Where's the market?

The days of the set-piece, fast-moving, locked-box, certain-funded, cov-lite, warranty-limited, diligence-restrained auctions are becoming a distant memory, writes Clifford Chance’s David Walker.

In 2009 to date the value of UK buyouts has been approximately £4.7 billion compared with £46.5 billion for 2007. So, unless there are an extraordinary number of high value deals set to announce in the next few weeks, this year will be remembered as a very subdued one for private equity deals. However, there have been increasing signs of life in the market in recent months and although it is difficult to identify trends when there is so little shopping going on, it is possible to see some common themes emerging on the execution and financing of PE deals, which are likely to continue into 2010.

The backdrop to much of the activity is a feeling of fear and uncertainty: fear for sellers trying to sell assets at a low point in the market, with a lack of certainty as to process and buyers' sources of funding; and fear for buyers engaging in expensive auctions in a falling market, again with a lack of certainty as to process and sources of funding. And it is these concerns that are driving many of the changes we are seeing in deals. Although there are some seemingly 2006 style auction processes in the market and certainly growing competition to secure scarcely available quality assets, the days of the set-piece, fast-moving, locked-box, certain-funded, cov-lite, warranty-limited, diligence-restrained auctions are generally becoming a distant memory. This fear and uncertainty has impacted heavily on processes, which are now slower and less formulaic, and as a symptom of these concerns we are also seeing an increase in buyers getting into exclusive positions with sellers earlier in negotiations than they might have expected to in the past.

David Walker

This dynamic has also impacted on certainty of funding. Sellers are understandably concerned about the sources of buyers' funding and so the commitment a private equity-backed buyer can make in relation to its equity and debt funding on signing a deal are ever more important. That said, there is an interesting tension between transparency and, ideally, certainty of funding on the one hand, and on the other hand, the time and money buyers and their banks are prepared to invest at an uncertain time in a sale process. This tension may lead to a reinvigorated debate around the use of equity underwrites, buyer deposits and reverse break fees, as more commonly seen in the States.

With the lack of availability of bank debt has come a return of vendor financing, to bridge funding gaps. The terms of this can be quite complex if the vendor requires rights and protections similar to those a senior lender might typically expect on a leveraged loan. We are also seeing vendors use earn-outs or retained equity to allay some of their fears about selling out too cheaply as well as to ease the buyer's financing burden at closing.

Buyers are less likely now to be prepared to sign sale and purchase agreements with mandatory anti-trust conditions without getting more protection for what might happen in the gap period. This means that MAC clauses are back on the negotiating table, giving buyers the right to terminate a sale and purchase agreement if there is a material adverse change in the business between signing and closing. And from a diligence perspective, buyers are now less likely to take a view on matters such as change of control clauses in material contracts. Fear of buyers and their banks of over-paying in an uncertain market has further resulted in pressure on sellers to give fuller warranty and indemnity protection and also a growing desire to return to the protection of completion accounts to verify and adjust the price paid on closing if the financial position of the company is not what the buyer had bargained for.

So as we head into 2010 the uncertain economic environment and the financial trauma of the recent past, combined with what seems to be increased competition for quality assets, is likely to translate into more complex, highly negotiated, bespoke deals where the argument “that is market” will carry even less weight in negotiations than it did in the past.

David Walker leads the private equity transaction team at international law firm Clifford Chance.