Overview

The 2023 M&A Deal Terms Study published by SRS Acquiom on April 25, 2023 provides an overview of market trends based on an analysis of over 2,100 of their private-target M&A transactions closed between 2017 and 2022. The vast majority of this sample involved U.S. public and private buyers, and ranged in transaction size from US$25 million to US$750 million. Below is a selection of some of SRS Acquiom's key findings, which provide valuable insight into the direction of today's M&A market.

  • Transaction values in 2022 have been returning to pre-Covid numbers following the notable "Covid bump" in 2021.
  • A generally seller-friendly market has greatly influenced trends across the board, and raises the question of whether these trends will continue going forward, or whether the pendulum will swing back to a more balanced (or even to a more buyer-friendly?) market.
  • Representations and Warranties Insurance (RWI) was identified on approximately 40% of 2022 deals in this study, and the actual number is likely slightly higher given that parties do not always disclose the presence of an RWI policy, particularly of a buy-side RWI policy. It is important to keep this in mind when analyzing overall market trends, as the use of RWI can have an impact on deal terms across the board, including the scope and survival period of representations and warranties, as well as the limitations and applications of indemnification regimes.

Financial Terms and Provisions

Lower Valuations with a few Mega Deals

Transaction values were generally lower in 2022, with buyers looking to acquire mainly lower-middle market targets as a result of uncertain economic conditions and limited financing options. The median return on investment was also down in 2022 (4.0x versus 5.2x in 2021), but still higher than it had been prior to Covid in 2019 and 2020. The average return on investment actually increased in 2022 (9.1x versus 8.5x in 2021), but these numbers are skewed by a handful of major deals in 2022 with extremely high transaction values and corresponding returns on investment.

Management Rollovers on the Rise to Bridge the Valuation Gap

In 2022, 20% of the deals analyzed structured their consideration using a combination of cash and management rollover. The use of rollovers not only bridges the valuation gap, but also ensures the continuity of the business by retaining key personnel and their expertise. In addition, in an uncertain market, structuring consideration to include a management rollover avoids having to obtain the additional financing or otherwise pay cash up front.

Earnout or Lose Out

Another trend emerging from the economic uncertainty was the rise of the earnout provision. In a bid to bridge the valuation gap created by starry-eyed valuation expectations from sellers who promised the stars during the Covid bump and a tightening of the debt markets, parties have increasingly turned to earnouts in structuring their purchase prices. The year 2022 saw a higher prevalence of earnouts in general (present in 21% of deals across all industries except life sciences), a continuation of an upward trend that began in 2018 (though saw a small dip in 2021). Revenue still remains by far the primary metric, hovering somewhere around 60% in the past three years. The use of earnings and EBITDA metrics did increase in 2022 relative to "other" metrics (such as unit sales, product launches or other milestones) also held strong. There was also an increase in the median length of earnout periods, which was 24 months for 2022. As the popularity of earnouts rises, so too does the question of whether and to what extent the buyer is required to work towards meeting these milestones. In 2022, only 1% of deals with an earnout included a positive covenant for the buyer to run the business in such a way so as to maximize earnout payments, though 23% contained a covenant that buyer would run the business in accordance with seller's past practices. An express disclaimer of fiduciary relationship was included in 19% of cases.

The Devil is in the Details

Purchase price adjustment ("PPA") mechanisms remain nearly universal, appearing in 94% of deals in 2022. However, we note that parties are increasingly opting for added certainty in PPA calculations, choosing to annex detailed illustrative calculations in over 25% of these deals. The use of a separate PPA escrow is also steadily on the rise, increasing substantially in both frequency of use and percentage of transaction value. For reference, in 2019, 59% of deals contained a separate PPA escrow with a median size valued at 0.61% of transaction value while in 2022, 73% of deals contained a separate PPA escrow with a median size valued at 0.88% of transaction value. The vast majority (98%) of deals with a PPA mechanism included some cap on a buyer-favorable adjustment, usually either limiting it to either the PPA escrow amount or the general liability cap. The Deal Terms Study also notes a strong correlation between the use of a separate PPA adjustment and RWI-insured deals (in 2022, 93% of deals with RWI contained a PPA escrow versus 56% of deals with no RWI). However, given that RWI should not have any impact on PPAs, we understand this to correlate more with the seller-friendly market conditions observable over the past couple of years than with the existence of RWI as such.

