Selling risk in mid market M&A transactions in Europe

Martin Mendelssohn and Thomas Meyding of CMS review some recent trends in legal practice which have seen sellers passing risk to purchasers in the mid market.

The last 18 months have seen the consolidation of various seller friendly legal practices in the mid market. This article considers the application of some of those practices in Europe, particularly in its two biggest M&A markets, UK and Germany; why they have emerged and how it has fundamentally changed the risk balance between the seller and purchaser.

The practices have been driven by financial owners operating the auction process in a seller’s market. These include seller friendly share purchase agreements with limited scope of warranties; much enhanced seller liability limitations with higher thresholds, lower caps and shorter claim periods; legal due diligence reports prepared on the instructions of the seller (VDD reports); lock box covenants instead of completion accounts adjustments; and more carve-outs from material adverse change clauses (MAC clauses).

CMS act for a number of mid market private equity houses and strategic buyers throughout Europe. In Germany, the client profile is supplemented by significant family owned Mittelstand companies. From this vantage point, we have seen a rapid acceleration of the seller friendly practices – and a grudging acceptance by buyers that a greater assumption of risk is now the market norm. This has led to more focused due diligence exercises with price tags being allocated to particular risks.

Limitation of Liability

Ten years ago, the overall liability cap for warranties and indemnities was generally 100% of the consideration. It was not even something that people argued about. With private equity investors increasingly becoming sellers, a problem emerged for buyers. There was a significant warranty gap. Financial sellers, required to return funds to their investors and, not being in the business of retaining residual risk, would not give warranties. Management sellers could not provide adequate financial comfort. The Warranty & Indemnity insurance market was only emerging (and of course required payment of premia). Buyers stepped up their due diligence process and began to evaluate the risk if there was to be a claim. Although logic demanded 100% potential recourse where good money had been paid, the reality was that a total disaster leading to anything like full recovery was very unlikely. The same trend had occurred in the USA. Whereas there has been no reliable research available in Europe, a sub-committee of the Business Law Section of the American Bar Association has produced a study (ABA Study) based on 128 US deals in 2004, predominantly involving US$25-500m transactions. Over 60% of the deals had overall general liability caps of 25% or less of the consideration. The ABA Study also records a substantial percentage of carve-outs from the liability cap (such as tax, fraud, intentional misrepresentation, capitalisation and due authority). In Europe one can only rely on anecdotal evidence and general experience in order to test the market, but we at CMS can certainly report a marked downward trend in general liability caps in Europe.

Another related area is the treatment of the basket in liability limitation. Although there is upward pressure on the amounts of the basket, practice has not changed dramatically (unlike in the case of overall caps) for setting the limit of the basket. What is changing, however, is whether there is a “deductible” or “first Dollar” treatment where the full limit of the basket is achieved. Until recently, “first Dollar” was the norm in the vast majority of cases. The ABA Study, however, reported that in 56% of US deals a deductible applied and in only 40% of US deals could the buyer claim the full amount (i.e. back to first Dollar). Our experience in CMS is that, although there is no market acceptance in Europe in favour of a deductible, it is increasingly raised as a point for negotiation. Acceptance of the deductible (as opposed to first Dollar) is in our experience much more a feature of upper mid market and larger deals.

VDD reports

A recent feature of European controlled auction disposals has been the emergence of vendor commissioned legal reviews or due diligence reports (VDD reports). Broadly, it follows the example of the accountants report widely used on disposals. Although prepared on the vendor’s instructions, VDD reports are ultimately relied upon by the purchaser. VDD reports may bring some significant advantage for the vendor, not least the perception that it speeds up the timetable once the auction is really under way. Because VDD reports require significant management time and front end cost, they are more likely to be commissioned on larger mid market transactions, where the additional cost and time are often an acceptable risk in return for a speedier result. They are also useful in explaining the regulatory and legal background in jurisdictions where the purchaser may be a first time buyer (e.g. Central & Eastern Europe). And most significantly, VDD reports inform the vendor about risks which can be rectified or otherwise covered (or avoided) specifically in the sale agreement. The vendor will want the VDD report to be full enough to persuade the purchaser that it need only do some confirmatory due diligence, but the scope of the work is established by the vendor.

All of this plays against the purchaser – and is one of a number of reasons why the VDD report has gained no currency as yet in American transactions. US purchasers are highly sceptical about the whole process. Not only is the deck stacked against the purchaser with very limited warranties and substantial seller limitations, but they do not even get to set the rules for their own due diligence exercise. In addition, US vendor’s counsel is not prepared to assume liability to third parties by addressing the VDD report to them. German counsel have, in principle, taken the same approach and whilst VDD reports may be produced for the purposes of the data room, this is often merely by way of further information for the purchaser, but without assumption of liability to third parties. Those UK law firms prepared to give VDD reports addressed to the ultimate purchasers (and funders) have become more comfortable with the process, provided they can impose appropriate liability exclusions and conditions.

MAC Clauses

One further area where the screw has been turned against the purchaser relates to MAC clauses. Such clauses allow the purchaser to terminate the sale agreement for a material adverse change arising between signing and closing. This issue arises if transactions do not sign and close at the same time. The most frequent reason for non-simultaneous signing and closing is a mandatory merger control regime such as that of the EU. Although to some extent, the degree of risk may be assessed in terms of the likely length of the gap, we have seen vendors seeking to adopt a harder line on MAC clauses, citing in some cases the importance to them of deal security. US practice again may be indicative in assessing likely trends in European M&A. According to the ABA Study, only 5% of relevant US deals did not have some kind of MAC provision, although it was not always a stand alone MAC clause. Negotiating a number of specific carve-outs (in 80% of relevant US deals according to the ABA Study) is likely to be seen in more European M&A deals. This will certainly not favour the purchaser.

Although driven by financial owners in recent years, many of these seller friendly practices also featured in government privatisations and mega deals involving the types of targets which were likely to be the subject of much greater scrutiny, transparency and general knowledge. For these targets, the purchaser’s commercial rationale for doing the deal at the right price probably far outweighed any perceived legal problems. However, this mindset should not apply to the same extent to the mid market – and the smaller the deal the less it should apply because it is likely that less is known about the target, management is unproven and a serious legal issue can undermine the rationale for the deal.

Many of the trends described above will now be the starting point in many deals. If the market cools then the seller’s oft repeated suggestion that buyers price the risk, rather than look for contractual protection in the sale agreement, may become a more viable option.