After the March budget’s much anticipated attack on entrepreneur’s relief (£10m per person reduced to £1m), and then the global impact of COVID-19, the mid-tier M&A world is seeing the biggest shake up for a long time. Deals have been pulled, or at least delayed, while buyers assess the wider position. Sellers who want to exit can no longer rely on the generous UK tax regime allowing significant proceeds to be secured at just 10% Capital Gains Tax (CGT) rates.
At times like these, the norms that have built up over years as to what is “market” for M&A deals become less relevant. It’s likely to be a time for innovation in deal structuring and some old discarded planning points may come back into favour. A key issue will be buyer and seller alignment on pricing – after the 2008 banking crisis a lack of realism amongst sellers (sometimes fuelled by their corporate finance advisers) delayed the resurgence of the mid-tier market.
So, what might we see? With over 30 years’ M&A experience our senior partner Richard Baxter shares some thoughts.
Larger group divestment of non-core businesses
Cash is king, and some groups will decide to hunker down and concentrate on core activities for a while. They will seek buyers for non-core businesses, perhaps offering attractive opportunities for MBOs to management teams as PE houses also look for good deals after a quiet spell concentrating on crisis management of their existing portfolios. Keen PE and trade buyers will be circling broader groups, hunting for break up opportunities.
Deferral of CGT on deferred/earn-out deals, and more of those deals generally
In recent years, sellers have sought to trigger CGT up front on as much of their sale proceeds as possible, to take advantage of the 10% CGT rate. Now we are more likely to see sellers seeking to defer higher rates of CGT on deferred or earn-out parts of the price. One way is through receiving interest-bearing loan notes or other qualifying securities which allow sellers (with tax clearance from HMRC) to “roll” their CGT liabilities into these securities and only trigger actual tax when they are encashed in the future.
We may also see more deferred and earn-out deals generally for obvious commercial reasons – de-risking the price for buyers and, at times of greater pricing caution, potentially allowing sellers access to fuller prices.
More asset purchases
The low CGT environment has meant that many sellers have insisted on selling shares to access entrepreneur’s relief. More risk averse buyers have always seen attractions in buying assets rather than shares – you can cherry pick what you buy and you don’t inherit the history of the target including the risk of contingent liabilities in areas such as taxation. If we see lower valuations for a while, a tougher climate for sellers and opportunistic buyers taking advantage of favourable conditions, buyers may be able to dictate the return of more asset purchases.
Remember though that asset purchases can have their disadvantages too. Contracts need transferring, possibly involving third party consents. Registered assets that are included in the sale (such as properties and registered IP) will need formal transferring to the buyer. Transfer of Undertakings Regulation (TUPE) compliance can cause additional structuring complexity and financial risk areas to be borne by the parties.
More focus on material adverse event (“MAE”) provisions
Many UK deals happen with simultaneous exchange and completion. But where there is a gap between exchange and completion, there may be a condition allowing the buyer to walk away if there is an intervening MAE. In a riskier climate, there will be greater focus on these provisions – and in existing deals which have not yet completed lawyers are arguing over whether the COVID-19 crisis is captured by pre-COVID-19 MAE drafting….
Simpler, quicker and lower risk deal structures to compensate sellers for lower valuations
Some buyers will of course see this as a time of opportunity, and there are always sellers for whom the time is right to exit even if valuations are not at their highest. In recent years the deal process has become DD heavy and costly, often with long lead times. While some buyers will see the climate as one in which to take greater care, some may offer quick and simple deal structures building their risk assessment into the price and taking advantage of all-time-low financing costs.
Partial acquisitions to de-risk for buyers and offer continuing value creation for sellers
In recent years some acquisitive groups, particularly in people businesses, have successfully followed buy and build strategies involving lower cost partial acquisitions, retaining the talent of the target management teams for longer than typically happens with 100% deals and offering a longer term return for those management teams combined with some immediate cash out. In lower growth recovery periods, these structures can be a way to access the benefits of M&A that suits both parties. These structures are often more complex as the legal documents should cater for the continuing shareholding relationship between the buyer and the management team, but once these structures are set up for one deal they can relatively easily be rolled out to others.
Buyer M&A financing terms
Lenders will be reviewing lessons learnt in the heat of the COVID-19 battle and new or increased financial conditions may emerge. Buyers will need to ensure that they “back to back” these provisions properly in their M&A deals, to avoid being forced to complete a deal where the lender has withdrawn its debt financing. Treasury and M&A teams – both at clients and at lawyers – will need to work closely together.
Continuing evolution of the warranty & indemnity (W&I) insurance market
The use of W&I insurance in deals has accelerated in recent years, with growing insurer sophistication and appetite to insure deals for a wide variety of reasons. If pricing comes under pressure will sellers seek to de-risk warranty exposure, making W&I cover a part of even more deals?
The UK mid-tier M&A market tends not to stay quiet for long – watch this space!
This piece was written on 1 April 2020 in response to the situation at that time.