Feature Article – Do Buyers Stand a Chance?
CURRENT TRENDS IN MIDDLE MARKET M&A –
DO BUYERS STAND A CHANCE?
By Wayne H. Elowe and Michael E. Hollingsworth II,
Kilpatrick Stockton LLP
Let’s face it – commentators have been lamenting over
the forces at work in the deal environment for quite some
time. While transaction levels remain robust, we hear the
complaints of an oversupply of capital chasing too few
quality deals, higher transaction multiples, a more
sophisticated base of sellers using auctions to drive
higher prices, strategic and financial buyers in heavy
competition, the list goes on… In short, it’s a seller’s
market out there, especially in certain industries. All
good when one is on the sell side, but for both strategic
and financial buyers having marching orders to find and
close deals that will pay off in the future, how does one
become the selected suitor and avoid overpaying?
The answer to this question depends on many factors
that can affect the transaction process. This article
focuses on the terms of the acquisition agreement and
looks at whether acquisition terms have dramatically
changed in the current environment and how buyers can
still effectively negotiate a reasonably balanced
agreement.
Current Purchase Agreement Terms
We hear frequent stories that the terms of private
company acquisitions are moving in the direction of
limited seller representations and warranties and even
more limited rights of recourse post-closing. There may
be some truth to this, and there are undoubtedly
examples of over-zealous buyers giving in to a seller’s
draft agreement simply to win the deal. More often than
not, however, purchase agreements still tend to contain
many of the provisions that buyers typically seek:
comprehensive
representations
and
warranties
(although they may be more tailored to the deal in
today’s market), purchase price adjustments and
indemnification rights – despite all the talk, sellers are
not walking away with premium prices without standing
behind their businesses.
Indemnification rights provide a good illustration of this
point. Indemnity survival periods may be somewhat
shorter, but still tend to cover one or two audit cycles;
baskets have been ranging between 1/2-1% of
transaction value and caps in the 10% to 50% range.
Representations and warranties, if anything, have
become more targeted on specific aspects of the seller’s
business. With the requirements of Sarbanes-Oxley,
buyers are also including representations targeting
specific compliance issues.
Are Buyers Caving-in to the Demands of the
Sellers?
The short answer – Yes and no. Buyers understand that
these days, the pendulum has swung in the favor of
sellers. In this regard, buyers have had to “give-in” at
times from their usual approach to pursue attractive
properties. On the other hand, buyers are not parting
with millions of dollars to purchase a company without
the appropriate business justification or coverage under
the purchase agreement.
What would appear as the curtailment of the traditional
protective provisions on which buyers rely is, arguably,
their response to the leverage sellers currently exert in
the market: buyers have made a qualitative shift in their
approach to the deal process and this shift is evident in
the terms under which the deals are getting done.
Higher purchase price multiples and competition for
deals are facts of life in today’s market. Buyers striving
to survive an auction process are making a significant
effort to be better informed about the quality of a target’s
assets and its potential exposures. More importantly,
buyers that can effectively use the quality information in
the transaction process will improve their ability to
negotiate an agreement that will win them the deal and
mitigate their risk.
Quality Due Diligence and the Purchase
Agreement
Performing extensive transaction due diligence is
certainly not a new concept. However, the quality of the
due diligence buyers are now performing has evolved
significantly and has room for even more improvement,
especially with regard to the potential value of certain
intangible assets of targets.
Legal due diligence provides a good example of this
trend. Traditionally, legal advisors have conducted due
diligence to uncover and report on potential legal
exposures or liabilities or compliance issues in the target
business. Absent some lingering exposure or litigation,
the evaluation of the future of the business was left to
the buyer and its financial advisors. While lawyers still
cover the traditional due diligence mandates, today,
buyers are (or if they are not, they should be)
demanding a more qualitative analysis about a target’s
assets or legal issues that may affect their proposed
business plan for the target. Consider the following
examples:
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Feature Article – Do Buyers Stand a Chance?
Intellectual property – how many deals are done where
the patents and trademarks are reviewed to verify
ownership and validity, then listed on a schedule to the
purchase agreement and forgotten? Unless the target is
a bio-tech or technology-based company where the I/P
is at the heart of the business, more often than not, once
a buyer hears that there are no issues concerning the
target’s ownership, they move on to other matters. Did
the buyer consider whether the target’s I/P will support
the future development and expansion of the business?
Will the target’s I/P provide a clear path for the growth of
the business or will you run into multiple parties with
similar (or worse, broader) I/P rights along the way?
Obviously this is a whole topic area in and of itself, but
the bottom line is that seeking a deeper and qualitative
analysis of these kinds of questions can provide answers
and information that will directly impact the terms you
agree to in the purchase agreement.
