John has blogged previously about the renewed reliance on earnouts in today’s uncertain environment. In fact, this Freshfields blog states that “one recent study found that the use of earnouts in U.S. private M&A deals in 2022 was higher than in any year since 2017.” But, as the blog notes, with more earnouts comes more earnout disputes “with the number of U.S. lawsuits involving earnouts nearly doubling between Q1 of 2022 and Q1 of 2023.”
Luckily, this litigation brings learning opportunities, and the blog describes how careful drafting can help reduce the chances of an earnout dispute. But, as we all know, clarity isn’t always achieved — or achievable. If the court concludes that a contractual term is ambiguous, it may look to external evidence submitted by the parties, which makes good record-keeping crucial. Here’s an excerpt from the blog:
Parties planning to use an earnout provision should practice good recordkeeping from the start of negotiations. A clear record of how the parties understood the terms of the earnout at the time of drafting may be crucial in a dispute, especially if the court concludes that a contractual term is ambiguous.
The Dematic case provides an example: there, the court held that the term “Company Products” was ambiguous and allowed the parties to introduce extrinsic evidence regarding how the products were made, the recommendations of the diligence team at the time of the transaction, and communications between the parties that reflected their understanding of the product at the time of signing.
In another recent case, Schneider Natl. Carriers, Inc. v. Kuntz,the agreement imposed strict constraints on the buyer’s management of the company in an effort to ensure that the company met its earnout EBITDA targets. One constraint required the buyer to purchase “60 tractors” per year, and if it did not, the seller would receive the full earnout payment regardless of whether the EBITDA targets were met.
The court determined that the requirement was ambiguous because the parties disputed whether the buyer had to simply purchase 60 tractors, or whether it had to grow its fleet of vehicles by 60 tractors per year. The court admitted extrinsic evidence, most crucially the parties’ negotiating history, and after a four-day trial and consideration of almost 300 exhibits, agreed with the seller’s interpretation and required the buyer to pay a $40 million earnout fee.
Last month, Boston Consulting Group released its 2023 M&A Report in four chapters. Since these reports have been issued annually since 2003, the first chapter, “Ten Lessons from 20 Years of BCG’s M&A Report,” discusses long-term trends over the last two decades and key takeaways.
It highlights the importance of having a well-developed M&A strategy and a tailored and rigorous approach to integration as well as the increased likelihood of success of serial acquirers of small to midsize targets and cash-only transactions with low multiples paired with high premiums over current valuations.
It also discusses alternative deal types, noting that the data shows they are increasing in frequency. Here’s an excerpt:
Traditionally, the default tool for dealmakers has been the plain-vanilla 100% acquisition, on both the buying side and the selling side. For instance, over the past two decades, majority deals outnumbered minority ones by about 3 to 1, although the annual ratio has evolved from 4 to 1 two decades ago to 2 to 1 more recently, largely owing to the rise in VC financing. The attraction of majority deals is clear: they are relatively simple to value and negotiate, and they are amenable to straightforward governance after closing. But in today’s ever-more-complex M&A and business landscape, this approach is not always optimal.
We have observed a consistent rise in alternative deal types, such as minority shareholdings, joint ventures, strategic partnerships, and corporate venturing. These structures may be more complex to execute and manage after closing, but they open new strategic options by giving dealmakers much-needed flexibility to customize capital allocation in response to specific conditions. Given the shift from the past decade’s abundant capital to the current scarcity, these alternative approaches have become an indispensable part of an experienced dealmaker’s toolbox.
Dechert recently released its annual Global Private Equity Outlook, which reports the results of a survey of 100 senior-level executives within PE firms based around the globe with at least $1 billion in assets under management. Here are some of the key findings:
– 26% of respondents, the largest share, believe that interest rates will have the single biggest impact on the deal environment over the next 12 months.
– 58% of respondents see market conditions for exits as being either neutral or somewhat favorable over the next 12 months, suggesting GPs are confident in a recovery but remain realistic. This is a marked decline from 84% who shared this view a year ago.
– Responding to the U.S. regional bank crisis earlier this year, 35% of respondents intend to move more towards private credit providers, a trend visible across all parts of the world.
