What's Market In Private M&A? - M&A/Private Equity

Executive Summary

In what is always welcome reading for dealmakers, the American Bar Association (ABA) recently published its 2023 Private Target M&A Deal Points Study (US Deals).

The Study provides valuable insight into the direction of M&A trends in the US market and is a leading resource in answering a key transactional question: what's market?

To facilitate review of the 134 page Study, we've summarized a selection of its most significant findings. We also highlight the following key practical and commercial takeaways:

Representations and Warranties Insurance (RWI) has become an increasingly dominant factor in driving private M&A negotiations, and its impact on deal terms is often significant.
While M&A parties were more willing to agree to earnouts, buyers were simultaneously more successful in imposing limits on their earnout-related obligations and risk.
The prevalence of "#metoo" representations continued to grow, as did the scope of their coverage, and this was particularly so in RWI deals. Similarly, deals featuring privacy representations and cybersecurity representations were also up, again especially in RWI deals.
Regarding when the target's representations must be accurate, i.e., whether at both signing and closing or at closing only, there was a strong reversion to a much heavier weighting toward the former than the latter.
Deals continue to go increasingly silent regarding sandbagging, and the correlation of this trend with the increased use of RWI is clear.
The Study confirms RWI deals are likely to have smaller baskets than non-RWI deals. As for basket size overall, the Study records a decrease in baskets between 0.5%-1% with small corresponding gains in larger baskets in the 1%-2% and >2% categories. Most notably, the Study records a significant growth in the percentage of deals with no eligible claim threshold.
Regarding damages caps, the Study confirms that RWI deals are likely to have lower caps than non-RWI deals. Regarding damages caps overall, the Study records a reversion from the 2020-21 study (which saw a significant, seller-friendly shift towards smaller caps) back toward the cap ranges of the 2018-19 study.

For Fasken's practice-focused overview of Canadian private M&A caselaw and commentary, see Private M&A in Canada: Transactions & Litigation (LexisNexis, 2024).

Overview of Study Sample

The Study is based on 108 private M&A transactions signed and/or closed in 2022 and Q1 2023. 18% of the sample was asset deals. De-SPAC (Special Purpose Acquisition Company) transactions, bankruptcy transactions and reverse mergers were excluded from the sample.

Transaction values (based on purchase price) ranged from US$30M to US$750M. However, the sample was weighted towards smaller deals with 39.8% between US$30M and US$100M, 35.2% between US$101M and US$300M, and only 24% above US$301M.

The study does not distinguish between private equity and strategic buyers. Of the 17 industry sector tracked, those comprising the largest proportion of deals were tech (19.4%), health care (15.7%) and financial services (10.2%).

Representations and Warranties Insurance (RWI)

Somewhat surprisingly, the Study records a drop in the percentage of deals referencing RWI from 65% in the 2020-21 study to only 55% in the Study.¹

Not surprisingly, the Study records that in 97% of RWI deals the RWI policy is acquired by the buyer. One notable development regarding RWI recorded by the Study is regarding the buyer's express covenant not to amend the RWI policy post-closing without the target's consent, climbing from 36% of RWI deals in the 2020-21 study to 64% of RWI deals in 2022-23. Finally, the Study records that whether the RWI policy is the buyer's sole source of recovery is a complicated and heavily negotiated deal point, and with no clear trend observable over the four ABA studies tracking the data point.

Financial Terms

Purchase Price Adjustments (PPAs)

The Study highlights the heavily negotiated nature of post-closing PPAs and that PPAs have generally been trending towards greater complexity over time. A new data point tracked by the Study is whether the buyer has an express right to approve an estimated payment to be made by the target at closing. In only 8% of deals did the buyer have such a right. However, even where the buyer did not, in a significant majority of deals (59%) the buyer had at least a review and consultation right (as opposed to no express review and consultation right, as in the remaining 34% of deals).

The Study notes an evolution in the methodology applicable to the preparation of PPA balance sheets and with a significant move towards simply generally accepted accounting principles (GAAP) (up to 28% from 11%) and away from (i) GAAP consistent with past practice (down to 14% from 25%), and (ii) GAAP with specific modifications (down to 18% from 25%).

One area regarding PPAs where the Study identifies a reversion to the 2018-2019 study is the ratio of deals where a PPA payment is only required where the amount exceeds a threshold (19%, up from 10% in the 2020-21 study and close to the 20% of the 2018-19 study).

Earnouts

The Study supports recent anecdotal evidence and professional commentary suggesting an increase in the use of earnouts over the last couple of years as a means of addressing valuation gaps between buyers and sellers prevalent amid the M&A drought, the incorporation of earnouts rising to 26% from 20% in the 2020-21 study.

That said, several trends suggest that, while M&A parties were more willing to agree to earnouts, buyers were simultaneously more successful in imposing limits on their earnout-related obligations and risk. Key examples here were a healthy uptick in the frequency of both the ability of the buyer to operate the business post-closing at the buyer's discretion (up to 50% from 33%) and the express inclusion of a disclaimer of any fiduciary duty of the buyer regarding the earnout (up to 25% from 8%). There was also a large increase in the frequency of expressly providing the earnout doesn't accelerate upon a change of control of the target (up to 75% from 42%).

