Key Takeaways: ABA 2021 Private Target M&A Transaction Point Study | Goulston & Storrs PC
The ABA Private Target Mergers & Acquisitions Deal Points Study is published semi-annually. The 2021 Dealing Points Study (the “Study”) analyzed 123 publicly available purchase contracts signed and closed in 2020 and the first quarter of 2021.
The study examines several areas of negotiation, including financial terms, representations and warranties, covenants, closing conditions and indemnification provisions. The breadth of analysis is one of the reasons the ABA report is so useful to practitioners. The ability to review a report and know that other attorneys are also reviewing the same facts and figures has led to the study being widely regarded as the best source for terms currently considered to be in the market.
The terms of a purchase contract that are “market” evolve and change with the economy and other circumstances. This constant evolution is why the ABA aims to produce the study on a semi-annual basis. This regularity ensures that the latest market data is reflected and allows lawyers to map market trends over time.
Goulston & Storrs identified several key trends to note in the most recent study. The most significant changes we have identified are briefly described below.
1. Purchase Price Adjustment Escrows. A separate escrow account in which to retain a portion of the purchase price at closing, to be used to settle a post-closing adjustment of closing or pre-closing estimates, is now present in approximately 47% of transactions. This is down slightly from 51% in 2019 (but a significant increase from a low of 20% in 2008). In addition, 39% of purchase agreements with such receivers specify that this separate purchase price adjustment receiver is the sole source of collection for the purchase price adjustment after closing. This tendency to use escrow as the only recourse for purchase price adjustments has steadily increased from 11% (of the 45% if it is such an escrow) in 2017 to 26% (or 51% to deal with such an escrow) in 2019 to 39% (i.e. 47% of transactions with such an escrow) in 2021.
2. Representation and Warranty Assurance (RWI). There has been a market-wide trend towards getting RWI. The study shows that 65% of transactions in 2021 included references to RWI. This represents a significant increase from 29% in 2017. Additionally, of the 65% of purchase contracts that reference RWI, 51% of agreements include an express obligation for the buyer to bind RWI upon signature, compared to 42% (out of 29 increasingly seen, is currently not used as frequently as in larger transactions. Therefore, we would expect that if this subset of transactions were excluded, the percentage of transactions with RWI would be even higher.
3. Compensation caps and escrows continue to decline since 2008 as a percentage of TEV, primarily due to RWI. It is common for sellers in a transaction to cap their indemnification obligations for breaches of general representations and warranties. In 2021, 99% of transactions included such a cap. The central negotiation around this point is what amount is appropriate for the cap. The median compensation cap (as a percentage of total enterprise value (TEV)) has fallen from around 11% of TEV in 2008 to 2% of TEV in 2021. This is largely due to increasing the RWI, which provides buyers with an alternative source of recovery in the event of a breach of general representations and warranties.
Additionally, parties often agree to retain a portion of the purchase price in an escrow from which a buyer can recover compensable losses. The study shows that 63% of transactions include an indemnification escrow. The median size of compensation escrow (as a percentage of TEV) has decreased significantly, from around 10% of TEV in 2008 to 1.35% in 2021. Looking only at transactions with RWI, the median size of compensation escrow in 2021 decreases even further to 0.55%. of the VTE.
4. Definition of MAE. Representation and warranties in purchase contracts are often qualified by reference to material adverse effect (MAE). The study shows that MAE qualifiers appeared in 99% of transactions. Qualification of a representation and warranty by EAW generally means that a breach will only be triggered if an EAW is also present (a relatively high threshold). Given its importance, the definition of MAE tends to be heavily negotiated. According to the study, 73% of transactions include an impairment of a target’s ability to complete the transaction as an MAE; a steady increase from 50% in 2008 to 61% in 2017 and 73% in 2021. On the other hand, the study shows a tendency not to include the impact on the prospects of the target as an MAE, this one appearing in only 7% of transactions in 2021; this is down from 38% in 2008.
5. Knowledge qualifiers. In qualifying representations and warranties by knowledge of the seller, buyers prefer wording of “implied knowledge” (i.e. knowledge that a person would reasonably be expected to acquire in the course of diligent performance of duties), while salespeople prefer a “real knowledge” standard of knowledge”. According to the study, 81% of transactions in 2021 used constructive knowledge formulation. Using constructive knowledge rather than real knowledge has become more common on a fairly steady upward trajectory from 61% in 2006.
6. 10b-5 Representation. In addition to specific representations and warranties provided by Sellers in a purchase agreement, Buyers will sometimes request a general representation and warranty from Sellers that none of the representations and warranties contain a false statement of a material fact or omits a material fact necessary to ensure that each statement contained herein, in light of the circumstances in which it was made, is not misleading. This is usually a “representative 10b-5” in reference to Securities and Exchange Commission Rule 10b-5. However, sellers are generally very reluctant to make such a broad statement and the inclusion of a 10b-5 rep seems to be falling out of favor. The study shows that 10b-5 reps were not included in 93% of deals (a significant increase from 10b-5 reps not included in 32% of deals in 2008). This represents a significant shift in M&A practice regarding 10b-5 reps.
7. Sandbags Compromise. A pro-sandbagging provision allows a buyer to recover compensation for breaches of which the buyer was aware before entering into a transaction. In contrast, an anti-sandbagging provision expressly prohibits a buyer from recovering losses related to breaches of which the buyer was aware prior to closing. The middle ground between these two positions is to remain silent on the issue (without an express pro or anti-sandbag statement). The study reports that 68% of agreements followed the middle ground of keeping silent, up significantly from 41% in 2006. In addition, the study shows that 29% of agreements included pro-bag provisions. sandbags in 2021, compared to 50% in 2006. – sandbag provisions remain rare (peaking at 10% of transactions in 2012).
8. Materiality scratches. Buyers will often negotiate to include a “materiality gratuity” in the indemnification section, to negate the impact of materiality qualifiers in the seller’s representation and warranties to determine damages, determine breach, or both. In 2021, materiality scratches were observed in 92% of transactions (compared to 14% in 2004). The “single materiality scraping trade-off” (where materiality is ignored for calculation of losses but not for determination of breach) is increasingly rare and has become largely neglected in practice (now only seen in 12% transactions; compared to a peak of 66% in 2010).
9. Damage Mitigation Provisions. A seller may request a provision in the indemnification section of the purchase agreement requiring the buyer to take action to mitigate damages related to an indemnifiable loss. The inclusion of damage mitigation provisions in indemnification structures that expressly oblige the buyer to mitigate losses has increased significantly – from 22% in 2006 to 56% in 2021 (although down slightly from the peak of 60% in 2019). We find that these mitigation commitments are often limited to mitigation actions that are otherwise legally required.
10. Consequential Damage Exclusions. Sellers will often negotiate express exclusions of damages payable as part of a claim. Potential exclusions include incidental, punitive and consequential damages. According to the study, in 2021 (i) incidental damages were expressly excluded in 27% of transactions and agreements were silent in 61% of transactions, (ii) punitive damages were excluded in 82% of transactions and agreements were silent in 14% of transactions, and (iii) consequential damages were expressly excluded in 32% of transactions and agreements were silent in 58% of transactions. While the results for incidental and punitive damages have remained fairly stable, there has been a trend of silence with respect to consequential damages – neither expressly excluding nor including consequential damages in compensable losses – which began in 2017 to be the (slight) majority position.
Each of the key takeaways from the above study reflects market trends that have developed over the past several years due to particular demands and changes in the overall global economy and in the M&A industry. We will explore the reasons and effects of these developments in more detail in a series of short, focused articles addressing each of these topics in turn over the coming weeks and months.