Issue 3 - November 2010
On The Same Page
After acquisition, buyers and sellers must do some heavy lifting to ensure that each party holds up its end of the bargain.
As the global economy struggles to shake off the lingering effects of the recession, private equity firms, with approximately $500 billion in uncommitted funds, are facing mounting pressure to identify desirable targets that will deliver a solid return on investments. The resulting competition has driven up the purchase prices in many deals: To outbid more than a dozen firms for Virtual Radiologic Corp., Providence Equity Partners paid a 41% premium. While private equity firms have always been known for their exhaustive due diligence, the postrecession climate has made them more susceptible to the misstatements of companies desperate to be acquired. As many buyers are discovering, the frenzied rush to close a deal can obscure issues that later come back to haunt the buyer. It’s been said that “love may be blind, but marriage is a real eye-opener.” The hard work of post-acquisition integration is now more likely to uncover errors and misrepresentations that can have a significant impact on the purchase price. As a result, an increasing number of M&A deals are involving some litigation. Since 2% to 5% of the purchase price — often a substantial sum — can be kept in escrow until disputes are resolved, companies have added incentive to settle matters expeditiously.
By understanding the common trouble spots in typical acquisitions, private equity firms can put themselves in a better position to resolve potential disputes. If problems do arise, determining the appropriate channel for addressing them — from early dispute resolution and mediation to arbitration and litigation — can be critical.
TRADITIONAL SOURCES OF DISPUTES
The complexity of M&A deals has the potential to create a range of issues, but certain areas are more likely to result in post-acquisition disputes.
During the deal, the seller will make certain assurances and formally confirm facts and figures. Representations (an account or statement of facts, allegations or arguments) and warranties (allocating financial responsibility for the accuracy of those statements of fact) can range from verifying that interim financial statements have been prepared according to GAAP and/or disclosing pending lawsuits to stating the value of inventory and outstanding accounts receivable.
Indemnification provisions. These measures are intended to protect the buyer and seller from each other’s actions. Indemnification provisions can cover representations and warranties and covenants. During negotiations on the purchase price, each side will insert language to cap damages arising from specific areas. However, these caps can be negated in the case of intentional fraud or on public policy grounds, such as in disputes arising from gross negligence.
Working capital. Within a certain time period after the closing date, the seller must provide a closing balance sheet that includes its working capital. The working-capital “true-up” determines the amount of actual working capital at closing compared with what the seller estimated. Since the buyer will seek to deduct any shortfall (a potentially substantial sum) from the purchase price, calculating the true-up can be particularly contentious.
Earn-outs. An earn-out is a contingent element of the acquisition’s purchase price that is determined after the closing based on the target business’s performance against contractually defined criteria or benchmarks. Disputes can arise, for example, from business decisions that negatively affect the performance of the purchased entity, how that performance is measured or how amortization and depreciation is recorded for accounting purposes.
THE EFFECT OF THE RECESSION ON M&A
In the postrecession landscape, several trends have emerged that are affecting not only how deals are being structured but also the most effective channels for resolving disputes.
Financial constraints slow deals. The overall decline of deals can be directly attributed to financing constraints. Private equity firms can no longer rely on banks to provide ready funding for highly leveraged buyouts. Because of this, not only have acquirers been pulling out of deals prematurely after failing to secure the necessary credit, but financial institutions have also backed out of acquisitions they deemed too risky. As a result, other arrangements such as club deals, where two or more firms form a consortium to acquire a company, have become more prevalent.
Increasing reliance on earn-outs. As buyers look for ways to finance deals that require less cash up front, purchase agreements are featuring earn-out provisions more frequently. Indeed, more than 30% of deals now include such provisions. The structure of earn-outs, however, lends itself to disputes over control, business decisions and accounting practices. The buyer can face allegations of acting in its own interests in ways that adversely affect the acquired company’s performance and, thus, the earn-out payment to which the seller is entitled. Attempts by the seller to exert its influence can be perceived by the buyer as maximizing the target’s performance at the buyer’s expense. Agreements will often include covenants by the buyer to operate the business consistent with past practice or in normal course, although that can still allow for substantial variance in interpretation. So if earn-outs are such magnets for disputes, why are they being included in more and more deals? The postrecession landscape and lack of available credit are two drivers. For the buyer, an earn-out not only reduces the cash necessary at closing but also acts as an incentive for the seller to perform up to expectations after the closing. Indeed, private equity firms want additional assurance that the companies they are buying will meet their high expectations. On the seller side, earn-outs offer potential for increasing total compensation, especially advantageous given the current climate. For these reasons, we expect to see more earn-outs over the next two to three years — and a corresponding rise in resulting post-acquisition litigation.