Applying What You Learn – Picking Your Battles
Carefully
The opportunity for buyers in this “seller’s market” is to
use the better quality due diligence information they
develop to identify and prioritize their “hot” issues and
address them in the purchase agreement. This approach
allows buyers to take a more refined and surgical
approach to a seller’s draft agreement by covering
themselves on the important issues and agreeing to the
seller’s position on others.
Consider a few examples:
●
Consider another situation facing middle market
manufacturing companies. At one recent private equity
conference the only foreign country mentioned by the
speakers and panel members was China – the
conclusion being that it has become paramount for
manufacturing companies to have a “China strategy.”
The existence of a strategy, however, is just one step in
the analysis. Most companies have little understanding
about the legal issues and costs (financially and in time
and personnel) to create a China-based sourcing
platform until they execute on such a plan. A buyer that
has an understanding of this process will have the
information necessary to analyze the target’s strategy (or
lack thereof), and quantify the impact on valuation. The
buyer can then choose to specifically address the issue
in the purchase agreement, or not, depending on the
dynamics of the deal.
In the context of a transaction, there are countless
opportunities for a buyer to push its due diligence
analysis further than what may have been typical in prior
years. What the foregoing examples demonstrate is that
by taking one’s analysis a step or two beyond simply
examining what currently exists within a target, a buyer
can develop additional information that may identify
specific “issue areas” within the target business. Many
buyers may claim that they have been pushing the due
diligence envelope for years. In some cases that may
be true. Based on the increasing use of industry-specific
consultants and advisors and the depth of analysis being
performed, however, it is evident that for many buyers
this is still a developing area.
Assuming a buyer has done a thorough investigation,
the real opportunity is how a buyer can use the
information to its advantage in the process of negotiating
the purchase agreement.
●
Purchase Price / Valuation: Better quality due
diligence can tell a buyer whether the asking price is
too high, or whether there is “hidden” value in the
business. Armed with this information, a buyer has
several options such as: (i) agree with the Seller’s
valuation and submit an aggressive bid for the
company; (ii) walk away from the deal if it is overvalued; (iii) consider options such as earn-outs or
other mechanisms to keep the seller with some
“skin” in the game as a way to offer a fuller price but
with some protection if the performance of the
business does not meet expectations or (iv) develop
purchase price adjustments targeting specific
financial concerns of the buyer. For example, in one
recent transaction, the buyer, concerned with
specific aspects of the cyclical nature of the seller’s
business and working capital, created a working
capital adjustment targeting only the specific items
of working capital with which buyer was concerned
as opposed to a full balance sheet working capital
adjustment. These may not be new transaction
techniques; however, with a greater degree of
detailed information, a buyer is better equipped to
propose price adjustments or other protections
specifically targeting the questionable aspects of the
purchase price/valuation model that the seller has in
mind without totally pushing back on the Seller’s
position.
Representations and Warranties:
With shrinking
baskets, caps and survival periods, buyers need to
know that they will have an adequate right of
recourse for the problems that arise post-closing.
Negotiating Representations and warranties that
focus on specific issues in a target company’s
business is another way of obtaining coverage for
problems associated with high-priority areas of the
business. Remember – there is no indemnification
right without a breach of a representation, unless a
stand-alone indemnification provision has been
negotiated (e.g., an indemnity for liabilities related to
pending litigation). Buyers may want to consider
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Feature Article – Do Buyers Stand a Chance?
representations targeting certain high-priority issues
such as a specific line item on a balance sheet, a
specific regulatory issue or an industry-specific
issue. In many instances, a clean and unqualified
representation on a specific issue may be more
palatable to a seller than trying to make an
unqualified representation covering a broad area of
the business. At the same time, the buyer gains the
ability to seek recourse over an issue that might
otherwise be subject to materiality, knowledge or
other qualifiers.
●
Indemnification Rights: M&A professionals are wellaware of the linkage between a seller’s
representations and warranties and a buyer’s
indemnification rights. Buyers rarely get a full set of
unqualified representations and indemnification
rights with small baskets, high caps and long
survival periods. In the current environment, what
sellers want most is to minimize the magnitude of
their exposure and the length of time during which
they can be subjected to indemnification claims.
Quality due diligence information enables a buyer to
craft an indemnification right in a number ways:
o The indemnity survival period: a buyer can
agree to the shortest period necessary to
learn whether there are indemnifiable issues
in the business;
o The basket: depending on the type of
business
and
the
nature
of
the
representations and warranties that a buyer
negotiates, the buyer can, in turn, suggest a
higher (or seller favored) basket as to most
items and seek a smaller basket concerning
the specific items that the buyer may have
targeted in the representations and
warranties. Alternatively, the buyer could
seek to carve out certain representations
from the basket altogether (in addition to
traditional carve-outs like title or taxes).
o The cap:
buyers can help themselves
further in the deal process by lowering the
cap on the indemnification rights to a level
that will cover the known and potential
unknown exposures. Again, better front-end
analysis and due diligence will enable a
buyer to be more flexible on this issue which
is often a deal-breaker for sellers.
