M&A Report 2023: Rise in transatlantic transactions puts M&A deal terms in focus
More US buyers – and more buyer-friendly deal terms – are entering the seller-friendly UK market, although the picture is increasingly nuanced, say Joshua M. Dubofsky, Sam Newhouse, Jennifer N. Cadet, and Catherine Campbell
While global M&A deal volumes have dipped at the start of Q1 2023, UK-bound M&A activity is expected to be one of the year’s highlights in 2023 as overseas buyers seek out attractively priced public and private targets. Within this activity, the deal term preferences of US buyers are likely to impact private UK M&A. A detailed understanding of UK and US expectations is therefore essential for transatlantic dealmakers.
While M&A slowed down from the highs of 2020 and 2021, the three months to December 2022 were the strongest quarter of the year for US inbound M&A to the UK, with deal values rebounding to just over $15 billion. This rise underlines the growing attractiveness of UK companies following exchange rate shifts, as illustrated by deals in the final months of 2022 and early 2023.
US private M&A deal terms – particularly related to deal certainty and post-closing recourse – have historically been viewed as more buyer-friendly than those in the more seller-friendly UK market. However, the picture is increasingly nuanced, and deal teams navigating economic uncertainty and financial market dislocation are being called upon to find new solutions to deal valuation, certainty, and recourse concerns.
Valuation and transfer of risk
The US and UK markets have different approaches to valuation and the transfer of economic risk. Private European and UK deals commonly feature locked-box mechanisms, which fix the deal price at an agreed date based on a set of accounts and view the buyer as owning the financing requirements and results of operation of the business from that date. In a locked-box structure, the seller provides undertakings to the buyer that value will not be extracted or ‘leak’ from the target before completion of the acquisition.
In contrast, most US deals use completion account mechanisms, such as cash, debt and working capital adjustments. These calculate a final deal price after completion of the acquisition by referring to an estimate of the target’s accounts at the date of completion and allow for post-closing valuation adjustments based on a final accounting adjustment mechanism. US completion account mechanisms generally provide the seller with the operational benefit of the business, including cash and account receivable generation, as well as the ongoing cost of funding the business and related operational risk, until closing.
Locked box v completion accounts
Locked-box mechanisms remain popular in Europe and featured in 49% of private deals, according to the eighth edition of the Latham & Watkins Private M&A Study. In contrast, completion accounts featured in just 25% of deals. In the UK, transactions were a bit more balanced – locked-box mechanisms featured in 37% of sales, and completion accounts featured in 29% of transactions. Meanwhile, SRS Acquiom reported in its 2022 M&A Deal Terms Study that 94% of private-target acquisitions in the US included post-closing purchase price adjustments in 2021.
Takeaways from recent deals
In private deals, UK sellers should expect US acquirers to ask for completion accounts, and US buyers should be aware of a typical UK seller’s expectations. To advance its position, a UK seller focused on using a locked-box structure should be ready to deliver audited financial statements to a US buyer or have accounts prepared that buyers can confidently rely on. If working to a tight timeline, US buyers can push for completion accounts on the basis that they do not need to do the upfront work of agreeing on locked-box accounts and instead just need to agree on the methods that will be used to adjust the purchase price at closing.
The prevalence of locked-box mechanisms may decrease further in the UK in 2023 if US acquirers favouring completion accounts outpace UK private equity (PE) buyout firms, which are expected to continue a slower pace of transactions given debt markets constraints. Where locked-box mechanics are used, ticking fees may become more prevalent, in particular as global complexity and the timelines for M&A antitrust and regulatory processes continue to increase.
UK and US dealmakers take different approaches to closing conditions, which must be satisfied before a deal can complete. In the UK and Europe, deals rarely involve conditions other than receipt of any required regulatory and antitrust approvals. As a result, assuming satisfaction of any regulatory or antitrust conditions, deal and business risk is typically transferred to the buyer upon signing of a deal.
Under US practice, deal and business risk is typically not transferred until deal completion. While completion conditions will vary, conditions in a US-led deal may include a requirement for the seller’s representations and warranties to be materially accurate at completion, material compliance with interim covenants, and the absence of a material adverse change (MAC), in addition to any regulatory or antitrust conditions. With increasing numbers of US acquirers in the UK market, UK dealmakers can expect to discuss a wider range of deal conditions than in the past and should familiarise themselves with the US approach to conditionality.
MAC clauses in focus
MAC clauses, which give a buyer the right to walk away from a deal in the event of a MAC to the target business between signing and closing, are far less common in the UK than in the US. In the UK, just 12% of private deals included MAC clauses in 2021. In comparison, 98% of US deals included some form of MAC clause.
