Dentons’ James Vernon reflects on how difficult economic conditions are impacting the M&A market
Geopolitical and economic volatility continues to impact the global M&A market, driving uncertainty around asset valuations. In brokering deals against this backdrop, there is an increased emphasis on the need for parties to navigate valuation gaps. In response to this, we are seeing the use of contingent consideration structures, as well as elements of non-cash consideration, feature more prevalently in M&A transactions.
An example of this can be seen in the use of earn-outs. Traditionally, the role of earn-outs has been to incentivise management sellers where they continue to run a target business post-completion. Recently we have seen more attempts to use such mechanisms creatively, including where there is little or no post-completion management role for the sellers.
Buyers concerned about risk or performance of a target may view such earn-outs as highly contingent; sellers confident in their business may view them simply as akin to deferred consideration. Addressing this conceptual divide will often require careful consideration and artful negotiation, with the reduction of subjectivity being a key goal. Clear dispute resolution mechanics are indispensable. Conduct of business controls should also be premeditated (including factoring in buyers’ business plans, strategic priorities and integration strategies), as should the treatment of exceptional events.
We have also seen a rise in partial acquisitions coupled with put/call options as a tool to bridge valuation gaps. Such structures involve the seller being left with a (usually minority) equity stake, typically with the parties each having an option to require the sale of that stake to the buyer at a later date at a price based on a metric such as multiple of earnings or revenue. This gives the seller some exposure to the trading of the business during the option period (along with the opportunity to realise value above that implied by the original valuation) while allowing the buyer to ensure that this element of the valuation is supported by the actual performance of the business.
As with earn-outs, the mechanics of a put/call option mechanism need to be carefully structured and will often be heavily negotiated. The timing of potential exercise of an option, the valuation methodology and any conditionality all need to be considered, as do potential gap-period controls. The interplay with business warranties (including potential repetition of warranties) will need to be scrutinised and agreed.
Other forms of contingent consideration are also becoming increasingly prevalent, including those focused on the realisation of value of a specific asset within a target business. Where the seller is more confident than the buyer of the value represented by such an asset, a contingent consideration mechanism can allow for this value to be shared without the buyer being exposed if such value is not ultimately realised. One example we are increasingly seeing is the use of contingent consideration mechanisms in relation to the realisation of tax assets.
Regarding the use of non-cash consideration, we are starting to see a revitalisation of public company share consideration as a competitive consideration component. Strong PLC balance sheets and perceived conservative share prices may offer significant potential value to sellers. This in turn can afford PLC buyers increased flexibility and purchasing power, particularly in the face of increased borrowing costs and lower liquidity elsewhere.
M&A may be facing more challenges than we’ve seen in recent years; however, we expect to continue seeing strong opportunities for parties prepared to be creative and flexible in their approach to deals – including to bridging the value gap.
