The fast pace of mergers and acquisitions continues into the fall of 2021 and is expected to carry into 2022. Both the pace and its drivers have implications for structures used.
- As a refresher, the recent volume has been driven by the following:
- A record amount of capital is available for private equity and venture funds to deploy.
- A slowdown earlier in the COVID-19 pandemic delayed transactions that are now impacting volume.
- Seller concern that proposed U.S. capital gains tax changes will significantly impact the value they can generate, causing them to accelerate transactions.
The sheer volume of transactions has resulted in a bottleneck in the services of advisers critical to completing a transaction. The time of investment bankers, attorneys, and due diligence providers is in short supply. Banks have backlogs of deals in underwriting. As a practical expedient, buyers and sellers are agreeing to structural shortcuts that allow them to move more quickly through the process. This results in more rollover equity, earn-outs, and insurance for representations and warranties.
Buyers and banks both see rollover equity as a way for sellers to demonstrate their confidence in the expected growth of the target company. As banks have more transactions available to finance, they are prioritizing those with a higher portion of the value in the form of equity.
One way to accommodate those targets is to require the selling owners to retain an equity stake. Even sellers who would like to monetize their full investment may be willing to leave some equity so they can monetize some of their ownership before the capital gains tax rates increase.
Earnouts are a structure that take some portion of the valuation and pay it out in the future (usually between one to five years) based on the business achieving agreed-upon goals. These goals most often relate to sales or gross profits.
Earnouts can be a particularly good way to overcome the opacity of projections coming out of the COVID-19 pandemic. Pandemic impacts include loss of revenue to customers that shut down, impact of disruptions in the supply chain, and increases in revenue that could be temporary. In 2021, we have also seen increased inflation.
While time will clarify whether these changes are temporary or permanent, neither the sellers nor the buyers want to wait. The sellers fear an increase in tax rates. The buyers want to deploy the capital they have available. Earnouts allow them to share the risk caused by uncertainty.
Insurance for representations and warranties (RWI) has become a bigger part of the M&A environment over the last few years. Most advisers to M&A note that they are seeing greater use of RWI. Intuitively, buyers and sellers believe that this will speed up the due diligence process. Practically, it replaces the due diligence needs of the buyer with those of the insurer. The volume of RWI has also increased its cost.
The outsized influence of “dry powder” waiting to be deployed by private equity in the M&A market has also influenced the nature of the transactions. An increasing number of private equity firms are open to taking minority interests in businesses, either through existing funds or in new funds established solely for minority positions. The funds are also sponsoring industry roll-ups and are buying smaller businesses through add-on deals executed by their current portfolio companies.
Pressures on both buyers and sellers have caused record M&A volume and an increase in roll-over equity, earnouts, and RWI.
To learn more, you can contact Jennifer L. Kreischer at Email or 215.441.4600.
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