King & Wood Mallesons recently launched its five annual DealTrends report (Report) for private M&A in Australia. The Report draws off actual private M&A deal data in the Australian market and is the only one of its kind currently being produced for the Australian market. The Report gives insight into the changes in market practice for private M&A and the data collected allows us to differentiate for a variety of factors, including deals involving PE sponsors.
Below we highlight the standout trends in private M&A over the last five years, recent material developments and areas in which PE sponsors are significantly diverging from the broader M&A market.
Average M&A deal value increases dramatically
This year’s Report highlights a noticeable increase in the typical deal-size in the Australian private M&A market with the median deal value more than double the previous year.
This trend is even more pronounced for PE sponsor-backed M&A with the median deal size of PE sponsor deals in 2015 being three times the size of the median for all deals and 2.3 times the median deal size of PE sponsor deals in 2014.
Cross border activity and agribusiness deals take off
Cross border deal activity remained high in 2015 with more than half of the deals in the Report’s sample having a cross border element. 2015 saw a significant increase in cross border deals involving Asia and, in particular, Asian countries other than Hong Kong and mainland China. We suspect this was in no small part due to the Australian dollar having weakened considerably against the US dollar in 2015, relative to prior years.
Real estate, construction, infrastructure and telecommunications, media, technology (TMT) made up a larger proportion of deals than in the last couple of years, with TMT being the largest single sector in terms of number of deals done. The fastest growing industry sector in terms of deal volume was agribusiness with the number of deals almost tripling.
PE sponsor activity closely followed the trends for the broader market in this regard, with the division of PE sponsor deals between industries closely aligning with the broader private M&A market.
PE deals more likely to have regulatory and financing conditions
As in previous years, Australia continues to offer buyer friendly deal terms compared to many other offshore markets. One of the key areas in which this is apparent is in the pervasive use of conditions precedent to completion, which appeared in almost all (91%) of PE sponsor deals.
Looking at the breakdown of conditions for PE sponsors, their deals were far more likely to have regulatory and financing conditions. PE sponsor deals also had substantially higher rates of conditions for non-government third party consents and pre-sale restructuring.
There are issues, however, associated with investing in emerging markets, such as the availability and quality of information, communication barriers and market regulations. Therefore we feel it is clear that having a specialist immersed in these economies is critical in order to capitalise on the alpha opportunities and to obtain an edge.
The prevalence of regulatory conditions in PE sponsor deals is not surprising when you recognise that the Australian FIRB regime catches many domestic PE sponsors as “government investors"1.
PE sponsor deals were also far more likely to include a material adverse change (MAC) condition. The vast majority of the MAC conditions were measured against specific financial metrics, with a reduction in net profit/EBITDA being the most common measure. In fact, in the Report’s sample of deals there were no ‘general’ MAC clauses, reflecting in our view a growing awareness by the market that such “general” drafting markedly increases the difficulty in relying on the MAC condition.
Pricing – PE sponsors favour locked boxes
The Report shows that 71% of deals contained some form of post-closing adjustment (other than an earn-out), with the majority of these being working capital and / or debt adjustments. Earn-out mechanisms have trended upwards slightly over the 5 years of the DealTrends report, but remain generally uncommon and much less frequently used in deals involving PE sponsors.
Where PE sponsors buck the trend on pricing mechanisms is in their more frequent use of locked box mechanisms. Such mechanisms were 3 times more likely in PE sponsor deals.
Warranty & indemnity insurance grows steadily
Each year of the DealTrends report has seen increased use of warranty & indemnity (W&I) insurance and 2015 was no exception (37%). W&I insurance was even more common in PE sponsor deals (55%). This likely reflects the nature of PE funds, as well as PE sponsors participating in more competitive sale processes and larger deals where W&I insurance has become very common.
Almost all W&I insurance policies remain buy-side (92%), whilst the vast majority (87%) contain a full release of the seller for its warranties, except in the case of fraud.
Of the deals utilising W&I insurance, only 54% provided for claims by the buyer back to the first dollar, rather than back to the aggregate claims threshold. This highlights the growing difficulty (and expense) of achieving full ‘tipping’ retention W&I insurance policies back to the first dollar.
Financial warranties
It has become relatively settled practice for private M&A deals (other than asset deals) to contain financial statement warranties confirming that the financial statements have been prepared in accordance with the Corporations Act/Accounting Standards and that the statements give a true and fair view of the target’s financial position and performance.
Where we have seen a significant change in the last five years is in the frequency of management accounts warranties. Management accounts warranties now appear in the majority (69%) of share deals. In PE sponsor deals we have also seem a dramatic increase in the appearance of a ‘no undisclosed liabilities’ warranty – showing greater consistency with US practice. This may, in part, be explained by the increased use of W&I insurance. A seller will likely be more amenable to broader warranties where W&I insurance is being used, particularly when it does not increase the overall premium cost.
Specific indemnities more common
The frequency of specific indemnities for income tax, employee-related liabilities and pre-completion restructuring has increased. Income tax indemnities are now found in the majority of deals and are even more common in PE sponsor deals (73%).
PE sponsors accept data room disclosure but it must be warranted
All of the PE sponsor deals in the Report accepted that the data room qualifies the seller’s warranties. However, 100% of those deals also required the seller to warrant the accuracy of the data room contents.
Across all deals, the Report shows that specific disclosures by way of a disclosure letter (or schedule) are still permitted in the majority of deals, but this has been one of the downward trends over the five year period.
Non-competes are common in PE sponsor deals
2015 saw a significant jump in non-competes in all deals sampled for the Report (68%). The trend was even more pronounced in PE sponsor deals, where 82% of PE sponsor deals included a non-compete prohibition. The median non-compete period was three years post-completion.
Anti-bribery provisions remain a cross-border issue
Anti-bribery provisions were seen more often in 2015, but remain generally uncommon.
This upward trend is not surprising when you consider the increase in 2015 of cross border deals and the relative breadth of the US and UK anti-bribery laws. In our experience, PE sponsors that have strong linkages with the US or UK will generally insist on anti-bribery provisions in their sale agreements to manage the international reach of the international anti-bribery laws.
Mark McNamara is the leader of the King & Wood Mallesons’s Australian Private Equity team. His expertise lies across the full range of corporate transactions for private equity sponsors – MBOs / LBOs, public takeovers, private M&A and securities offerings.
Ros Anderson is a corporate partner in King & Wood Mallesons’ Australian Corporate team. Ros is author of KWM’s market leading DealTrends publication which analyses the prevalence of key deal terms in private sale transactions, including competitive sale processes and cross-border transactions.
Alex Elser is a Special Counsel in King & Wood Mallesons’ Australian Corporate team, with a particular focus on private equity sponsors.
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1 http://www.kwm.com/en/au/knowledge/insights/new-requirements-foreign-private-equity-investment-australia-20160119
