The outlook for international M&A in 2011 is more positive than at any time since the "crunch." Corporate buyers, particularly those from the U.S., are carrying huge amounts of excess cash on their balance sheets, and private equity buyers are sitting on significant pools of capital that they need to deploy. In the U.S., takeovers reportedly topped $256 billion in the first quarter of this year. Banks seem more willing to lend, and as interest rates continue to stay at record lows, increased lending activity seems likely. However, the continuing global economic uncertainty, influenced by political instability in the Middle East and the tsunami in Japan, means that buyers remain cautious on the international stage. Further, the constant refrain heard from buyers, both corporate and private equity, is that there continues to be a lack of quality companies available to buy. While buyers continue to chase "proprietary deals" and seek to avoid auctions, such deals remain elusive. Consequently, we believe it is likely that some of the trends that have been prevalent over the last few years will continue to shape the market for the remainder of the year and beyond. In light of these macro issues, we have in the remainder of this article identified some of the specific deal trends we have seen on negotiations and the deal process.
Valuation continues to be one of the most significant issues in getting deals done. Expectations between buyers and sellers can be vastly different, with buyers saying that sellers have not awakened to new market realities. In addition, market volatility and surging commodity prices continue to present difficulties for valuation. Interestingly, for quality targets, multiples are approaching pre-recession levels. It is often the case, though, that dealmakers need to be creative in bridging the gap between buyers and sellers. As one might expect, earn-outs and completion accounts are being used to bridge this gap, as are other creative deferred payment techniques. Earn-outs have the advantage of appealing to both buyers (reducing the up-front price) and sellers (potentially increasing the upside). Nevertheless, the structuring of an earn-out depends significantly on expected performance of the target business. This results in increased scrutiny and "stress-testing" of projections and valuation models, and increasingly complex provisions. The consequence is that while earn-outs can help get a deal done, in practice, they often set up a conflict down the road between the buyer and seller.
Deal certainty remains a critical "must-have" for both buyers and sellers. We continue to see a high percentage of transactions that fail to reach the finish line. Buyers are continuing to demand material adverse effect (MAE) "outs" both in the U.S. and internationally. MAEs have always been less common outside of the U.S., and sellers tend to resist strongly the inclusion of an MAE (particularly if it is widely drafted), although we note that in practice the courts have often prevented buyers from relying on an MAE clause to terminate a transaction. Of course, it is difficult to assess how many MAE clauses have come into play in negotiations that have not been pushed into court.
In addition, break fees continue to be strongly utilized, and reverse break fees are increasingly being utilized. However, in the UK, the Takeover Panel (the body that regulates public takeovers in the UK) has recently announced proposals to ban the use of break fees altogether. It remains to be seen whether this change (if implemented) will influence the private M&A market, and whether it is indicative of a wider shift.
Regulatory risk continues to be a challenge to both buyers and sellers, and the trend seems to be that regulatory intervention is on the rise. New merger control regimes are beginning to be implemented in the Middle East and elsewhere (such as India). The $7.9 billion takeover of the Australian stock exchange by the Singapore stock exchange looks likely to be blocked by the Australian authorities, who have cited the deal as being contrary to Australian national interests. It remains to be seen whether any similar action will affect the other proposed international stock exchange mergers. BHP's proposed takeover of Potash Inc. recently failed to secure approval in Canada, and AIG's proposed sale of its Taiwan insurance arm to a Hong Kong consortium was blocked by regulators who questioned the ability of the buyer group to run the business post-acquisition. In the U.S., an increasing number of transactions are being blocked on national security grounds. Last month Huwaei, the Chinese telecoms equipment maker, was prevented from acquiring patents from 3leaf, after the Committee on Foreign Investments in the United States (CFIUS) blocked the transaction. Data released by CFIUS shows that its investigations are lengthening - in 2007 four percent of deals were subject to full investigation (i.e., beyond the initial 45-day mandatory period). In 2009 this had risen to 38 percent. Protectionist action by regulators and governments is likely to continue as national economies struggle to emerge from recession and unemployment remains historically high.