Termination Fees

The proportion of deals that included a termination fee remained relatively steady at 80% (being 78% in the 2020-21 study). On the other hand, and not surprisingly given that the 2020-21 study covered Covid dealmaking, the Study records significant fluctuation since the 2020-21 study regarding the interaction of termination fees and (i) the right to seek specific performance, (ii) entitlement to costs and expenses incurred, and (iii) entitlement to damages resulting from breach.

Target's Representations & Warranties

Several new data points are included in the Study regarding target representations and warranties that distinguish amongst deals involving RWI and those not involving RWI, including regarding the likelihood of (i) target's financial statements "fair presentation" representation being GAAP-qualified, (ii) target's "no undisclosed liabilities" representation being limited to GAAP liabilities or including all liabilities, and (iii) target's "compliance with law" representation covering both present and past compliance. For example, 74% of the deals where the target's "fair presentation" representation was GAAP qualified involved RWI.

The Study marks a steep increase in the prevalence of "#metoo" representations, growing to 57% from approximately 40% in the 2020-21 study. In a new data point, such representations were also likely to include allegations of sexual harassment as well as settlement agreements. And in each of these three cases the prevalence of the representation as well as the broader coverage was significantly more likely in RWI deals than in non-RWI deals. Deals with privacy representations (78%) and cybersecurity representations (81%) were also up, and in each of these cases the likelihood of the representation was again significantly higher in RWI deals than in non-RWI deals.

Material Adverse Effect (MAE) Clauses

Perhaps reflective of post-pandemic MAE fatigue, the Study marked the highest percentage of deals (5%) since 2008 choosing either to forego an MAE clause or not define its meaning. Similarly, the Study marked a drop in the inclusion of the most lengthy portions of an MAE definition, with the percentage of deals (i) foregoing carveouts climbing to 6% from 2% in the 2020-21 study, and (ii) foregoing disproportionate effect qualifiers climbing to 7% from 4% in the 2020-21 study.

Not surprisingly, the inclusion of MAE carve-outs specifically referencing "pandemics" increased to 85% in the Study from approximately 70% in the 2020-21 study. However, corresponding small decreases in MAE carve-outs for "changes in law", "industry conditions" and "force majeure/acts of god" suggests some buyers were happy to gain explicit reference to pandemics at the cost of related carve-outs covering similar territory such that, at the broader level of external/systemic risk allocation, the result may have been a net neutral.

The Study evidenced inconsistent market practice regarding whether an MAE is forward looking, the percentage of deals including reference to the target's "prospects" climbing to 10% from 7% in the 2020-21 study but the percentage of deals foregoing inclusion of the "could be reasonably expected to have" qualifier dropping to 93% from 95% in the 2020-21 study. However, these contradictory signals may be reflective of nothing more than the complicated and controversial nature of this deal point.

Interim Period Covenants

Several new data points in the Study illuminate the impact of RWI on the updating of disclosure schedules before closing. Notably, unlike in non-RWI deals, the great majority of RWI deals go silent on the issue.

The bulk of deal points addressing ordinary course of business covenants did not exhibit significant variation. An exception here is that the percentage of ordinary course covenants not qualified by an "efforts" standard grew from 60% in the 2020-21 study to 71% in the Study, although this does not mark a full return to the 81% level of the 2018-19 study or the 90% level of the 2016-17 study. Conversely, carve-outs to ordinary course covenants that grew significantly in popularity during the pandemic, namely "except as otherwise provided in this agreement" qualifiers (67%) and "except as required by law" qualifiers, generally remained as popular as in the 2020-21 study

An emergent trend in ordinary course covenants is a slow but steady increase in expressly precluding the buyer from unreasonably withholding consent to actions that would violate (i) the covenant (up to 64% from 57% in the 2018-19 study), and (ii) the target's negative covenants (up to 65% from 59% in the 2018-19 study).

Closing Conditions

Regarding when the target's representations must be accurate, i.e., whether at both signing and closing or at closing only, the Study marked a strong reversion to pre-pandemic ratios. Specifically, whereas in the 2020-21 study "at signing and closing" held only a moderate lead over "at closing only", the Study saw a reversion to a heavier weighting toward "at signing and closing" (66%) than "at closing only" (33%).

Regarding how accurate the target's representations must be, the Study marked a minor reversion toward pre-pandemic ratios. The 2020-21 study set a high water mark for the popularity of the seller-friendly "except as would not have a MAE" threshold as compared to the buyer-friendly "in all material respects" threshold. The Study saw a slight rollback on this front, but as the longer-term trend since the 2016-17 study favours the "except as would not have a MAE" threshold, the balance going forward remains to be seen.

Regarding materiality scrapes, the Study found slight decreases in the regularity of their inclusion from the 2020-21 study and towards levels more aligned with the 2016-17 and 2018-19 studies. Similarly, the Study found that percentages surrounding "back door" MAE conditions (i.e., via a target "absence of changes" representation coupled with a "bring down" of the target's representations at closing) had reverted to levels seen in the 2016-17 and 2018-19 studies.

