The Australian M&A market resurged in 2021 with record-breaking deal activity as investors turned their backs on pandemic-induced economic uncertainty. With significant amounts of deployable capital preserved as a result of cost-saving initiatives during the height of COVID-19, this trend continued strongly through the first half of 2022, but trailed off in Q3 as a result of significant market disruptions, with the aggregate value of global M&A deals in the second half of last year falling below $1 trillion. By the end of 2022, the aggregate global value of M&A transactions reached $3.6 trillion, down from the record-breaking $5.9 trillion in 2021.
The Russian invasion of Ukraine, followed by swiftly imposed sanctions and retaliatory diplomatic actions plunged many of Australia's supply chains into disarray, and heralded a global energy crisis that placed increased demand on Australian commodities which consequently saw domestic gas and electricity prices skyrocket. These events coupled with inflation, rising interest rates, supply shortages, fiscal policy tightening and volatile equity sectors all contributed to stymied market confidence with a consequential reduction in M&A deal volume, dropping 40% by the second half of 2022.
Despite this, in Q1 of 2023, we are seeing plenty of investor enthusiasm in the resources and renewables sectors. Investment in clean energy must increase globally by $3 trillion by 2030 to achieve net zero emissions under international commitments. Although we expect further headwinds as buyers adjust to tighter debt settings, we anticipate plenty of investor interest in renewable energy sectors as quality projects become available. That, however, is likely to fall into insignificance when compared to the high-value transactions anticipated as global energy and resources companies look to reposition themselves in the global drive for decarbonisation. Already we have seen BHP and its business partners taking material steps in this regard by planning to exit its coal mining activities. The opportunities this, and similar strategies from other global players, presents to the market and the impact on M&A activity generally cannot be underestimated. There are likely to be some significant success stories that result from those taking advantage of these changes in strategy.
Having been fortunate to work alongside many of our valued clients in some of Australia's key M&A transactions. Arising from this experience, we have identified several key trends in M&A transactions which we anticipate will continue through 2023.
Broader due diligence investigations
We have seen a significant move away from the quick and limited approaches to due diligence adopted by some buyers, with more buyers looking to leverage as much protection as possible by imposing settlement conditions that due diligence must first be completed to the buyer's satisfaction. This creates a burden on sellers to maintain and present a clear log of key documents and information that buyers will need to consider when determining whether to proceed with a transaction. This has also become important in the context of obtaining warranty and indemnity insurance (which we also discuss below).
Buyers are becoming even more astutely aware of the need to focus on the ability of a target company or asset to continue to operate in less than certain business environments. Following an uptick in cyber security incidents in 2022, buyers are now paying close attention to cybersecurity and critical infrastructure considerations as part of the due diligence process.
Although the extent of due diligence required is dependent on the nature of the target company or asset, as well as the industry sector, sellers are encouraged to set up and maintain a detailed data room of key documents and information that can be accessed by key personnel to the transaction. Sellers need to be thorough in disclosing as much information as possible to limit their liability under increasingly onerous warranty and indemnity regimes.
With buyers focusing on due diligence now more than ever, sellers will want to avoid any liability for pre-contractual representations or non-disclosures which could amount to misleading and deceptive conduct under the Australian Consumer Law, including by failing to disclose key information.
Bridging the price expectation gap and price adjustment mechanisms
Traditionally, buyers have paid consideration for a target company or asset by way of cash, or a combination of cash and shares ('scrip') in the acquiring company or its ultimate parent company which is driven in many cases by tax considerations.
However, deal-makers in the resources sector are now coming up with more creative ways to secure and complete transactions in order to spread and limit their risk profile.
Royalty and similar arrangements
Buyers are utilising contractual royalty arrangements as a component of the purchase price consideration. A private contractual mining royalty is at its essence a future income stream that is agreed to be paid by the purchaser of a project by reference to the future success of the project. There are no set guidelines or attributes required to be negotiated or included in any agreed royalty terms. This flexibility is an attractive proposition for both buyers and sellers as it allows them to agree to arrangements that might satisfy a broad range of commercial needs.
