By Dr. Tobias Will
The world is in the grip of the coronavirus pandemic. Companies’ priorities are shifting – away from transactions and towards ensuring their own ongoing viability. But as soon as the economy starts up again, corporate transactions will be back on the agenda. The CMS European M&A Study provides decision-makers with an important resource in this respect.
The coronavirus dominates the pages of every newspaper, magazine and professional journal at present, leaving little room for other news. Especially in times like these, it is often worth looking back in order to identify the right way forward. The transaction market is no exception. The key finding of the recently published CMS European M&A Study is that Europe is still a sellers’ market. In 2019, sellers were again able to agree on key aspects of risk allocation in M&A transactions in their favour. It is doubtful whether this trend will continue in 2020, though, not least because of the coronavirus pandemic and its impact on the economy.
Each year, the CMS European M&A Study examines contractual provisions in M&A transactions handled by CMS (a total of 466 share and asset deals in 2019) and compares them with the previous year’s results. It also presents the trend over the entire twelve-year period since the inception of the study, and a nine-year reference period (2010 to 2018) based on more than 3,300 evaluated transactions. This comparison in particular shows that both buyers and sellers have become increasingly sophisticated and demanding. It is therefore even more important for deal participants and their advisers to prepare carefully and rigorously in advance of any transaction. The size of the deal sample and range of countries involved means that the study is a uniquely valuable and rich resource for all M&A practitioners across Europe and provides useful guidance.
Trend continues: market remains seller-friendly
The existing market trends across Europe continued in 2019. They included deal participants again tending to allocate risk in favor of the seller. This can be seen especially in the use of provisions that are generally considered to be seller-friendly, such as liability caps, de minimis, basket and locked box arrangements. Warranty & indemnity insurance (W&I) has become even more prevalent as a replacement for, or an addition to, warranty coverage by sellers. In many respects, market practice has remained broadly unchanged over the last five years, particularly with regard to purchase price adjustments, locked box structures, liability caps, earn-outs and security for warranty claims. It is noteworthy, however, that deal drivers have shifted significantly compared to the previous year. Some 46% of the evaluated deals involved the buyer seeking to enter a new market – a substantial increase over the previous year (32%). The acquisition of know-how or skilled employees (acqui-hire) also played a much more prominent role in 2019 (41% compared with 23% in the previous year). Whether or not this constitutes a trend can probably only be established with any certainty in a year’s time.
Locked box provisions increasingly popular
Buyers insist on purchase price adjustment clauses to ensure that they pay the right purchase price for the target company at the closing date. Locked box arrangements, on the other hand, are intended to provide the seller with certainty about the purchase price. Purchase price adjustment clauses are being used less often overall (45%), whereas locked box provisions are on the rise (56%). Where a purchase price adjustment is agreed, the parties increasingly use adjustment parameters that are as simple as possible and difficult to manipulate – in particular the cash-free/debt-free position (50%). This reflects a desire by sellers and buyers to obtain certainty as to the amount of the purchase price when signing the transaction documentation and to minimize the potential for dispute if the purchase price has to be adjusted.
Record year for W&I insurance
W&I insurance is in particular demand where sellers only accept a low liability cap, as in the case of private equity sellers, or where there is an insufficient amount of coverage provided by the warrantors. The year-on-year rise in popularity of W&I insurance continued, climbing 2 percentage points to 19% of all deals in 2019, while almost half of deals worth more than EUR 100 million now involve a W&I insurance policy. As premiums have decreased, the W&I market has become more accessible and particularly for larger deals the seller is now able to offload liability to the W&I insurer. Real Estate & Construction is the most popular sector for W&I insurance.
Liability caps depend on deal size
The concept of limiting the seller’s aggregate liability under the company sale and purchase agreement is absolutely standard in M&A contract practice. The issue during contract negotiations is usually merely the exact level of the liability cap. In 2019, the cap was below the purchase price in the majority of transactions (65%). Overall, liability caps are increasingly determined by deal size. The purchase price is most likely to be the overall cap for a smaller transaction (30% of transactions worth under EUR 25 million), while for larger transactions the cap is most likely to be significantly less than the purchase price – often just 10% to 25% of the purchase price.
Outlook: Distressed M&A transactions set to be a major factor
Existing market trends continued in 2019, especially with regard to seller-friendly provisions and W&I insurance. But what will the M&A market look like after the coronavirus pandemic has abated? Although transactions are now largely at a standstill, it is highly likely the second half of 2020 will see a rebound. Having said that, distressed M&A will probably dominate. The recent very high valuations can be expected to fall, or at least stop rising. Many buyers have put transactions on hold for the time being, but they will want to spend their funds this year, or may be compelled to do so. In the process, they will encounter sellers who are under increased selling pressure due to the coronavirus crisis, especially in cases where they need to restructure.