By Steven Keeler
Buyer Appetite Strong Even as Economic Clouds Persist
Just few weeks to go in Q3 2022 and even with economic storm clouds persisting, we’re expecting a busy year-end for private company sales, acquisitions and mergers, at least in the US. We understand the negative vibes: M&A deals slowed after an unusually robust 2021, and now we’re talking about a “technical” recession (business growth contraction plus inflation is never good). But, surprisingly, the market is still strong by historical standards. This is especially true in the U.S., where the impacts of COVID and the war in Ukraine have been easier to manage than in Europe and China. The continued optimism around US M&A is due in large part to our “innovation” economy, as its darling sectors (technology, media, and business and financial services) seem to thrive on global challenges (every sector seems to be focused on operational improvements driven by technology and all things data). And private equity’s hand in the lower-middle-market (as sellers and buyers) is an equally impactful positive dynamic. Of course, we can’t take our eye off the economic ball, and there are new negative indicators around industrials and manufacturing, which may be showing signs of stress from the supply and demand (export) sides. And there are early signs that consumer spending will be the next problem. Source: Datasite® Mergermarket, Deal Drivers: Americas HY 2022. But this discussion is about your company and how your exit plan might overcome and even capitalize on the economic uncertainty.
The main challenge in providing a deal done in Q4 2022 will be, as always, busy year-end schedules and the need to work fast. Many buyers will want to get a deal done in 2022, but many of them already have deals in the pipeline. Sellers that already have a sale process in the works will more likely be able to close in 2022. But even sellers that are just now deciding to move forward, and who can create the right story in the coming weeks, may be able to get a deal done in 2022.
Turn Uncertainty into Opportunity with Your Company Positioning and Pitch
PE funds are flush with cash and public corporate buyers are deploying their excess cash for less risky buy-versus-build (product and service enhancement through digital transformation and technology generally) and add-on (customer and capacity) acquisitions. Buyers really want and need to find good companies to acquire. So, if it’s time for you to exit your company, take it from our experience with recent deals: prepare your pitch to differentiate your business, highlight its and your management’s strengths for a downturn, and demonstrate your customer traction and loyalty. More important, tailor your pitch to each buyer, highlighting the synergies it will derive from your company. If your company is in a currently challenged industry such as industrials and manufacturing or consumer products, then consider how you can differentiate yourself either technologically or as a brand. If your company is in a strong sector like IT, AI, cyber or media, you’ll have more competition from other good companies, but an easier road to getting your price and terms. Contrary to prior cycles where money was following disruptive, first-mover technology companies, the current environment will reward sellers that can demonstrate an ability to weather a recession (and “green” or evolve their business) through solid third-party relationships, bottom-line management and an ability to evolve and transition to new verticals and markets. It will be important for sellers to find buyers who might see synergies in your business, whether revenue, cost, operational, product, technology, or talent related.
If you decide to press forward with a year-end sale, get your company housekeeping in order. You team of advisors should help you clean up your financial and legal records so that you can be prepared to respond to buyer questions and due diligence. This requires a lot of work, but it is part of the company sale process, and is well worth the time and expense.
Educated Guesses About Deal Process and Terms
Despite the economic uncertainty and expected increase in buyer due diligence, the “market” for legal or purchase agreement terms is still relatively favorable to sellers. Following is a list of some of the trends that we are seeing.
Deal Closing Time and Year-End Pressure. On the plus side, virtual or remote closings and data rooms will continue to quicken the pace of (legal) deal processes, but deeper buyer (business, financial, market) due diligence dives will lengthen deal process timelines, especially when the buyer is making its first acquisition in a particular vertical. Six months to close a deal is the norm, but faster sale processes can happen with focused buyer identification and effective teamwork. Every market, and every company and buyer candidates, are different. So some companies will still be able to close a deal in 2022 even if they are just starting their sale process.
Pricing and Payment Terms: Sellers Should Resist Large Earnouts or Post-Closing Payments. While many believe valuations have come down, it depends on the company and the buyer’s objectives. Buyer-seller valuation gaps may again have to be closed with post-closing royalties or earnouts, seller notes and rollover equity. This, notwithstanding the recent decline in the frequency, size and time periods of earnouts. Apparently, there was a slight increase in the number of strategic acquisitions using cash and buyer equity in 2021. Sellers will of course want to maximize closing cash and minimize or eliminate any post-closing consideration. In our experience, there is always one buyer who may be willing to pay the seller’s price in cash at closing. But this will depend on the seller’s value proposition and story. In private equity deals, sellers will often agree to retain or “roll over” some of their equity in hopes that they can benefit from a second “pop” on a second sale of the company by the private equity buyer. This can also go a long way to reducing the buyer’s closing cash need and bridging valuation gaps.
Closing Certainty: PE Buyer “Equity Backstop Commitment Letters”. A surprising number of deals will continue to be sales to private equity funds. Sellers should always be mindful of the buyer’s ability to close. Private equity buyers will almost always use debt in addition to their equity to close deals. As leveraged buyout or “LBO” debt becomes more expensive and harder to get, larger private equity funds may be willing to win the best deals by not only avoiding financing contingencies but providing a contractual commitment to close an all-equity deal. To get a deal done in Q4 2022, sellers may be willing to take some closing risk for the right price, but this will make assessing the buyer’s objectives, strategic interest in the deal, and desire to close critical.