From a buyer's perspective, a contractual royalty arrangement is a very favourable outcome commercially as it allows them to de-risk their investment. For the most part, a buyer may not agree to pay anything to a seller until a project becomes successful. While the deferred timing of royalty payments to a seller may appear to be detrimental it is, in many ways, a form of 'at risk' vendor finance. A seller might not receive a component of the proceeds from the sale of its mining operations until a later date, however, it is still attractive to the extent it might allow the seller to secure higher ultimate sale proceeds than might otherwise have been available.
Profit-based earnouts have similar features and outcomes to royalties and have proven efficient in an era where significant global market disruptions have led to difficulties in valuing businesses. For this reason, some parties to transactions now favour contingent price mechanisms such as an 'earn-out', which enable part of the purchase price to be adjusted by reference to the target company or asset's future profit performance. 'Earn-outs' are generally calculated by reference to the target company's Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) performance milestones for a particular period following transaction settlement.
Buyers have also traditionally sought to simply defer or retain part of the purchase price (by way of an 'escrow' or 'holdback' mechanism) to offset uncertainty of the target company or asset's future performance. However, because of significant debt tightening over the past year, many sellers are now negotiating away from escrow or holdback mechanisms as they look for certainty over buyer payment commitments.
With the rise of deferred payment mechanisms, parties should prepare for the likelihood that a dispute will arise in relation to a post-completion adjustment amount and should, generally, incorporate a robust dispute resolution mechanism into key transaction documentation with enough flexibility to resolve disputes without the need for recourse to costly and time-consuming proceedings. Common alternative dispute resolution mechanisms include negotiation between the parties, mediation, expert determination or, in cross-jurisdictional transactions, international arbitration.
Conditionality — material adverse changes
Buyers are revisiting the conditions which protect them against target company or asset risks prior to closing.
Until recently, there had been an emphasis by buyers on the inclusion of a material adverse change (MAC) clause in key transaction documents, either as a condition to completion or as an express termination right. The effect of a MAC clause allows a buyer to walk away from a transaction if the target company or asset is adversely affected by certain defined events. A MAC clause is generally intended to cover unforeseen events or consequences that materially affect the operation of the target company or asset, including the diminution of revenue, earnings, or net assets.
The use of MAC clauses dropped by about 13% across domestic M&A transactions in 2022, continuing a downward trend in their use since the beginning of the COVID-19 pandemic. The waning use of MAC clauses may be attributable, in part, to the growing adoption of extensive carve outs, which make it difficult for buyers to confidently rely on them to terminate a transaction. We also expect that economic disruptions and geopolitical uncertainty has steeled sellers' resolve to outright reject MAC clauses without the insertion of broad carve outs.
Generally, MAC clause carve outs will include events arising from general economic, industry or political conditions or changes outside of the sellers' control. Given the current global economic landscape, buyers face considerable difficulty in relying on MAC clauses which contain such carve outs and consideration must be made as to whether the existence of a MAC clause with extensive carve outs is worth its inclusion at all.
Buyers who wish to proceed with the inclusion of a MAC clause should be wary of attempts by sellers to carve out broad economic and industry-specific events that would effectively render the MAC clause redundant. To ensure the robustness and enforceability of a MAC clause, buyers should take care to draft them in such a way that the triggers underpinning the MAC clause are narrowed to those events specifically relevant to the target company or asset, such as the availability of suppliers or key personnel becoming unable to perform their duties.
Transaction insurance
As a result of global economic challenges, we are seeing a significant uplift in demand for warranty and indemnity (W&I) insurance from both buyers and sellers.
