The private equity market in Europe remains at least as buoyant as in Canada and the United States and, despite political and market uncertainty, PE M&A activity remains high.
There was strong attendance at the International Bar Association‘s Private Equity Transactions Symposium 2017, held last month in London. I also attended and felt the event was further proof that investor interest in the European PE market remains steady.
It’s also clear that year-to-date fundraising is almost as robust as 2016 and realizations on exited investments is strong. For this reason, the accumulation of dry powder across markets continues unabated. However, the realities of sourcing and executing on deals remains a challenge, as it does globally.
Despite this shared reality, deal-making in Europe has some features or norms not common in North America that prudent businesses (and investors) can leverage to their advantage. Some of them arguably make deal execution more predictable and completion more certain.
Here are a few examples.
Very much the norm in European deals and still uncommon in North America is the use of a lockbox structure in the sales process.
Use of a lockbox mechanism involves the parties agreeing to a fixed equity price calculated using a recent historical balance sheet of the target prepared before the date of signing the purchase agreement. Cash, debt and working capital as at the date of the lockbox reference accounts are therefore known by the parties at the time of signing and there is no post-completion adjustment.
From the selected date forward, the box is locked and therefore the risks and rewards of the business transfer to the purchaser as of the effective date, with some negotiated protections to address agreed “leakage” between signing and closing. The result is no closing statements and hence no purchase price adjustment.
While not perfect, and some would argue very seller-friendly, the lockbox mechanism provides certainty of price to both buyer and seller, eliminates the need to negotiate purchase price adjustment provisions (including agreeing to working capital targets). It also avoids protracted post-closing disagreements around price adjustment.
Much like the lockbox mechanism, preparation and provision of a vendor due diligence report (VDDR) is commonplace in European deals, but has yet to catch on in North America.
It is routinely the case in a European auction that before commencing a sales process, a vendor will hire advisors, such as legal, accounting, environmental and any other experts relevant to the business, to undertake a full due diligence review of the target and prepare a comprehensive report that will be provided to potential purchasers.
While VDDRs add expense for the vendor in preparing a company for sale, most people agree that the process ultimately saves time, effort and expense down the road. As issues are flushed out early, appropriate remediation can be undertaken where necessary and parties enter into negotiations with a shared knowledge and understanding of the target business.
From a purchaser’s perspective, while they may have a different perspective of materiality or areas of particular concern, a VDDR will at the very least provide a roadmap of where to direct resources and attention.
Generally, the VDDR will be provided to all interested purchasers initially on a non-reliance basis, but as the sales process advances and the successful bidder is identified, the various advisors will be required to deliver a final VDDR to the buyer subject to the terms of a reliance letter. Such a reliance letter will invariably include a cap on the advisor’s liability to the recipient for any deficiencies in the report.
Full equity backstop
A common feature of U.S. deals is a requirement for the sponsor purchaser to provide an equity backstop for the full amount of purchase price in the transaction documents. While the failure of banks to fund at closing may be somewhat of a distant memory, such incidents are not forgotten and therefore this requirement to provide the full equity backstop is still a hotly negotiated and at times a contentious part of private equity deals.
In Europe, on the other hand, no such commitment is required. This is how one commentator put it: “Even during the financial crisis our banks showed up. Once contractually obligated to fund, they do so.”
Management at the table
Management equity terms form an integral part of the deal process in Europe, unlike North America, where such matters would still be considered ancillary.
In Europe, particularly in mid-market deals, it is not uncommon for the management team to hire advisors (financial and legal) early in the process and develop a term sheet setting out management asks that will go to bidders in the second round of an auction.
Typically at the time of signing the purchase agreement, a wrapper agreement setting out legally binding indicative terms relating to management is signed, with detailed documents being drafted, negotiated and settled between signing and closing. Key equity terms covered typically relate to economics, leaver mechanics, vesting periods, tax sharing and planning, and minority protections.
North American practitioners may view this management involvement as having the potential to derail or at least distract from the main deal. However, U.K. advisors insist it can help in the long run to ensure management’s interests are being protected and needs are being met, and therefore they are supportive of the deal and there at closing.
The IBA event reinforced my view that interest in private equity from investors shows no sign of slowing and there is resulting pressure on sponsors to identify and close on deals as efficiently and quickly as possible.
For this reason, unique differences in regional deal-making should not just be of passing academic interest. Alternative practices may instead be adopted, where appropriate, to make deal execution more efficient and closing more certain.
Mary Abbott is a partner at Osler, Hoskin & Harcourt LLP and co-chair of the firm’s private equity group. She advises domestic and foreign companies and sponsors, as well as Canadian pension plans, on mergers and acquisitions, complex corporate restructurings, and securities law matters, including financings.
Photo of European money concept courtesy of nevarpp/iStock/Getty Images
Photo of Mary Abbott courtesy of Osler, Hoskin & Harcourt LLP