A Good Time in Terms of Post-Closing Seller Risk. Sellers should always be mindful of post-closing purchase price adjustments and potential buyer indemnification claims for breaches of representations and warranties. Sellers and buyers increasingly prefer insuring against liabilities for breaches of seller representations and warranties through representations and warranties insurance or “RWI”. This avoids large cash holdbacks or indemnification escrows and buyer recourse against sellers. And RWI significantly reduces the lawyer time required to negotiate the purchase agreement. And even in smaller deals, sellers have been increasingly able to limit their post-closing liability to only fundamental representations and warranties (referred to as “no seller indemnification” or “NSI”). In terms of seller post-closing deal risk, this is the golden age. Don’t be afraid to push buyers for RWI and NSI. The worst they can do is say no.
Continuation of Equity Versus Asset Deals. Fortunately for sellers, most deals will continue to be structured as mergers or stock purchases, as opposed to asset acquisitions. The reasons for this are now well-known: corporate acquirors care less about tax treatment, creative deal structures can provide financial and corporate buyers with asset-purchase tax treatment in equity purchases, equity purchases are often less tax-expensive to the sellers, and equity deals are easier to close as, among other advantages, they avoid the need for third-party contract, intellectual property and other assignments and conveyances.
Good Financial Statements and Minimizing Post-Closing Price Adjustments.Virtually all deals will continue to provide for a post-closing audit of the seller’s working capital, cash, debt and transaction expenses and a true-up or down of the purchase price. Company financial statement audits prior to a sale will be a real value-add as buyer comfort is increased and definitive agreement terms usually focus on “GAAP” whether or not a company’s financials are audited.
Positive Seller Trends in Legal Terms. Although RWI will go a long way to making the negotiation of legal deal terms easier, sellers should understand and make sure their counsel negotiates seller-friendly definitions of “material adverse effect” and seller “knowledge”, as these have become somewhat more middle-ground than in the past. Sellers’ counsel should insist on making the purchase agreement indemnification provisions the sole and exclusivity legal remedy for seller breachers. Sellers should also be able to reject any “full disclosure” or “10b-5” representations. Also favorable to sellers, they should be able to get “no other representations” and “no-reliance” clauses in the purchase agreement.
The End of Reverse Termination Fees? There was a period during which sellers became aggressive about demanding that buyers pay a termination fee in the event the buyer failed to close a deal. At least in the lower-middle-market, such fees have become rare and, assuming that a good buyer has been selected, pushing for termination fees is usually not productive. On the other hand, if the seller is an attractive target, in order to keep multiple buyers in an auction process and avoid exclusivity until a purchase agreement can be signed, sellers can often convince buyers to stay in the process without exclusivity in exchange for an agreement to reimburse the buyer’s legal fees and expenses subject to some cap in the event the buyer’s bid is not accepted.
Take Aways
We have every reason to believe that the active M&A market will continue for some time through Q4 2022 and maybe beyond. Given the economic uncertainty, it’s hard to make any prediction about the M&A market in 2023. Every economy and downturn is different, but this one presents an unusual combination of CEO and PE fund optimism about doing deals and concern about the economy. As always, good companies will be able to sell at good prices and on good terms, and good buyers will find them. In terms of closing timelines, sale processes and deal and legal agreement terms will remain the same (perhaps plan on six months to get a deal done, unless a buyer can be convinced to close more quickly at year-end), but much may begin to change in such a dynamic market. As we always recommend, don’t let the economic and deal trend news drive your decision making as an owner or buyer. Every company is unique, and many of the best deals, for sellers and buyers, are struck during so-called down markets or even recessions. That’s because some owners and businesses figure out how to leverage downturns to their advantage. To be sure, sellers should carefully consider whether pushing to do a deal in 2022 might make good sense given that the currently active deal market may not continue into 2023. But for good companies (i.e., those that are relatively recession-proof and have differentiating and best in class characteristics like strong management and customer “stickiness”), a good deal might be possible, and even more lucrative, in any market.
Suggested reading:
3 M&A trends to watch in 2022, CEO North America, https://ceo-na/business/industry/3-ma-trends-to-watch-in2022/.
2022 Future of M&A Trends Survey, Deloitte.
M&A Trends in the Lower and Middle Markets, Benchmark Internation (6/8/22), https://blog.benchmarkcorporate.com/ma-trends-in-the-lower-and-middle-markets.
Downshifting: M&A trends in industrial manufacturing, KPMG.
2022 Emerging trends in U.S. Mergers and Acquisitions, https://www.wolterskluwer.com/en/expert-insights/2022-trends-in-us-mergers-and-acquisiitions.
Deals 2022 midyear outlook, PwC, https://www.pwc.com/us/en/services/consulting/deals/outlook.html.
© Copyright 2021 by Keeler PLC
All rights reserved.
Terms of Use & Privacy Policy
Design by NexFirm