Bridging the value gap

Last week Jessica Adam, a partner in our corporate and M&A team, was joined by Harry Bourne, from the investment banking group at Jefferies, to discuss bridging pricing expectations between buyers and sellers. Jessica and Harry acknowledged that, whilst this isn’t a new issue, due to the number of different macro-economic factors that we are experiencing in the M&A market, we are seeing a larger gap between the pricing expectations of buyers and sellers in current transactions and different methods are being used to overcome this. Some of the methods they discussed having seen in the market recently include:

1. Earnouts: Over the last few years we have been operating in a seller friendly M&A market which has meant that earnouts have not been used regularly, especially in private equity transactions. Traditionally, using an earnout could have benefits for a private equity house when acquiring assets in particular sectors in which access to new products or developments will vastly increase the growth of the target business but that access and growth is not certain at the point of acquisition.
   In the current market and due to the impact that Covid 19 has had on previously profitable businesses however, earnouts are increasingly being considered as an option when structuring transactions in light of recent trading volatility. It allows valuation of the target business to take into account that the business has suffered a recent drop in profitability but there is an expectation that it will recover. However, caution should be exercised if an earnout is going to be used to ensure that there are no unintended repercussions on the business in the future and careful consideration should be given to how it is structured and the performance metrics on which it is based.
2. Vendor Rollover: The willingness of a seller to re-invest in a target business demonstrates its confidence in the business, and is particularly appealing for sellers where there is anticipated growth, as it gives a them a share of any future upside. Historically we have seen vendor rollovers in businesses where it is anticipated there will be a steep growth trajectory, however, we are increasingly seeing in the current market so called fund to fund transactions, in which a financial sponsor sells a portfolio company out of one fund and reinvests via a later fund.
   Fund to fund transactions have become more prevalent due to the market conditions caused by Covid 19 and the negative impact that this has had on the valuations of some businesses. Moving an asset to a new fund allows the business to continue to grow and ensures that the selling PE house continues to see some benefit of this growth (albeit via a different fund). In some instances, earnouts combined with vendor rollovers are being used to help bridge any gap between valuations.
3. Vendor Financing: Whether this mechanism is used depends on the growth profile of a target business. Financing is considered a less risky and volatile investment compared to a vendor rollover, however, it provides less of the upside on any growth of the target business. Vendor financing and vendor rollovers have similar commercial points to consider and similar issues arise when using them to structure transactions. From our experience, vendor rollovers are being utilised more than vendor financing in the current market conditions.
4. Anti-embarrassment clauses: Despite, at the start of Covid 19, it being predicted that these types of clauses would be more widely used, to avoid buyers taking advantage of the volatile market conditions to drive down prices, we have not to date seen widespread use of them in practice - and it would be fair to say that anti-embarrassment clauses are not common in private equity transactions. They can however, be a useful way to manage deal specific points, for example on a “forced” or time critical sale where a seller may be prepared to accept a lower price but wants protection in the event that the asset is flipped on at a higher valuation within a short period of time.