Sandbagging & Non-Reliance

In a steady trend since the ABA's 2016-17 study, deals are increasingly silent regarding sandbagging, climbing from 51% to 76%. A new data point in the Study corelates the impact of RWI and evidences that the strong majority (62%) of deals going silent on sandbagging involve RWI.

The Study also includes several new data points regarding "non-reliance" and "no other representations" clauses, including to corelate the impact of RWI. On the one hand, the likelihood of inclusion of these clauses grew only slightly in the Study as compared to the 2020-21 study, being 74% for "non-reliance" clauses and 81% for "no other representations" clauses. However, a new data point illustrates that in each case the clear majority of deals including these clauses involve RWI (being 61% of deals including a "non reliance" clause and 59% of deals involving a "no other representations" clause). Other new data points go further in corelating these clauses with various other clauses, including express fraud carve-outs and sandbagging clauses.

Indemnification

More than in any other area, the impact of RWI on indemnity regimes is unmistakable.

Regarding the survival of the target's representations and warranties, the Study confirms that RWI often results in a public M&A-style, no post-closing recourse structure. The Study also confirms that, where an RWI deal does allow for post-closing claims, the survival period is typically shorter than in non-RWI deals. Interestingly, for non-RWI deals, the Study evidences a move towards extremes with the number of deals with a 18 month survival period dropping and with corresponding increases both in the shorter 12 month category and in the longer 24 month category.

Regarding baskets, the Study confirms that RWI deals with baskets are much more likely to use a deductible than a "first dollar" or combination of the two. Indeed, unlike in previous studies, in the Study's sample all RWI deals with baskets used a deductible. As for basket size, the Study confirms that RWI deals are likely to have smaller baskets than non-RWI deals. As for basket size overall, the Study records a decrease in baskets between 0.5%-1% with small corresponding gains in larger baskets in the 1%-2% and >2% categories. Most notably, the Study records a significant growth in the percentage of deals with no eligible claim threshold (climbing from 62% to 76%), a level not seen since the 2010 study.

Regarding materiality scrapes, the Study records a significant jump in the number of basket deals without a scrape, rising from 7% (in the 2018-2019 study) and 8% (in the 2020-21 study) to 21%. Of basket deals including a materiality scrape, a healthy majority (62%) were non-RWI deals. Where RWI deals included a materiality scrape, the scrape was much more likely to be unlimited rather than limited to the calculation of damages.

Regarding caps, the Study confirms that RWI deals are likely to have lower caps than non-RWI deals. Regarding caps overall, the Study records a reversion from the 2020-21 study (which saw a significant, seller-friendly shift towards smaller caps) back toward the cap ranges of the 2018-19 study.

Regarding escrows, the Study confirms that RWI deals are more likely to feature smaller escrows than non-RWI deals. Regarding escrows overall, the Study confirms a longer term trend against the inclusion of a stipulation that the escrow is the buyer's exclusive remedy.

Concluding Comments

Notwithstanding the importance of the Study, readers should always be mindful of the nature of the deal sample on which its is based. As discussed above, this includes that this year's sample is relatively heavily weighted towards smaller deals (in terms of transaction value). The results detailed in the Study may also be influenced by the fact deals are sourced from the public filings of reporting issuers, meaning the transaction was material to the public issuer.

The Study's time period is noteworthy as it begins with the still frenzied deal market of early 2022 (i.e., the tail period of the 2021 "Covid bump") and ends with the rapidly cooling deal market of late 2022 and early 2023. Two related considerations are:

The Study sometimes only compares its sample to the ABA's 2020-21 study and without comparison to the ABA's deal point studies between 2006 and 2019. In these instances it should be recalled that the 2020-21 study covers the pandemic period and the somewhat anomalistic market factors applicable during that time.
Where the Study provides comparisons to ABA studies prior to the 2020-21 study (which is typically the case), we often see a reversion to market practice reflected in the 2018-2019 study. Stated differently, and as we largely expected, the Study records a general return to more balanced dealmaking as compared to the more "seller-friendly" deal market that characterized the 2021 "Covid bump".

Finally, it should also be recalled that many deal points are best resolved through an appreciation of the underlying reasonableness of each parties' position or, in some cases, their negotiating leverage.

For Fasken's practice-focused overview of Canadian private M&A caselaw and commentary, see Private M&A in Canada: Transactions & Litigation (LexisNexis, 2024).

Footnote

1. We do not, however, interpret this to reflect a decrease in the popularity of RWI but rather that RWI may be increasingly obtained outside the express terms of private M&A agreements, perhaps due to the ever greater comfort and familiarity of M&A parties with RWI. The decrease in the competitive nature of the M&A landscape and seller's leverage during the period of the Study is also likely partly responsible. Perhaps most importantly, RWI became increasingly expensive at the height of the market due to insufficient capacity, which likely discouraged some buyers from procuring the product. This capacity gap has since been corrected by RWI insurers and brokers.

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.