Our experience is that overall liability caps remain largely unchanged, although there may be a slight lowering of sellers' overall liability caps, particularly in the UK where traditionally the cap would be equal to the purchase price. Historically, caps in the U.S. and in other European jurisdictions remain significantly lower than in the UK, with caps of between 20 to 25 percent of the purchase price being common in the U.S. Caps this low are less common in international deals.
Warranty time limits also remain unchanged, although there has been a slight trend in buyers seeking increased time limits, with the minimum nearly always being 12 months. The average continues to be between 18 and 24 months.
Where signing and closing are not simultaneous, we have seen push-back from sellers as to "bringing down" the warranties to closing. Buyers are increasingly being asked to take on the risk of a material warranty breach between signing and closing. In the UK, it is now not uncommon to have warranties provided at signing only, which is rarely seen in the U.S.
Escrows and holdbacks, however, appear to be more widely used, particularly where the buyer feels it is unable to get comfortable with potential risks identified through due diligence.
Warranty And Indemnity Insurance
Warranty and indemnity insurance is on the rise driven (though not exclusively) by the number of private equity deals. Another factor driving the uptick in the use of insurance is that premiums have fallen considerably in the last five years. A typical premium of between one and two percent of the sum insured is common, compared to three to five percent five years ago.
Joint Ventures And Minority States
Joint ventures/minority have become increasingly popular in international M&A, particularly in developing economies where local law may prevent the acquisition by foreign companies of wholly owned subsidiaries. These types of transactions are prevalent in the energy sector, as resource-rich states, seeking to take advantage of industry know-how and expertise, look to partner with established multinationals. Joint ventures also have the advantage of allowing buyers to "test the water" before committing to an outright purchase and to take advantage of changing business conditions without running the regulatory risk that an acquisition of a controlling interest can carry.
Due diligence remains a critical item. As one would expect, diligence is used to help bridge differences in liability issues between buyers and sellers. More interestingly though, we see diligence increasingly being used as a tool to help overcome valuation gaps, with buyers pointing to specific issues in order to reduce prices. It is increasingly the case in auction situations, in particular, where buyers commonly use diligence findings to lower valuations following being selected as a final bidder. Similarly, we also see sellers attempting to use diligence, particularly with respect to new products or patents that have not yet been commercialized, to increase prices off of a simple multiple of EBITDA.
In addition, increasing focus during diligence is being placed on anti-corruption issues. Global enforcement of anti-corruption laws is growing - and many of these prosecutions are connected to M&A transactions. As usual, U.S. authorities are leading the way with pro-active enforcement action. A buyer needs to know as early as possible in the diligence process whether there are any compliance issues, otherwise it could find itself liable for illegal practices, weaknesses in controls or inaccuracies in books and records. New anti-bribery legislation in the UK, the Bribery Act (introduction of which has been recently delayed), will introduce a strict liability corporate offence of failing to prevent bribery. The only defence will be having in place "adequate procedures" to prevent bribery. Accordingly, a buyer needs to beware not to inherit liabilities for previous acts of target, particularly if the buyer may be seen to benefit from those pre-acquisition questionable activities.
As a topical example of these types of concerns, there are currently many stories appearing in the press with respect to foreign oil and gas companies allegedly paying bribes to secure contracts in Libya following the opening of the Libyan market over the last decade. Given the current situation in Libya, much of this illicit activity is likely to be uncovered. It remains to be seen whether any of the companies alleged to be involved will face any sanctions, but this highlights the need for buyers to vet thoroughly potential targets for these types of issues. When corruption is discovered, other connected offences such as fraud, tax evasion and money laundering often follow.
Mark E. Thompson is a Corporate Partner in King & Spalding's London office and Co-chair of the firm's Private Equity Practice. His practice focuses on international and cross-border transactions and on the representation of private equity funds and fund sponsors. Marcus A. Young is a Senior Associate in King & Spalding's London office. His practice focuses on cross-border transactions, with an emphasis on complex joint ventures, primarily in the energy sector.