Feb 24, 2014

Acquisitions outlook and review: lawyering M&A

By Stephen M. Honig


The big M&A news for 2013 was the intensity of private equity acquisitions. PEs acquired to build out platforms, rather than acquiring new platform companies. PitchBook suggests this emphasis on add-ons led to a preponderance of smaller acquisitions of private companies. Dow Jones’ 2014 “Outlook & Review” agreed that 2013 was a sellers’ market.

But buying private companies for any reason was expensive in 2013. Valuations, expressed as multiples of EBITDA (adjusted earnings), rose for all targets, not just larger companies enjoying a “size premium.”

The anticipation for 2014 is more cautious. Notwithstanding “dry powder” in the hands of acquirors, and notwithstanding the alleged abundance of cheap credit, increasing public equity valuations may price private acquisitions out of reach of many buyers.

Additionally, some pent-up seller pressure was relieved by deal volume in 2012 and 2013. Remaining sellers may be reluctant to accept lower multiples not only because of deal price inflation during 2013, but also because those most anxious to sell already have concluded transactions.

Finally, recent Wall Street Journal analysis suggests that while banks have ample money to lend, they remain very risk-adverse in financing M&A activity.

However, one argument against selling has disappeared. Prior to the 2013 public bull market, there was no good place to invest proceeds. The 2013 bull market created investment opportunity that, if sustained, now might induce other owners to sell.

The ABA’s Private Target Mergers and Acquisitions Deal Point Study released Dec. 31, 2013, focusing on 2012 acquisitions of private targets, addresses many heavily negotiated issues.

Contractual trends

More than 90 percent of deals included a post-closing purchase price adjustment, typically based on working capital variances from closing estimates provided by the target.

But the buyer prepared a post-closing balance sheet, calculating changes in working capital resulting in price adjustments. Only 16 percent required GAAP analysis; 45 percent required GAAP accounting but “consistent with past practices” (practitioners know this suggests some past practices are not GAAP-compliant).

Almost one-third of deals saw an escrow (separate from the indemnity escrow) for pricing adjustment. Conversely, slightly more than half of those without separate escrow allowed payment of true-up deficiency from the indemnity escrow. Unlike indemnity for misstatement, which often enjoys a “basket” that does not trigger financial restitution by target, post-closing true-up is effected dollar for dollar.

Per the ABA study, one in four private acquisitions included an “earnout” (future payments contingent on future performance). It will be interesting to see current statistics, in which increased price multiples might drive an increase in earnouts as a solution to disparate target and acquiror assessments of enterprise value.

About one-third of all 2012 earnouts were based on gross revenue, and another third based on EBITDA. Earnouts also have been tending shorter; 38 percent were for 12 months or less, another 18 percent for two years.

Targets suspect EBITDA earnouts; acquirors have operating control over the enterprise and thus over profits. Targets have not done well in protecting against this risk. In a significant decline from prior years, buyers in 2012 covenanted only 18 percent of the time to “run the business consistent with past practice,” a vague articulation nonetheless generally acceptable to targets. Only 6 percent of deals included buyer’s covenant to “run the business to maximize earnout.”

Material adverse effect

The target representation — that there are no facts that will have material adverse effect on target business or assets — requires definition.

Should “material adverse effect” cover not only current business and assets, but also target’s “prospects”? The “prospects” articulation is vague, and, although there has been fluctuation in usage of the provision over time, in 2012 only 17 percent of definitions of material adverse effect included impact on target “prospects.”

Most deals have carve-outs from material adverse effect representations. Typically, targets are not liable for: change in the economy; change in industries or markets; world events such as war; change in law or accounting; and an acquiror taking action contemplated by the acquisition agreement, including announcing the transaction itself.

Are targets permitted to say that there are no material adverse effects “to their knowledge”? Less than a fifth of targets represented only to their knowledge; the majority seemingly were required to represent absolutely. Typical provisions also include an obligation to investigate and specify the officers charged with such investigation.

Other battleground issues

Acquirors require targets to represent that financial statements are a fair presentation. However, almost four-fifths of all targets were not required to say that financials were per GAAP.

