PRIVATE MERGERS

By Charlie Geffen

The growth of transatlantic private M&A (including private equity) has led to increasing examples of “two nations divided by a common language.” Although many of the core principles of deal making are the same, there are market and cultural differences in the UK and US that participants should understand. We have seen many hours spent working through these differences and, whilst some are meaningful, others are in reality more “form over substance.”

1. Pricing mechanisms and adjustments. Post-closing price adjustments, such as for working capital, EBITDA or net assets, are familiar to the UK market but more commonly used in the US. In the UK many deals are instead done using a “Locked Box” structure (described in 2 below) where the economic risk of the business transfers as at a prior accounts date rather than at closing. This structure is beginning to feature in the US but the details are still largely unfamiliar.

2. “Locked Box” structures. This has evolved in the UK over the past few years and is now a common way for deals to be done, particularly for PE portfolio companies. The basic concept is that the target is sold as at an agreed balance sheet date prior to signing called the “Locked Box Date.” Financial statements are prepared as at that value date, from which point the economic risk of the business passes to the Buyer and the Buyer gets the benefit of all cashflow. Interest will typically be added to the agreed value from the Locked Box Date to closing to compensate the Seller for the cashflow accruing prior to closing.

The Buyer will be concerned to ensure that no value leaks out of the business between the Locked Box Date and closing. Language is included to make it clear that the Seller does not receive any dividend or other value after the Locked Box Date that should properly belong to the Buyer. Nonetheless, there will be some legitimate payments that the Seller should be entitled to receive (e.g. director fees and monitoring payments) which are defined as “Permitted Leakage.”

US sellers often have an instinctive dislike of having to define, and therefore limit, the value a Seller can extract from the business following the “Locked Box Date” for fear of missing something. We are not aware of any examples where a Seller thought they were entitled to value but were prevented from receiving it as a result of the definition of “Permitted Leakage.” However, it always helps to prepare a clear financial model showing the bridge from the EBITDA-driven headline price to the equity price setting out the agreed individual deductions.

3. Conditionality. The UK has a culture of “cash confirmed” deals driven from its public M&A regime. This is well understood and accepted in the UK with the result that, absent regulatory requirements, there is no material adverse change or other “out” prior to completion. In particular, there are no conditions at all relating to financing and Sellers will want to satisfy themselves that Buyers have unconditional financing available. There will be the usual covenants that require the business to be operated on a normal and consistent basis. US Buyers, however, are used to repetition of warranties and a right to walk away in the event of a material adverse change. It is important therefore that Sellers make clear in their sales process that they are requiring Buyers to transact on an unconditional cash confirmed basis. Like all communication, this position needs to be repeated at every opportunity.

4. Warranties, indemnities, representations and disclosures. The difference between warranties and indemnities can be as much of a mystery to clients as it is a source of endless, and often fruitless, discussion amongst lawyers. In practice, the most important difference is that warranties are qualified by disclosures whereas indemnities are not. This means that the purpose of warranties is generally to elicit disclosure, although they do afford substantive protection in relation to financial statements, trading and material liabilities where proper disclosure has not been made.

Indemnities are designed as a pure risk allocation mechanism: if the defined liability arises the indemnifier pays, irrespective of either the buyer’s knowledge or whether there has been a diminution in the value of the business acquired. Unlike the UK, in the US the practice is for all the warranties to be given on an indemnity basis which is why so much debate arises around the UK practice of disclosure. Again, when dealing with US bidders it is important to focus clearly on the basis on which warranty and indemnity cover will be provided.

“Representations”
have a different legal meaning under English law and, if breached, give rise to different remedies to warranties—in particular termination rights. It is almost universally the case that English law agreements contain language making it clear that no “representations” are given. Sellers should only “warrant,” never “represent and warrant.”


“Disclosures”
against warranties is also a key area of difference. In the US disclosures against warranties are typically only specific and set out in a schedule. In the UK disclosures tend to be by reference to “liabilities the nature of which can reasonably or fairly be identified in the Data Room” or similar language. There will also be a formal letter setting out specific exceptions to the warranties.

5. W&I insurance. W&I insurance is increasingly common in UK deals and is a growing feature of the US market. While the products are similar, there are key differences. Generally, coverage in the US is more comprehensive, with fewer general exclusions and the ability to recover for breach of any warranty on an indemnity basis. This means that UK policies are usually significantly cheaper, with premiums from 1%-1.5% compared to 3%-4% in the US. It is therefore important to consider at the outset the kind of insurance coverage sought and the appetite of the Buyer to pay more to cover the risks involved in the transaction. In both jurisdictions, careful consideration should also be given to the W&I insurance if the warranties are to be repeated at closing. Any disclosure against the repeated warranties may compromise the insurance cover of the signing date warranties. As a result the expectation (particularly in the US) may be that any material disclosures of breaches of warranty must necessarily lead to a price renegotiation or a busted deal. In the UK, where termination rights for breach of warranty are uncommon, many insurers are starting to adopt more practical positions to protect the cover of the signing date warranties, and in some instances are accepting that there will be no further disclosure at completion if the period between signing and completion is short.

6. English law or US law. In practice there is likely to be little practical difference in the interpretation of the contract under English or US law—although there are some important differences in language. The issues will turn on the likelihood of a dispute, the reluctance of English participants to expose themselves to an unfamiliar US judicial system and the cost implications of fighting a claim in the US. Litigation in M&A is far more common in the US than UK. However, “US style” agreements are increasingly being used for UK deals albeit subject to English law. That is not to say however that most deal structures cannot operate perfectly well under either US law or English law. The law of the contract should not determine whether there is a locked box structure or a purchase price “true up.” That is driven by market practice and negotiating strength.

7. Fund structures. Finally, given the size of the US market there is a much wider variety of fund structures. In selecting prospective Buyers, advisers should always take care to ensure they understand the fund structures of those admitted to a process and satisfy themselves as to whether the GP they are dealing with has full power to draw down funds or whether they are dealing with a “club” like structure where investors have a deal by deal choice as to whether to invest.

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