W&I insurance is a means by which the seller can facilitate a clean exit from the target company, while for a buyer it provides a certain level of security knowing that if a claim arises post-completion in relation to a warranty, the buyer can turn to the W&I insurance to compensate it for its losses. W&I insurance is particularly useful:
- for sellers, to circumvent the need for an escrow or a holdback arrangement under the transaction document; and
- for buyers, to provide greater protection by potentially providing a higher liability cap and extended periods of warranties than a seller may be willing to offer, and also greater certainty that any claims can be paid, particularly where the seller is in financial difficulty or leaving the jurisdiction following completion of the transaction.
With demand increasing, it is important for parties to understand it is not the role of W&I insurance to cover the sort of risk which the fallout of recent global economic challenges represents, and typically W&I insurers will not insure matters known by the parties. It is becoming common for W&I insurers in the Australian market to impose exclusions from their policies for known issues, including any matters which can be traced to certain supply chain issues.
An erase in competition comes naturally with demand. We are seeing, increasingly, many insurance brokers only agreeing to insure transactions with a consideration value of more than $50 million and, in any event, only those transactions which they consider have the highest degree of risk mitigation. When assessing each particular transaction, insurers are emphasising the need for comprehensive due diligence. Some insurers are now only agreeing to consider transactions at the earliest stages, so that they can follow a buyer's journey and direct due diligence or impose conditions in transaction documents. Insurers are now looking for and demanding broad warranties in transaction documents, with particular emphasis being placed on environmental, social and governance compliance, before considering whether to grant W&I insurance. From a seller's perspective, this underpins the importance of having a well-prepared data room and comprehensive disclosure of relevant information.
For parties considering W&I insurance, we are seeing the benefits in real time of bringing W&I insurers on board as early as possible. From a buyer's perspective, insurers can play an important role in due diligence investigations, creating greater certainty in negotiations. On a seller's side, having W&I insurance reduces the prospect of negotiations breaking down over the provision of warranties and indemnities, and bridges the warranty gap where a seller would prefer to provide warranties that are heavily qualified or for periods of time that are shorter than those usually provided in the market.
Limitations of liability
It is becoming common for sellers to qualify a number of the material warranties they provided to buyers such that they are only made to the extent to which the sellers have actual knowledge.
A 'knowledge qualifier' protects the seller because, to succeed in a warranty claim, a buyer will need to establish a breach of the warranty and also that the seller had knowledge of the circumstances leading to the breach. In these circumstances, it is in a buyer's best interest to include a definition of the knowledge qualifier in the transaction documentation to require the seller to have taken 'reasonable care' to discover and disclose the relevant facts before it can rely on the benefit of the qualifier. This includes requiring the seller to disclose matters 'to the best of its knowledge' (being all matters within the knowledge of the seller after making reasonable enquiries and undertaking reasonable searches).
Another standard mechanism to limit liability is to impose certain thresholds on the seller's total liability to the buyer for a breach of warranty.
These thresholds are generally split between time-based caps and monetary-based caps. For example, the parties may impose a minimum threshold (for example, that the amount of claim must exceed $10,000) and an aggregate threshold (for example, that the aggregate amount of all such claims exceeds $100,000) that must be met before the buyer can make a certain claim. Parties will often if not always seek to cap overall liability to 100% of the Purchase Price. The liability cap for certain warranty claims however is more of a negotiation. Our experience over the past year shows that caps for warranties other than tax warranties can range from 50% to 70% of the overall purchase price of the transaction. The cap for title and tax warranties will invariably always be 100% of the overall purchase price. Timeframes for breach of warranty claims are usually split between claims for tax warranties and claims for all remaining warranties. For example, we are seeing conditions that a claim for breach of warranty (except tax warranties) must be made within 12 to 24 months after the transaction completes, while a claim for breach of tax warranty must be made up to between five to seven years following completion.
Regardless of the limitations that the parties can negotiate, it is important for sellers to carefully review all warranties to ensure that warranties are able to be given subject to any disclosures and, for the buyer to be satisfied that those warranties give sufficient comfort and protection that the assets being acquired are worth how much is being paid.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
