Mark Legaspi, Associate General Counsel and Director of Corporate Strategy, M&A, investments and Emerging Technology at Intel, kicked off this interesting discussion during the annual M&A Conference at the University of Chicago, which was held live online, by offering his perspective on the circumstances faced by companies in a “post-COVID” environment, including the evolution of negotiation factors around market conditions during 2020. 

The chair of the session, Matthew Gemello, a leading Corporate Partner in the M&A and Private Equity practice at Orrick, started by observing that deal valuations have not fallen as drastically as many industry participants had feared. But while there have not been significant declines, Brett Shawn, Senior Vice President and Assistant General Counsel at Warburg Pincus, cautioned deal teams to scrutinize how they underwrite deals and to perform more detailed diligence of target companies before agreeing to valuations given the current uncertainty. 

How do we, virtually, pursue this deal?

Online meetings, including diligence discussions and calls, are proving to be more efficient and focused, Legaspi observed. However, this new format has made it harder to differentiate bids through softer characteristics such as culture and vision. As dealmakers continue to operate on Zoom, Google Meet and other virtual platforms, it appears more important than ever to find new ways to compete for desirable targets.

Establishing reasonableness, during the pre-sign period with respect to reps and warranties, covenants, etc., is a critical best practice this year as sellers’ patience for long deal processes is proving to be limited, Legaspi explained. Ensuring there is alignment upfront between the parties on the ‘narrative’ around the deal thesis was offered as the most important element of a successful deal. Shawn talked about sellers pushing for a higher RTS and negotiating commitments to close when the delay of going to court may cause debt financing commitments to expire. 

Clearly, the buyer takes COVID risk, just like other general market conditions. But the heightened focus on certainty is leading dealmakers to prefer to close quickly, even if they end up giving up some consideration from an indemnity post-close, in Gemello’s experience working across a large number of deals.

Can you trust the forecast?

During the past six months dealmakers were concerned about the strength of a target’s revenue stream and estimates, given the economic downturn. Now things have changed. In Shawn's view, finance teams are now applying a more sophisticated COVID-19 discount, if appropriate, to valuation. Legaspi extended his remarks to remind participants that M&A is more impactful when it affects long-term market plans, existing teams and product lines. These more strategic considerations should be more meaningful than the short-term accretive benefits that may be subject to the pandemic and economic cycle.   

Shawn agreed, adding that the final headline price is an important “partnership aspect” of deal negotiations.

Transaction insurance is now, always, on the table

Legaspi is finding nearly all transactions include at least a conversation on reps and warranties insurance, with sellers increasingly pushing to have a policy in place. For strategic buyers, who typically rely on diligence and self-insurance, this is an area one should expect to have to rebuff.

In the financial sponsor community, which regularly sees deals where the seller is looking for a no-indemnity transaction, insurance is the standard mechanism to offload risk – although this is determined on a deal-by-deal basis accordingly to Shawn, who pointed to the recent AIG claims study and the potential impact on pricing that may come into the market during the next 12 months.

Forms of consideration considered     

The consideration mix in deal negotiations was also discussed, mainly focused on discernible differences in consideration packages offered to target companies including equity stakes. 

Private equity firms always expect management to roll over some portion of the proceeds to ensure maximum alignment. Interestingly, Shawn observed a higher level of rollover interest from deals between two private equity firms – with more sellers looking to capture some of the future upside.

Legaspi responded that, while larger companies such as Intel typically do not offer equity in consideration mixes, certain larger companies whose share prices have weathered the COVID-19 pandemic might well consider offering equity stakes as their valuations continue to climb. According to Legaspi, such decisions largely come down to a strategic calculus of the target company, and whether its management believes the acquisition will significantly increase the share price of the buyer. Otherwise, cash is still the preferred currency.

Bridging the gap with contingent consideration

The panelists continued the discussion with a look at contingent consideration, and a question from Gemello on whether companies are increasingly tying consideration to performance metrics.

Both Shawn and Legaspi cautioned against using long-term or vague earn-outs as such terms can cause issues later on, especially given the volatile economy. Legaspi believes short-term earn-outs can be used, but only for a very limited window post-closing and should only account for a small portion of the overall purchase price. Additionally, any metrics used to measure earn-outs should be easily audited (for example, sales targets).

Shawn agreed with Legaspi’s approach to earn-out consideration, adding that earn-outs in uncertain markets or with unclear metrics often lead to disputes. Deal teams should work in tandem with the target to define key metrics that are easily accessible and agree beforehand how disputes will be mitigated. Legaspi cautioned that earn-outs quite often restrict and bog down the business after close.  

Acquisition financing surprisingly steady

Shawn mentioned that most leverage financing terms are largely unchanged this year, while seller financing and deferred purchase price is a way to provide more of a "headline" number to the sell side. JVs are also interesting ways for private equity firms to tap a corporate balance sheet to support the financing and de-risk the financing process.

SPAC-mania

SPACs (Special Purchase Acquisition Companies) are a new competitor for both strategic and private equity buyers. Although it is unclear whether their presence is driving up competition and valuations, the panelists warned this is an area to watch as a SPAC merger offers an attractive path for management teams that seek to remain in control, achieve liquidity, and avoid the traditional IPO process.

Clearly this year has seen some important shifts in the M&A practice that are important for understanding the ways strategic and private equity buyers compete.