Although MAC clauses are commonly included in US documentation, a MAC is seen as a truly significant and sustained adverse change in the target’s business that was not known to, or anticipated by, the buyer at the time of signing. As a result of this high threshold, US courts rarely find that a MAC exists. Instead, US buyers will walk away from acquisitions following the target’s failure to satisfy a closing condition likely tied to a material breach of interim covenants or, where a materiality standard other than a MAC applies, a breach of warranties by the target.
As more US buyers enter the UK market, MAC clauses may become more common in UK deals. However, deal certainty remains critical, and UK sellers can be expected to resist requests for MAC clauses, particularly on competitive deals, instead relying on market precedent in Europe and the scarcity of case law in the UK as to what may signify a MAC event (albeit this can be addressed with appropriate drafting). UK sellers that do agree to a more traditional US conditionality construct should focus on conditions related to compliance with covenants and accuracy of warranties.
Post-closing economic risk allocation in M&A in the US and the UK is increasingly nuanced and requires a multifaceted approach to risk minimisation and mitigation.
The rising appeal of ‘public-style’ deals
Historically, commercial warranties were a key tool in US and UK private deals for understanding and allocating risk, as well as forming part of the diligence and disclosure process. Acquisitions under US law have traditionally provided buyers with strong recourse against sellers through claims for breaches of representations and warranties, often given on an indemnity basis, in addition to escrow or holdback arrangements.
In contrast, a breach of warranty claim under English and Welsh law typically requires a buyer to prove how the breach reduced the overall value of the acquired shares, so these purchase agreements require buyers to rely more heavily on specific indemnities, and, in recent years, insurance.
Today, the allocation of risk between buyers and sellers for commercial warranties and other common areas of recourse is changing. In the US, ‘public-style’ or ‘no-recourse’ deals have become much more common in the highly competitive M&A markets of recent years, providing private sellers with risk protection levels similar to those in public deals. In a no-recourse deal, buyers have no recourse against sellers after closing for any breaches of representations, warranties, and pre-closing covenants.
In the UK, buyers’ ability to seek recourse post closing has also narrowed, though this trend remains deal dependent. Competitive deals have featured buyers accepting a limited, or sometimes nominal, level of seller recourse by way of warranty protections. Regardless, parties generally make exceptions to carve out obligations that are to be performed following closing and for claims for fraud.
Warranty and indemnity insurance
If a seller is not willing to stand behind warranties, then warranty and indemnity insurance (W&I) (or representations and warranty insurance (RWI) in the US) can provide a solution, with the insurance market offering a range of M&A risk management options for acquirers.
Insurance has become an important component of UK transactions in recent years. However, many buyers are now more critically evaluating the merits of W&I due to changing market dynamics and challenging macro conditions (which have cooled deal flow). As W&I has matured and buyers have become more experienced consumers of the insurance (and of low or nominal liability caps for warranties), the emerging picture is one of a product with a nuanced value. Deal-specific characteristics, structures, and issues are playing a key role in the demand for, and success of, W&I.
Increasingly, buyers in the UK are opting to forgo W&I altogether; instead accepting that they will have no recourse against the sellers and choosing to spend the W&I premium costs elsewhere. They are relying on the disclosure process, taking comfort from management rollover/seller reinvestment, and assessing/pricing any issues as they come to light. Despite the current slowdown, W&I will likely remain a feature of UK dealmaking in the coming years. However, W&I is not a panacea for all transactions, and dealmakers should structure processes accordingly.
In the US, the use of RWI has increased significantly in recent years. In most transactions, PE buyers have migrated to a no-recourse structure back-stopped by RWI. Some US strategic acquirers have similarly moved towards a no-recourse or ‘limited recourse’ structure that generally permits claims for breaches of ‘fundamental representations’ and/or for some portion of the deductible under an RWI policy. As with their PE counterparts, these buyers retain RWI, particularly in competitive auctions with PE sellers, as a back-stop.
However, many US strategic acquirers remain more focused on traditional US remedies, including seller indemnification and escrow obligations. The buyer requirements for a traditional remedy structure are often framed as part of the buyer’s willingness to pay a significant premium and the seller’s need to retain perceived post-closing accountability.
Given ongoing market uncertainty, deal practitioners expect UK and US market practice to pull back from the recent heavy focus on no-recourse transactions. US acquirers will likely expect a more traditional US approach, particularly in strategic acquisitions and proprietary PE transactions, and parties are likely to land on a hybrid recourse package.
The next 12 months will likely present significant opportunities for UK and US dealmakers, but in a world increasingly difficult to predict, dealmakers will need expert legal counsel to translate transatlantic terminology and guide optimal M&A terms to navigate key risks.