DOING DEALS IN A COVID WORLD – SOME THOUGHTS ON BRIDGING THE PRICING GAP
One of the problems facing dealmakers in the current market is the mismatch of pricing expectations between seller and buyer. Sellers may contend that valuation reductions are temporary and will bounce back whilst buyers wish to take advantage of current conditions to lock in favourable pricing. Of course, dealmaking can always be put on hold to see who is right, but on the assumption that the deal makes sense to do in the immediate short term, what are some of the mechanisms that could be considered to bridge the pricing gap, and what are the pitfalls associated with such mechanisms?
What follows is not by any means to be considered an exhaustive list and each deal may offer opportunities for dealmakers to be creative. Also, some mechanisms may depend on the type of deal under consideration – what is appropriate in a share subscription may differ from a purchase from a family shareholder looking to dilute but remain invested, and from an out and out sale by an exiting shareholder.
An agterskot (as it is known in the South African market) is a top up to the price if financial performance post sale is in line with that projected by the seller (and disputed by the purchaser). This mechanism would be suitable in a business which could bounce back quickly and should reward a quick recovery. An agterskot that endures over a lengthy period is unadvisable for a purchaser, as there is a strong argument that you are paying the seller for value you have created yourself.
The pitfalls of an agterskot for a financial buyer is that a seller who has sold down in part, but which remains invested and involved in management, has an incentive to manipulate performance to achieve the agterskot. Although less likely this is a risk even where the seller has exited in full – ensure that the seller has not offered behind the scenes incentives to management payable on achievement of the agterskot targets.
Activities to look out for include cutting long term expenditure, offering favourable credit terms to boost sales, recognizing revenue whilst deferring expenses and reducing provisions. The sale agreement needs strong language around the conduct of the business during the agterskot determination period and the shareholders agreement may need additional reserved matters focusing on the levers the seller could pull to run the business for immediate short term gain but at the expense of long term performance. The appointment of a director by the purchaser and that director’s enhanced oversight of management during the agterskot period are vital.
The pitfalls of an agterskot for a seller are in many respects the mirror image of those that concern the buyer – the conduct of the business clauses are critical and the seller may want access to financial records and to management (or even to retain a director on the board) to ensure that financial performance is not depresse during the agterskot determination period.
Placing disputed shares in trust
A second mechanism we have used is to place some shares in trust. So, if the buyer contends that its price buys it 70% of the shares and the seller contends that it only buys 55%, then shares representing the difference can be placed in trust, being released to the successful party once future events prove either the buyer or seller to be justified. The risks associated with this mechanism are similar to those identified with an agterskot – this mechanism adjusts the percentage of shares purchased rather than the price payable but is otherwise similar.
Buying in tranches
This enables a seller to sell down over time. An initial tranche is sold with options (put and call or put or call) over additional shares at pre-determined prices based on financial performance. This mechanism may not suit a PE fund which is unlikely to want to stagger its investment, but could be useful if the measurement period is fairly short term. It is more likely to find application where a trade buyer is looking to make a strategic acquisition and wants the founding shareholder to remain involved and incentivised over a period of time.
Pitfalls are similar to those previously identified, but are also nuanced – if the purchaser starts off as a minority shareholder and subsequently moves to control, concern about manipulating performance shifts from the purchaser to the seller, and the shareholders agreement needs to provide clear direction about the conduct of the business, the making of acquisitions and the making of changes to the business that may have short-term negative implications but long term post-transaction upsides. Also, the longer the option period, the more the purchaser is likely to feel it is paying for value it has helped create.
Ratchet mechanisms seek to defer the valuation discussion until exit. They do this by setting financial hurdles (usually related to the PE fund’s times money back or internal rate of return achieved on exit), above which other shareholders (typically but not necessarily only management shareholders) participate disproportionately. So, for example a fund with a 70 per cent shareholding may allow the 30% management shareholders to participate in more than 30% of exit proceeds above the hurdle. Often this is done on a sliding scale depending on the level of outperformance, up to a cap. Ratchet mechanisms are usually given effect to via a separate class of shares. To avoid complexity for buyers, these shares can convert into ordinary shares on exit, with out of the money shares being redeemed at a nominal value.
The benefit of ratchet shares is that they create alignment between shareholders over the life of the fund’s investment. All shareholders are aligned to maximize exit proceeds, with shareholders who believe they sold at a cheap price being able to claw back value.
Ratchet mechanisms are unlikely to be appropriate where a shareholder exits completely, and are more likely to find favour where shares are bought from a shareholder that is looking to dilute but remain invested, or in the case of a share subscription.
Changing the funding mix
In the case of a subscription for shares, changing the funding mix from ordinary equity to a mix of equity and mezzanine finance could help to bridge the gap. The fund will need to be satisfied with the overall blended return, but has the comfort that the mezzanine loan allows for earlier preferential cash flows than pure equity. The existing shareholders must be comfortable that notwithstanding the higher coupon that mezzanine finance attracts, there will still be a positive gearing effect on their ordinary equity.
And finally, an ‘embarrassment clause’
An embarrassment clause provides, in essence, that if a purchaser flips the shares it has bought from the seller within a defined period of time (usually up to two years), then any profit derived from such sale must be paid over to the seller, in whole or in part, as an agterskot. The seller will need information rights to ensure it can exercise this right, and must of course ensure that it has the systems in place to monitor the right.
The obvious problem with the embarrassment clause is that the purchaser simply delays the transaction until the day after the right lapses, but we have nonetheless seen them used successfully.