On the other hand, acquirors typically obtained an absolute representation that the target had no undisclosed liabilities, regardless of actual knowledge; similarly, about four-fifths of targets represented absence of all undisclosed liabilities, not just those that GAAP reporting would disclose.

In the so-called “10b-5” representation, the target says that all representations are true and do not “omit to state a material fact necessary to make the statements … not misleading.”

That language, appearing in the ABA model stock purchase agreement, is excluded in almost two-thirds of deals. I have always objected to its inclusion when representing target. It seems unquestionable that representations must contain omissions that may prove material. If the acquiror wants to know something, let the acquiror insist upon that representation. Why should the target be insurer of the completeness of information?

When the 10b-5 standard is applied to a public prospectus, “risk factors” required by the Securities and Exchange Commission to explain possible omissions (which omissions might prove materially misleading) run many pages and are extremely speculative (“the company is at risk that the sky may fall … .”). No acquisition agreement contains such a lengthy dissertation for the protection of target.

At what point in time must target representations be accurate? The majority articulation is to require accuracy both at signing and at subsequent closing, but 42 percent of deals required accuracy of those representations only at closing.

Fortuitously, there has been a decline in legal opinions from target counsel. Acquirors perform diligence; many factual matters, historically the subject of opinions, are obtainable from public record; target deliverables at closing typically include documentation of corporate compliance; the cost of preparing opinions usually has been disproportionate to value.

In 2012, a full 81 percent of transactions did not require legal opinions from target counsel.


Few provisions are more hard fought.

  • Must representations be accurate in all respects, or only in “material” respects? Since many representations are negotiated to be limited to “material” accuracy, in calculating indemnity liability an agreement should not repetitively require “material” accuracy of such already modified representations. The ABA study addresses the “double materiality” conundrum and whether indemnity calculations should ignore any “materiality” modifier. It also addresses whether a target’s MAC representation (assuring no target material adverse change as a condition of closing) should run from date of signing or date of the last financial statement.
  • Does acquiror diligence, uncovering misrepresentation, mean that the buyer cannot be indemnified for that misrepresentation? About half of agreements are silent, but 41 percent specifically provide that whatever the acquiror learned during diligence is irrelevant to indemnification; appropriately, the ABA study refers to this as “pro-sandbagging.”
  • Most representations generally survive between one and two years; only 4 percent survived longer. But some representations are carved out for longer survival, notably for fraud or tax.
  • The vast majority of indemnifications do not limit liability for misstatement to out-of-pocket damages, permitting buyers to claim deterioration in deal value.
  • Most deals have “baskets” — a dollar cost of misrepresentations below which the target need not indemnify. However, almost one-third of transactions had zero baskets and required indemnification from first dollar. Deals with baskets did have modest ones; only 1 percent of deals had a basket exceeding 2 percent of transaction value.
  • However, some misrepresentations are excluded from the basket and must be indemnified from first dollar, notably representations relating to target organization and authority, fraud and taxes.
  • Most transactions capped indemnification (subject to carve-outs). About half of the transactions capped below 10 percent of transaction value, and the mean cap was 16.6 percent. Some caps were much higher. Uncapped carve-outs focused primarily on representations concerning the nature and authority of the seller, fraud and tax liabilities. Typically, indemnification is an exclusive remedy except in cases of fraud.
  • Mean escrow holdback (reimbursing acquirors for misrepresentations) was about 8 percent of transaction value. In most cases, escrow holdback was not a liability limit, permitting an injured acquiror to sue target or its shareholders if the escrow ran out.
  • Most target indemnification liabilities are reduced by insurance proceeds received by acquiror; half credited target for acquiror’s tax benefits derived from suffering a misstatement that resulted in loss.
  • Alternative dispute resolution seems to have had its day. Only 15 percent of agreements provided dispute resolution outside court, a substantial decline in ADR since 2008.
  • Conclusion

    Speculation about deal trends is interesting, but not edifying in an individual case. Statistics of past deals offer arguing points for lawyers and guidance for clients, but do not address vagaries of any given transaction.

    Thus, the future for M&A negotiations remains bright. M&A lawyers needn’t quit their day jobs (yet).

    Stephen M. Honig is a partner at Duane Morris in Boston, where he practices business law with an emphasis on corporate and securities law, and mergers and acquisitions.