MoFo 2020 Asia Buyouts Report: Update on Deal Terms – I. Pricing the Deal

INTRODUCTION TO OUR REPORT

We looked at 28 deals across Asia signed or closed pre-COVID-19 in which the buyer or a group of affiliated buyers acquired all or a significant majority of the outstanding equity of the target. We examined the common key terms in these deals and have sought to provide our insights on the patterns that the results reveal.

Approximately one-third of these deals involve a target in Southeast Asia and another third involve a target in Korea, with 25% involving a target in China or Hong Kong and 7% involving a Japanese target.

Ten deals involve an implied target value of between USD100 million and USD500 million; seven deals involve an implied target value of USD500 million or above. While the deals we have looked at may not represent all the recent deals in the Asia market in the past 12–18 months, they do represent buyouts of a wide range of deal sizes and we believe are indicative of certain market trends. 

We will be releasing a series of short articles highlighting the key trends identified from these sample deals and will in parallel examine, where relevant, how they may have been impacted by availability of warranty and indemnity insurance.

In this first part of our Report, we first look at the consideration mechanics used in our sample deals. In summary:

• Completion accounts remain the most common mechanism across Asia used to determine the purchase price.  More than one-third of these deals feature completion accounts mechanics.
• Financial sellers preferred locked box mechanics for price certainty. More than one-third of them managed to agree to settle the price on that basis.
• A seller needs to be prepared ahead of time to ensure the financials of the target are in a form that can get the buyer comfortable with taking up the economic risk from the locked box date when the target is still in full control of the seller.

WHAT IS A LOCKED BOX MECHANISM?

Locked box mechanics pass on economic risk to the buyer, while ownership remains with the seller until closing.

Many sellers and buyers in Asia may still be unfamiliar with the locked box mechanism as historically sellers and buyers in Asia generally favored a completion accounts mechanism. Under a completion accounts mechanism, sellers and buyers agree a valuation for the business on “cash-free, debt-free and normal working capital” basis. That value is the “Enterprise Value.”  At closing, the buyers pay a closing amount representing a good-faith estimate of the cash, debt and working capital level as at the closing date. After closing, closing statements are prepared (often by the buyers) to verify the actual level of cash, debt and working capital, which will result in adjustment to the final price paid to the sellers. The final price paid post-adjustment is often referred to as “Equity Value.” Because the final adjustment is not made until after closing, neither seller nor buyer has any certainty over the final price until well after closing.

Locked box mechanics, on the other hand, fix the Equity Value at signing and thus provide more certainty to sellers and buyers with respect to the final price. Such Equity Value is calculated based on the most recent historical financial statements of the target group, in which the cash, debt and working capital level as at that historical date (the “Locked Box Date”) would have been known to both parties. Parties then work into the fixed price all adjustments appropriate based on the known amounts of cash, debt and working capital and agree on the single number to be inserted as the price in the sale and purchase agreement (the SPA). No definitions of cash, debt or working capital are required in the SPA, as no adjustment will be made to the price fixed in the SPA.

Buyers take the economic risk and benefit from the Locked Box Date. In return, sellers will typically provide an indemnity in respect of any “leakage” (i.e., transfer of value of the business to the seller or any seller-related party between the Locked Box Date and closing) but will be compensated (for not receiving the Equity Value until closing) by receiving interest accrued at a rate agreed between the parties from the Locked Box Date to the closing date.

If locked box provisions are tightly drafted, any movement in working capital between the historical Locked Box Date and the closing date will be equivalent to the movement in net cash/debt, so no party will be worse off by agreeing to adopt the locked box mechanics than they would be under completion accounts mechanics.

Below is a quick summary of key actions using the two different types of pricing mechanics:

PRICE CERTAINTY IS KEY

Completion accounts remain common, but financial sellers preferred locked box mechanics.

Completion accounts have been the preferred post-completion price adjustment mechanics in Asia, where the parties are not able or willing to agree on a fixed consideration at signing. This has remained the case during the past 12–18 months, with 39% of our sample deals using a completion accounts price adjustment and only 25% using locked box mechanics.

In the case of deals involving financial sellers, 36% of them adopted locked box mechanics, while only 28% of financial sellers opted for completion accounts mechanics.

These statistics demonstrate the following:

• Financial sellers are often well prepared ahead of their exits and are ready to present a solid set of accounts to the bidders or preferred buyer(s). The sellers may insist that it is unnecessary for the parties to incur the additional expense to prepare closing accounts and to engage in the prolonged negotiation of definitions (such as cash, debt and working capital) necessary to work out the completion accounts.
• One of the key goals of financial sellers in exits is price certainty. In the arguably seller-friendly market during the 12–18 months preceding COVID-19, financial sellers have been keen to insist that buyers complete thorough due diligence and structure deals such that buyers take on the economic risk with respect to the target business as early as the date on which the locked accounts were prepared.
• Buyers (including both financial and corporate buyers) could find locked box mechanics attractive in (i) giving certainty on the amount of funding required, (ii) reducing risks of a dispute over closing accounts and (iii) facilitating the consolidation of the target business into their existing portfolio companies or operation.

Corporate sellers may find it difficult to adopt locked box mechanics and get their buyers comfortable with pricing with historical financial statements.

None of the exits by corporate sellers used a locked box structure.  This fact can probably be explained on the basis that:

• Some corporate sellers need to carry out carve-outs or restructurings immediately prior to the disposal, resulting in difficulty in presenting to their buyers accounts for consecutive years that relate solely to the target business; and/or
• A locked box approach requires buyer’s confidence. If the buyer is a financial buyer that is not familiar with the industry sector, it may be challenging for the buyer to effectively agree on what should be “Permitted Leakage” (which essentially should only be actions required to preserve the value of the business between the locked box date and closing) and to price in all the risks between signing and closing.

KEYS ISSUES IN CONSIDERING WHETHER TO ADOPT LOCKED BOX MECHANICS

In addition to being aware of the differences between locked box mechanics and completion accounts mechanics, it is important for PE investors and sellers who desire to price their deal by way of locked box mechanics to bear in mind the following:

• Benefit in simplifying documentation versus challenge of negotiating leakage and permitted leakage – While there is no need to define cash, debt and working capital in the SPA using locked box mechanics, parties need to agree on what constitutes “leakage” (against which sellers have to provide full indemnity) and “Permitted Leakage.” This requires sellers to be fully transparent with respect to how the business has been (and will be) operated between the Locked Box Date and closing and on details of the transaction expenses that the target may incur.
• Audited locked box accounts and related timing considerations – Often buyers only feel confident to price a target based on audited and unqualified financial statements prepared up to a very recent date (often less than six months). Management accounts based on which a locked box price is determined will usually be subject to thorough due diligence and buyers usually insist on such accounts being audited prior to signing, unless the target and its management have a strong track record and both inspire confidence in the buyers. To ensure the relevant financial statements will not become stale, PE sellers should communicate with their accountants and financial advisors early in relation to the timetable for executing the deal and the requirements of the locked box accounts, and any distribution should be made prior to the Locked Box Date.

If you are interested in the content of our full report, please reach out to us and we will be happy to discuss other aspects of the report with you.