– 94% of respondents say they are likely to consider pursuing take-privates at present, a marked departure from last year’s edition of the survey when less than half said they were likely to do so.
– 92% of GPs say that utilizing earn-outs is a strategy their firms are employing to manage the valuation gap that emerged last year in response to macro and market conditions.
Other key findings address, among other things, respondents’ assessment of the implications of the current antitrust environment, the percentage of respondents contemplating GP stake divestitures, and the percentage of respondents expecting their firms to invest in hedge fund capabilities during the coming year.
We’re taking tomorrow off in celebration of Veterans Day. Our blogs will be back on Monday. Have a safe and enjoyable holiday weekend and thanks to all who served!
Earnouts are particularly popular as a tool for bridging valuation gaps in life sciences deals. This Hogan Lovells memo provides an overview of some of the key considerations for buyers in those deals when negotiating their obligations under an earnout provision. This excerpt addresses the alternative standards that may apply to the efforts that will be required of the buyer to achieve earnout milestones, and the considerations that should be kept in mind when negotiating them:
Efforts levels come in many flavors: a more buyer-friendly approach may permit a buyer to take any action, including terminating a product line at the center of an earnout milestone, regardless of the impact it would have on achievement of the earnout; a more seller-friendly approach may grant a seller board participation rights (as a voting member, advisor, or non-voting observer), information rights to monitor the company’s development, or veto rights over certain actions (such as terminating a key employee or changes to a clinical trial); and variations in the middle may require that a buyer use “diligent efforts”, “reasonable efforts”, or “commercially reasonable efforts” (and other variations thereof) during the post-acquisition period. There are many varietals of compromises that can be negotiated between the parties depending on the sensitivities at issue.
As we have described in detail elsewhere, many jurisdictions have their own case law interpreting the levels of efforts required to carry out the standards that are often used in purchase agreements. This case law can vary and often does not delineate a meaningful distinction between such standards, regardless of any perceived hierarchy among practitioners. Unsurprisingly, interpretation of the efforts clause used is a common source of post-acquisition disputes among parties.
The memo says that in order to avoid judicial interpretation of these standards, if the parties desire an efforts standard to be articulated in an acquisition agreement, that standard should be defined contractually in a way that reflects their intent with respect to regulatory and commercialization obligations. It goes on to point out that the parties often need to choose whether to apply an objective standard that looks to industry practice or a subjective one that looks to the buyer’s or the seller’s past practices with respect to similar assets. Because courts are more willing to consider extrinsic evidence of the buyer’s or the industry’s past practices when the parties define the required efforts, a thoughtful approach here will make it more likely that the contract will be interpreted as the parties intended.
For many deal lawyers and other M&A participants, the DOJ’s recently announced safe harbor for voluntary disclosure of misconduct discovered in connection with an acquisition is considered a positive development. But it turns out that not everyone is a fan of the program. Here’s an excerpt from a recent Reuters article:
More than a dozen groups are pressing the U.S. Justice Department to retreat from a new policy they say gives a “free pass” to corporate wrongdoers, a sign of mounting criticism among progressives of enforcement under President Joe Biden.
Demand Progress, Public Citizen and 12 other progressive non-profit organizations and lobbying groups want Attorney General Merrick Garland and Deputy Attorney General Lisa Monaco to reverse the policy designed to coax companies to disclose misconduct they uncover during mergers and acquisitions, according to a letter sent on Friday.
The “newly announced policy will incentivize more concentration of corporate power through strategically-timed mergers or acquisitions sought in order to wipe the slate clean for lawbreakers,” the groups said in the letter.
The letter, which apparently hasn’t been made public yet, comes on the heels of a new Public Citizen report finding that despite the Biden Administration’s promises to ramp up corporate criminal enforcement, corporate prosecutions remain near record lows.
You might think that with 2023’s challenging M&A environment, PE fund employees would be experiencing a big compensation hit. This Institutional Investor article says that’s not the case. In fact, this excerpt says that those folks are seeing double-digit increases in their pay:
The median total cash compensation for all levels of private equity employees — analysts through managing directors and partners — rose 13 percent in 2023, according to a survey of 1,179 workers across the U.S. by Odyssey Search Partners, a recruiting firm focused on alternative investment professionals. Analysts, the most junior employees, got the biggest bump this year, with a 21 percent increase in total cash compensation. All others expect raises in 2023, except for managing directors and partners, who said theirs would be flat.