Seller Reps and Warranties

"No Other Reps" and Non-Reliance

Another observable impact of RWI is the increased inclusion of "no other representations and warranties" and non-reliance clauses. Since 2019, in cases where RWI was identified, both "no other representations and warranties" and non-reliance clauses were included in 70%-80% of cases, depending on the year. In deals without RWI, this number is closer to 50-55%. Probably also resulting from the increased presence of RWI, express carveouts for fraud are on the rise, with such carveouts being included in 21% of "no other representations and warranties" and 19% of non-reliance clauses in the 2022 sample.1

It's Not Material

Other trends observable over the past three years relate to the requirement for accuracy with respect to the representations and warranties of the seller, both at signing and at closing. Since 2019, there has been a steady increase in the use of the "material adverse effect" qualifier (with a carveout for capitalization), which was included as the standard in 95% of deals in 2022. This is another trend that can be credited to the seller-friendly market conditions, and which we may see return to a more balanced (e.g. "in all material respects") type of standard as market conditions shift. Despite this generally seller-friendly market, buyers are not without protection in this realm, as the Deal Terms Study also noted an increased frequency in the use of materiality scrapes, which were included in 96% of deals in 2022.

Indemnification

I Will Survive?

Another obvious impact of RWI has been on the existence of survival periods for seller representations and warranties following closing. Over the past four years, in deals where no RWI was identified, the "survival rate" of representations and warranties is close to 90%. However, where RWI is identified, that rate drops significantly, varying between 50-79%, and generally trending downwards. Unsurprisingly, and closely connected to the use of RWI, is the fact that fraud and intentional misrepresentation are the single item most frequently indicated as surviving indefinitely, even beyond the term of fundamental representations.

Sandbagging and Scrapes

Also affected by the prevalence of RWI are the use of sandbagging clauses and materiality scrapes. Pro-sandbagging clauses, though relatively rare in Canada, were found in approximately 50% of the deals included in this sample from 2019 to 2022, with the other approximately 50% of deals remaining silent on the matter (and virtually nil including anti-sandbagging clauses). These numbers are significantly affected by the presence of RWI. In deals where RWI was identified, 33% contained pro-sandbagging clauses and 66% were silent on the question of sandbagging, while in deals where no RWI was identified, 57% contained pro-sandbagging clauses and 40% were silent. Materiality scrapes are likewise significantly affected by the presence of RWI. Between 2021 and 2022, some form of materiality scrape was included in about 85% of deals, with double materiality scrapes being the most common and appearing in approximately 50% of deals. Over the past four years, the existence of RWI has consistently reduced the presence of both double and single materiality scrapes in M&A deals, in some cases even eliminating them altogether.

Baskets and Caps

Trends on baskets have remained relatively stable over the last four years, though the amount of deals with no basket have steadily increased (19% in 2022, up from 11% in 2019). Like some of the other seller-friendly trends noted above, we expect that this is a result of market conditions and we might see a return to the use of baskets as the pendulum shifts back. Where baskets are present, they most often represent a true deductible (in 42-48% of cases) versus a return to first dollar (37-39% of cases). Once again, the presence of RWI plays a huge role in negotiating limits on indemnification in general, and baskets in particular. It is certainly the key factor in the overall reduction of baskets over the past four years, as well as the increase in provisions that provide for a true deductible versus a return to first dollar (the latter being substantially more common in uninsured deals). RWI makes its presence felt again when it comes to caps on liability and indemnification. In 2022, the average cap was 13% of transaction value and the median was 10% of transaction value. If the subset is limited to uninsured deals, the average cap rises to 15.5% and the median remains at 10%. If the subset is limited to insured deals, the average cap goes down to just 5.7%, and the median all the way down to 0.5%.

Indemnity Escrows

Unlike the PPA escrow mentioned above, indemnity escrows are heavily impacted by both seller-friendly market conditions and the existence of RWI. In 2022, indemnification escrows were present in 66% of all deals, but only in 46% of insured deals (versus 79% of uninsured deals). Furthermore, the presence of RWI also affects the amount of the indemnity escrow, which is an average of around 4.5% of transaction value in insured deals versus approximately 14% of transaction value in uninsured deals.

Conclusion

The Deal Terms Study confirms what many of us working in the private M&A sphere have observed over the past couple of years. First, it is becoming increasingly evident that the 2021 "Covid bump" was indeed a true anomaly; one that has and will continue to normalize. Second, and potentially as a vestige of the "Covid bump" era, parties are continuing to operate in a very seller-friendly market, which has had an impact on everything from valuation to indemnification. The real question for the upcoming quarters is whether this will continue to be the case, or whether the pendulum will shift once again and result in more balanced market conditions, giving buyers an opportunity to negotiate for some more buyer-friendly, or at least more balanced, deal terms. Finally, RWI continues to take the private M&A market by storm, proving year after year that the product is here to stay, and will continue to shape the way that parties think about and negotiate transactions.

Footnote

1. We note that such carveouts are not typically required in Québec, as the civil law imposes an implied duty of good faith, but is nevertheless interesting to note for out of province and cross-border transactions.

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.