Challenges continue for private equity funds seeking to deploy unfunded capital—estimated at US$1.7 trillion in December 2017.1 Financial buyers are working diligently to both identify investment opportunities outside formal sales processes as well as source deals through auctions. In both cases, the competition for good assets remains fierce.
As these macro-dynamics remain unchanged, buyers looking to distinguish themselves, particularly in hot auctions, are adjusting their strategies. In this article, we examine three strategies that private equity funds are successfully putting to use.
Relieving Sellers From Post-Closing Indemnity Recourse
Some private equity buyers offer to acquire private company targets without seeking a post-closing indemnity from the seller for breach of representations and warranties in the purchase agreement, relying instead on representation and warranty insurance (RWI) to cover any potential claims.
These no-seller-indemnity transactions are bringing private M&A transactions in line with public M&A transactions, which lack purchase price adjustment and indemnity provisions as buyers do not require a claw back of sales proceeds from a large group of public shareholders once the public-company acquisition has closed.
Historically RWI insurers have requested “retention amounts” (i.e., the deductible under the insurance) in excess of 1% of enterprise value. Since that amount was greater than what a buyer would typically have been prepared to absorb as a deductible in a private M&A deal prior to the advent of RWI, buyers frequently asked sellers to “share the retention.”
In recent months, the retention requested by RW insurers has come down, putting buyers in a position to let sellers “off the hook” for claims within the retention. From there it’s only a small step to eliminate any post-closing recourse to sellers, including for “special” indemnities. The result? Brokers are reporting that 20%-25% of RWI deals do not provide for any seller indemnity.
While RWI deals without a seller indemnity will attract slightly higher policy premiums, there are other potential costs to the buyer, including limited recourse to the seller post-closing for breach of covenants, company debt and transaction costs not included in the purchase price adjustment (resulting in potential buyer exposures once the RWI policy limit has been exhausted).2
Light Touch on the Mark-Up, Roll Up the Sleeves on Due Diligence
As an alternative to offering the seller a clean exit from the transaction through RWI, we have also seen some buyers adopt a “light touch” approach to marking up the auction draft of representations and warranties a seller is willing to give in respect of the target.
Buyers will need to weigh the importance of conducting thorough due diligence against that of offering sellers speed of execution.
As prospective buyers move away from relying on the seller’s representations and warranties to provide comfort on the quality of the assets being acquired (in scenarios where RWI is not used), due diligence is becoming more critical to the deal process. However, there is an inherent tension between extensive due diligence and competitive auction dynamics; a buyer will need to weigh the importance of conducting thorough due diligence against that of offering the seller speed of execution—often a key element of a winning bid in a hot auction with buyers vying aggressively to close the transaction.
Accordingly, many financial buyers are conducting more diligence ahead of engaging in a deal process, developing deep sector knowledge and expertise, and valuating and testing key deal drivers and financial metrics so that they can comfortably move fast when a target comes up for sale. This is especially the case given the many high valuations that good assets are commanding in today’s climate.
Getting the scope of due diligence “just right” is also of eminent importance on deals featuring RWI. The buyer’s diligence and industry expertise is not always a benefit to the RWI process—a known breach will result in denied coverage from insurers, while too little diligence can lead to exclusions from insurance coverage.
Debt Financing Moved Until After Closing
Having no need for debt financing at closing (and thus no need for reverse break fee constructs or conditions) may be another winning bidder strategy in a hot auction context, one that is particularly well suited for deals with smaller enterprise value.
Those deals may permit financial buyers to fund the purchase price with equity only, or in some instances, to bridge-fund the acquisition through an existing facility at the fund level. Third-party debt financing is then handled after closing at the portfolio company level. A fund limited partnership agreement can include the appropriate flexibility to permit borrowing for these purposes.
Some prospective buyers will also consider a locked box structure to enhance price certainty for the seller. In the last year, we have seen a notable uptick in the use of this structure.
The locked box structure has the advantage of offering price certainty at signing and relieves parties from negotiating purchase price adjustments and potential related disputes post-closing.
With a locked box structure, the purchase price is fixed at signing. From that date onward, the “box is locked,” and the risks and rewards of the target business are transferred to the buyer. Robust interim covenants for the period between signing and closing are negotiated to ensure no value leakage from the target to the seller and that operational risk is mitigated. The locked box structure has the advantage of offering price certainty at signing and relieves the parties from negotiating purchase price adjustments and potential related disputes post-closing. But—like the other tactics discussed above—the locked box is not free from drawbacks from the buyer’s perspective.
For example, the buyer will need to thoroughly diligence the balance sheet on which the purchase price is determined, because unlike transactions using the conventional mechanism, there will not be an opportunity to dispute balance sheet positions once the value has been locked. This is particularly true where the balance sheet is not audited. It may be difficult to reconcile that upfront due diligence commitment with other transaction dynamics, especially in a hot auction.3
The crowded market is impacting deal processes and strategies as prospective buyers face ongoing hurdles to deploy capital. Aside from evolving strategies in the course of formal sales, we are seeing financial investors look at different ways to remain competitive. These include pursuing alternative structures, such as teaming up with strategic buyers to pursue investments, minority-stake investments and opportunistic transactions in struggling sectors. While some speculate that the private equity market may soon be peaking, we anticipate that investors will continue to adapt their strategies to suit changing market conditions. Overall, private equity continues to thrive, with growth in ongoing institutional investor support and plans from more investors to allocate capital to the asset class in the coming months.4
1 See Bain & Company’s “Global Private Equity Report 2018.”
2 See more on RWI trends in our earlier Torys Quarterly commentary, “The New Normal: The Latest Trends in Representation and Warranty Insurance.”
3 For more details on the locked box structure, see Torys’ commentary on “Deal Certainty: More Sellers Will Seek to “Lock the Box.”