The pay increases during a tough year aren’t as counterintuitive as they seem, Anthony Keizner, a partner at Odyssey, said. Unlike other professionals, such as investment bankers that rely on transactions, the most lucrative parts of private equity compensation stem from the performance of funds that span several years. Private equity firms charge investors management fees annually, so they can afford to pay higher salaries and bonuses, and right now they have to do that, according to Keizner.
The article goes on to say that the reason firms have to pay up for talent is that there’s still a strong demand for trained laterals in the PE industry. Funds have a lot of dry powder and they need quality people to work on deals and with portfolio companies. So, if one PE fund isn’t willing to keep its employees happy, there’s another one that will jump at the chance to do that.
About this time last year, I blogged about Chancellor McCormick’s decision in Crispo v. Musk, (Del. Ch.; 10/22) which addressed an issue that Delaware is still sorting out – the circumstances under which a stockholder may assert a claim as a third-party beneficiary to an acquisition agreement. Earlier this week, she revisited that issue while addressing a mootness fee petition in that case. Her opinion sheds some light on the enforceability of a contractual provision intended to preserve claims for target stockholders’ expectancy damages in the event of the buyer’s breach.
The parties to a merger agreement don’t usually agree to convey third-party beneficiary status on target shareholders because, among other things, nobody wants to give plaintiffs’ lawyers a right to kibbitz in negotiations to resolve problems on a deal. But many targets are interested in preserving the ability to seek expectancy damages on behalf of their stockholders, and one alternative that has been devised to achieve that objective is a so-called “Con Ed clause” asserting the target’s right to seek those damages.
The Twitter merger agreement included a Con Ed clause, but the Chancellor noted that in the absence of language designating stockholders as third-party beneficiaries of the agreement, such a provision may not be enforceable. This excerpt from her opinion summarizes that argument:
A target company has no right or expectation to receive merger consideration, including the premium, under agreements that operate like the Merger Agreement. The Merger Agreement provides that at the “Effective Time” (defined as the time when the parties file the certificate of merger with the Secretary of State), stock will be converted into the right to receive merger consideration. Under this framework, no stock or cash passes to or through the target. Rather, merger consideration is paid directly to the stockholders. Accordingly, only a stockholder expects to receive payment of a premium under the Merger Agreement.
Where a target company has no entitlement to a premium in the event the deal is consummated, it has no entitlement to lost-premium damages in the event of a busted deal. Accordingly, a provision purporting to define a target company’s damages to include lost-premium damages cannot be enforced by the target company. To the extent that a damages-definition provision purports to define lost-premium damages as exclusive to the target, therefore, it is unenforceable. Because only the target stockholders expect to receive a premium in the event a merger closes, a damages-definition defining a buyer’s damages to include lost-premium is only enforceable if it grants stockholders third-party beneficiary status.
However, Chancellor McCormick pointed out that this interpretation would violate the “cardinal rule” of contract construction “that, where possible, a court should give effect to all contract provisions.” That led her to suggest an alternative construction that wouldn’t violate this principle:
There is another possible construction, which involves interpreting the Merger Agreement as granting stockholders third-party beneficiary status that vest in exceptionally narrow circumstances and for the limited purpose of seeking lost premium damages. As discussed above, third-party beneficiary status is a creature of contract and can be expressly or impliedly limited by the parties’ contractual scheme. If stockholders had third-party beneficiary status to bring a claim for lost premium damages, then such standing would be impliedly limited by the parties’ contractual scheme.
The Chancellor went on to address the nature of those implied limitations on the stockholders’ third-party beneficiary status and indicated that this status would vest only if the deal were terminated and abandoned and the remedy for specific performance was no longer available. Any such right also would be concurrent with the target’s right to pursue damages under the merger agreement.
Chancellor McCormick didn’t resolve which of these competing interpretations was the correct one. Instead, she ruled that any third-party beneficiary rights the plaintiff may have had did not vest, and therefore the plaintiff’s claim was not meritorious when filed. As a result, she denied the plaintiff’s motion for a mootness fee award.
