Two years on: Deal pricing now and through the pandemic

Every two years we analyse the deals that our M&A team has worked on, looking at the key legal terms of each transaction, to take stock of what is “market” and identify emerging trends.

That two year cycle would have meant undertaking our analysis at the end of 2020 but, with what happened in Q1 of 2020 and subsequent COVID 19 restrictions being imposed on many UK businesses, we wondered how informative such analysis would be. Postponing our review, which we ultimately undertook at the end of 2021, allowed us to look at transactions across the three years from 2019. Our deal sample was therefore made up of pre-COVID (Pre Deals) and since-COVID deals (Since Deals), and there were some clear differences in the before and since trends. In this article we’ve outlined the impact of the pandemic on the most fundamental of deal terms – the pricing mechanism.

There are three main ways of pricing deals in UK midmarket M&A:

1. Fixed price – where the price is agreed between the parties and fixed ahead of completion with no adjustment or other pricing mechanism;

2. Completion Accounts – where the price is determined after completion by reference to accounts of the target company or group made up to the completion date;

3. Locked Box – where the price is calculated ahead of completion based on a set of pre- completion accounts made up to an agreed date with no subsequent price adjustment.

During the pandemic, many businesses have seen significant changes in their financial performance, some for the better and others unfortunately for the worse.  It has been, and in many cases still is, difficult to know what the long term, sustainable performance of those businesses will be going forward. Typically deal valuations have looked at past performance as an indicator of future performance, but looking back to what we all hope were exceptional times, is no longer a reliable basis against which to predict future performance. When combined with the prevailing uncertainty that plagued many sectors since 2020, with restrictions, regulations and guidelines constantly changing, it has been difficult to agree valuations. As a result, there has been a marked increase in the number of deals involving pricing mechanisms, coupled with a similar increase in the use of earn outs, retentions and deferred consideration. Deals involving completion accounts or a locked box represented 87.5% of our Since Deals, as opposed to 67% of our Pre Deals, with completion accounts remaining the prevalent mechanism, with their use increasing from 37% to 50% and locked box deals increasing from 23% to 37.5% (7% of the Pre Deals featured some form of hybrid completion accounts/locked box mechanism).

The number of deals featuring unconditional deferred consideration (where only part of the price was paid on completion with the balance payable in one or more tranches on specified future dates) was fairly consistent across the before and since periods analysed but the deferred element as a proportion of the overall price increased in the Since Deals.

The use of retentions or hold backs (where the buyer retains part of the purchase price as security to ensure funds are available to cover any purchase price adjustment, and/or any claim under the share purchase agreement) also increased from featuring in 13% of our Pre Deals to 37.5% of our Since Deals.

As well as being used more frequently, the amounts being withheld have increased as has the length of time that buyers typically hold back funds. Where it was typical for the retention to cover just the completion account adjustment, it is increasingly being used to cover all transaction claims.

Earn outs (where part of the purchase price is calculated by reference to future performance of the target company) are a useful pricing mechanisms to bridge any gaps in value expectations between the buyer and the seller and, again, we’ve seen their use increase as they were a feature of 37.5% of the Since Deals but only 23% of the Pre Deals.

All of the mechanisms outlined above are tools to mitigate valuation risk for the buyer, which is to be expected in the circumstances. However, it is not just buyers looking to mitigate risk, as we are seeing more sellers requesting or requiring security in the form of a charge over the assets of the company post sale or parent company guarantees to mitigate the buyer’s credit risk.

Whilst many of the restrictions imposed in response to the pandemic have lifted, times are still uncertain with Covid here to stay and with war in Ukraine. With that in mind, we expect to see continued use of the pricing mechanism, as parties look to navigate fluctuations in financial performance and to bridge value expectations.

If you would like to discuss any of the themes identified above, or would like a copy of our market monitor report, which goes beyond an analysis of a pricing mechanism and looks at all the main legal negotiation points on a M&A transaction, please get in touch here Nina.Searle@tlt.com.

This article was first published by Bluebox.