British American Business 2008

British American Business 2008 | Practical Advice | Mergers and acqusitions

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Field Fisher Waterhouse LLP

Turbulent times in
transatlantic M&A

Mergers and acqusitions activity is always cyclical, but this year has begun with a fair amount of uncertainty. Neil Foster and Sabina Coles explain

Neil Foster

This deal year has started with considerable uncertainty for transatlantic deals due to the volatile state of the global markets.

M&A activity is, of course, cyclical. After the boom in 2000, the last economic downturn took hold in 2002/3 and the recovery, from 2004, drove corporate growth and returns on M&A deals right up to the middle of 2007. With profits at an all-time high, some argue, the sellers’ market could not have lasted for long.

So, what has changed ?

In 2006, the US invested approximately $364bn into the UK, 15% of its total outward investment.1 However, the value of acquisitions in the UK by foreign companies decreased from £51.4bn in the second quarter of 2007 to £14.0bn in the third quarter of 2007.2 Acquisitions by US companies in the UK decreased by value from £5,078 m in the second quarter to £1,920m in the third quarter of 2007.3

In practical terms, the following trends have been seen:

deal valuations and prices are coming down: private equity investors had driven up prices, while borrowing was cheap and on favorable terms;
strategic trade buyers are competing against private equity on more equal (or even more advantageous) terms;
the flow of large deals has been affected; small to midmarket company acquisitions in the $25m to 250m range continue steadily;
deal timetables have extended;
overall, target earnings and growth rates will slow and returns ratios have come down;
after unprecedented transatlantic M&A volumes in 2006 and 2007, volumes are predicted to return to pre-2006 levels.

Impact on structures and legal terms

The above developments have led to the return of prudent risk reduction strategies, as well as some new structures and legal protections. For example:

Auction processes

Sabina Coles

Auctions are advantageous for sellers and so may reduce in a buyer’s market. By using an auction process, a seller can reach more potential buyers. A seller will compare the bids to obtain the best terms and price offered. This process also enables a seller to control the due diligence and transaction timetable. Auctions will not be appropriate for all businesses, for example if there is a limited pool of potential buyers or if the deal or business structure is complex. Many cash buyers and strategic investors may increasingly refuse to participate in auctions.

Due diligence

In 2008, more time and money is being spent by US buyers on carrying out a thorough local due diligence exercise. Due diligence will be carried out by the buyer in conjunction with its UK lawyers, accountants and other advisers.

Warranties, indemnities and disclosure

Warranties and indemnities are used in the acquisition agreement to reduce risk and to gather more information on the target and seller. Buyers are including fuller sets of warranties and agree fewer qualifications and limitations of liability of the sellers for breach of warranty. A UK seller will usually limit its liability exposure in its disclosure letter to the buyer, which sets out matters which at completion may otherwise constitute a breach of warranty. A buyer will now be more strict in accepting only disclosures made in sufficient detail so it can quantify the risks.

Price protections

The buyer may seek a guarantor of the seller’s liability in the acquisition agreement or a mechanism for holding back part of the price payable to the seller. Examples would be a deferred payment of part of the price after completion of the transaction with the ability of the buyer to set-off its loss for breach of warranty against this sum, or possibly a retention of part of the purchase price in an escrow account of the parties to be released on a specified date if the buyer has not made any claims for breach of warranty. Earn-out mechanisms have increasingly been appearing, even on larger deals.

Warranty and indemnity insurance

The parties may consider taking out insurance so that the buyer can recover its loss in the event of a breach of warranty or indemnity claim. The terms (for example, exclusions) have in recent years become more favorable and the premiums are cheaper as a proportion of the transaction price. In 2007, just over a hundred of such policies were written. Many more are likely in 2008. With their greater risk exposure, banks in the UK and US have quickly re-evaluated their lending terms for acquisition finance deals. Borrowing cost has increased and is on much tougher terms. Specific ways in which lenders will seek to manage their exposure on M&A deals is:

Ratios

Lending ratios, such as debt to equity and debt to EBITDA, have tightened considerably.

Financial terms and covenants

Financial controls over the target will have been tightened in loan facilities, and the loan security packages over the target business have been enhanced. Covenant-lite deals no longer exist.

Conditions precedent

Material adverse change (“MAC”) provisions were often deleted from deal terms in early 2007 in the UK, even for US buyers who expect MACs. In 2008, MACs are now rarely successfully resisted, although there is scope for negotiating the definition. Another difference in the UK is that fewer deals are “subject to financing”. Indeed, our takeover code prohibits this on public deals. However, more private UK deals are subject to a “financing out” in these market conditions.

What next?

While the effects of the banking credit crunch will continue to be felt, and the M&A marketplace as a whole will cool down, active US buyers will increasingly be able to acquire UK assets at attractive prices, provided sellers are prepared to sell. Lori Murphree of Grant Thornton comments that: “UK trade buyers willing to put up significant amounts of their own equity may take the initiative back from private equity in 2008, as lenders avoid the complex debt structures utilised so readily by PE houses over the past two years. For many shrewd, asset-rich trade buyers there will be bargains to be had, as there is now little appetite for anything in the market deemed even slightly overvalued.”

Among the turbulence, certain sectors are holding up well and are out-performing the market. Lori Murphree identifies strong performance in the software sector, particularly software-as-aservice, and the IT security sector.

Business as usual

Whilst economic conditions for the next year are uncertain, many US buyers, having adopted robust risk-reduction strategies, are as active as ever. Neil Foster is a partner and Sabina Coles is a solicitor in the corporate department of Field Fisher Waterhouse LLP, specialising in mergers and acquisitions and private equity.

For more information, contact:
E-mail: neil.foster@ffw.com

Footnotes

1 D irect Investment Positions for 2006 by Marilyn Ibarra and Jennifer Koncz, July 2007, and data published by the Bureau of Economic Analysis of the US D epartment of Commerce.
2 Mergers and acquisitions involving UK companies for 3rd quarter 2007. Area analysis of cross-border activity in the UK by US companies, and data published by National Statistics for the O ffice for National Statistics.
3 As footnote 2.

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