For what it’s worth, Chancellor McCormick’s opinion suggests that there’s a straightforward fix for enforceability issues associated with a Con Ed clause. The parties could avoid requiring a court find an implied right to third party beneficiary status by expressly conveying third-party beneficiary status in the limited circumstances that the Chancellor enumerated. The limited nature of that status may make that alternative more palatable to dealmakers than a traditional third-party beneficiary provision.
If you needed any more proof about how challenging M&A financing conditions are, check out this recent Axios article, which says that equity contributions to US LBO transactions are at record levels. The article says the reason that PE sponsors are putting more skin in the game is simple – debt is getting very expensive:
Debt’s gotten pretty expensive this year, so the companies being acquired by PE firms can’t afford as much of it. Loans to companies purchased by PE firms have yielded 11% on average at issuance during Q3, a record high, according to PitchBook LCD.
PE firms have been forced to use more of their funds’ own money. Equity contributions are collectively around 51% this year, PitchBook LCD says — the first time that metric crossed the 50% threshold since the firm began tracking the data back in 1997. For comparison, the average equity contribution in the 10 years through 2021 was 41%.
While debt may account for a lower percentage of total capitalization than in years past, that doesn’t mean the burden of carrying that debt is declining. According to the article, interest payments are eating up a larger share of target company earnings than they have since 2007.
Meredith recently blogged about the distinction Delaware courts have traditionally drawn between an “expert determination” and “legal arbitration” when referring to dispute resolution language in the provisions of an acquisition agreement dealing with a purchase price adjustment. That blog pointed out that when the operative language calls for an expert determination, the third-party decision-maker does not have the authority to make binding decisions on matters of law or contract interpretation. Instead, its authority is limited to factual disputes within its expertise. In contrast, the third-party decision-maker’s authority when acting as an arbitrator is broader and is subject to much more limited review by a court.
The Chancery Court’s decision in Archkey Intermediate Holdings v. Mona, (Del. Ch.; 10/23), points out that Delaware recognizes a third alternative dispute resolution mechanism – an “Accountant True-Up” – and this excerpt from Vice Chancellor Laster’s opinion discusses that ADR procedure:
In between the two poles is another well-established form of ADR: the Accountant True-Up Mechanism. Purchase agreements governing the sale of private companies routinely include Accountant True-Up Mechanisms. Comm. on Int’l Com. Disputes, N.Y.C. Bar Ass’n, Purchase Price Adjustment Clauses and Expert Determinations: Legal Issues, Practical Problems and Suggested Improvements 1 (2013) [hereinafter “N.Y.C. Bar Report”]. In one standard use case, the parties “agree that any dispute concerning the values reported in the financial schedules used by the parties to determine the amount of any price adjustment are to be submitted to an independent accounting firm for a final and binding determination.”
The Vice Chancellor goes on to catalogue the standardized steps involved in an Accountant True-Up:
– The agreement gives the purchaser a defined period of time to prepare a proposed post-closing statement to be used to adjust the purchase price.
– The purchaser submits the proposed post-closing statement to the seller.
– The agreement gives the seller a defined period of time to review the proposed post-closing statement.
– If the seller agrees with the statement, then then the purchase price is adjusted based on the post-closing statement.
– If the seller disagrees with the statement, then the seller submits a written response detailing any objections.
– If the seller submits an objection notice then the parties engage in negotiations for a set period.
– If the disputes remain, they are submitted to an accountant for resolution.
– During the dispute resolution phase, the parties tender initial and rebuttal submissions with supporting documentation.
– The accountant’s determination is final and binding.
The Sheppard Mullin blog that Meredith referred to in her blog pointed out that language in an acquisition agreement to the effect that an independent accountant will serve as “an expert and not as an arbitrator” is a key indicator of the parties’ intent to obtain an expert determination. In this case, the stock purchase agreement provided that the independent accountant “shall act as an arbitrator.” But Vice Chancellor Laster concluded that this was not dispositive, and that the language of the agreement considered as a whole supported the conclusion that the dispute resolution process involved an Accountant True-Up.
As usual, there’s a lot more going on in this case than I can cover here. Fortunately, Glenn West has a more detailed take on the decision in his latest blog. In particular, be sure to check out his take on language in the opinion that could form the basis for a “malicious adjustment” claim.