The Seller’s Perspective
The inevitable question is whether a Seller will view a
buyer’s efforts to take a focused and targeted approach
to negotiating a purchase agreement in a favorable light.
The approach helps buyers in a number of ways:
●
Sellers will know that a buyer is serious about
purchasing the business if the buyer is capable of
negotiating in a focused manner that demonstrates
the depth and quality of its due diligence.
● Sellers will believe that there is a greater certainty of
closure if dealing with a buyer that has taken the
time to engage in quality due diligence and is
selective about the issues that are of importance in
the transaction. For example, Sellers are more
comfortable with bringing down their representations
to the closing date if, although there has been a
breach of a representation between signing and
closing, the buyer still has to close unless the breach
results in a material adverse effect on the seller’s
business.
● Target company management will be more confident
in a buyer’s ability to manage and grow the business
post-closing if the buyer demonstrates a thoughtful
and detailed understanding of the business.
● A buyer’s mark-up of a seller’s draft purchase
agreement that thoughtfully connects specific due
diligence issues to specific revisions rather than
inserting wholesale typical “buyer provisions”
demonstrates to a seller that the buyer has
prioritized its issues and is prepared to move
forward with the transaction on that basis.
Obviously, there are many other factors and
considerations that can affect the course of a transaction
or an auction. For a buyer however, the purchase
agreement is its calling card whether the buyer is
responding to a seller’s draft or is preparing the first
draft.
After all of the meetings, dinners and gladhanding, it will set the tone for the course of the deal.
To some extent, transaction professionals will expect
negotiations to be difficult over certain issues regardless
of who the buyer is. The goal for a buyer is to use the
benefit of a quality due diligence effort to “self-regulate”
and eliminate points of contention when possible and
provide protections only to the extent necessary.
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Feature Article – Do Buyers Stand a Chance?
A Few Words of Caution…
While the foregoing discussion offers some thoughts that
can help a buyer in today’s deal environment, buyers
should keep a few additional points in mind:
●
●
●
Prioritizing your issues is critical:
While this
discussion offers thoughts on how to take advantage
of the information you develop through better due
diligence when negotiating purchase agreements, as
in any deal, you will not win all of the points you
pursue. Prioritizing the most important ones will
maintain your focus through the negotiation period.
Do not get caught in the due diligence trees: Quality
due diligence can give you the ability to attack the
purchase agreement with focus.
It can also
overload you with information that can distract you
from the important issues in the transaction. For
example, in one recent deal, a $120 million buyout,
a well-known private equity fund teaming with
management had maneuvered into the preferred
bidder position. Most of the major issue had been
negotiated, but in the final stages, the buyer sought
to adjust the purchase price downwards by
approximately $300,000 with respect to a list of
smaller “issues” they discovered in the business
through discussions with management. As a result,
the seller delayed the deal and ultimately selected a
different buyer who offered $1,000,000 more in
purchase price to lock up the deal. No doubt a case
of bad deal-making, but the lesson is not to let good
due diligence create non-material issues that creep
into the negotiations and take you off track, or worse
out of the game.
Don’t become married to the deal: Too often,
buyers find warts on a seller’s business that should
cause them to run away as fast as they can.
However, because of “land grabs” in certain
industries and the ongoing pressure to do deals,
buyers sometimes become too entrenched in a bad
deal to let go. Admittedly, it is hard for business
development officers or managing directors of
private equity firms to walk away from a transaction
in which they have invested hundreds of hours, but
sophisticated buyers should develop objective deal
team members to ensure that, after the warts are
uncovered, the negotiated price and overall
transaction still makes sense for buyer.
Do buyers stand a chance in this market? The answer
is yes, but they need to be more precise and selective in
their approach to negotiating the purchase agreement.
Quality due diligence is a key driver in the process, but
equally important is how the information is used in
negotiating the purchase agreement.
Wayne Elowe and Michael Hollingsworth are partners in the
Corporate Group at Kilpatrick Stockton LLP in Atlanta. They
both are members of the Firm’s Middle Market/Private Equity
Team handling domestic and international mergers,
acquisitions and other transactions for corporate clients and
financial sponsors. Wayne can be reached at 404-815-6590 /
[email protected] and Michael can be reached
at 404-815-6040 / [email protected].
Kilpatrick Stockton LLP is an international law firm with over
480 lawyers practicing in nine offices across the Southeast,
Washington, D.C., New York, London and Stockholm.
www.kilpatrickstockton.com.
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