected by the implied contractual covenant of good faith and fair dealing if the buyer makes management decisions that negatively affect reaching the earn-out trigger?
What if the buyer rolls up other companies and drops them into the same entity; how do you measure the earn-out in that case? Conversely, can the buyer acquire and keep separate a competitive entity?
Can the seller ever enforce agreements on post-closing operations where (as in some cases) the acquirer includes a disclaimer that no fiduciary duty is owed to the seller relative to post-closing operations?
In a hot 2018 M&A market, acquirers will need to look out for competing bidders while dealing with the growing body of learning that defines the ground rules for negotiating the deal terms.
If predictions prove true, 2018 is going to be a vibrant M&A year.
Stephen M. Honig is a partner at Duane Morris in Boston.