The Locked Box—UK v US Private Equity M&A Perspectives
In M&A, a key risk is that the target company will, at closing, be in a worse financial condition than reflected in the target’s accounts which were used to determine its value and, accordingly, the purchase price. The risk is exacerbated when there is a long period between signing of the transaction and closing. The purchaser is subject to the moral hazard risk that the seller extracts value from the target company in the interim, and the exogenous risk that the target’s business simply suffers a downturn prior to closing. Traditionally, such risks have been mitigated through the ‘post-closing adjustment mechanism’. After closing of the transaction, the purchaser will determine how, for example, the target’s cash, debt and net working capital as of the closing date differ from the estimated cash and debt, and targeted net working capital, values used to determine the purchase price. If any variations exist, the seller will pay a balancing payment to the purchaser or vice versa, as appropriate.
My recent paper (‘Boxing Clever: Explaining UK and US Private Equity Locked Box Perspectives’), forthcoming in The Company Lawyer, discusses the rise of the ‘locked box’ pricing mechanism that took the UK private equity industry by storm in the late-2000s, to now become the ‘go-to’ pricing mechanism in UK M&A generally. Locked-box is particularly attractive to private equity sellers, since, unlike post-closing adjustment mechanisms, the price is fixed based upon a historic balance sheet, with no balancing payments made after closing. It enables private equity sellers to distribute the returns from a sale soon after closing, without having to wait for the completion of a post-closing purchase price adjustment determination. The purchaser, for its part, protects itself from the moral hazard that the seller extracts value from the target company by including seller covenants in the purchaser agreement whereunder the seller agrees that it has not extracted, and will not extract, value from the target, and that the target has conducted its business in the ordinary course of business, between the date of the locked-box accounts and closing of the transaction. Covenants breaches are remedied on a pound-for-pound indemnity basis. Over time, as a seller’s market developed, locked box mechanisms began to permeate into M&A generally as sellers, and indeed even purchasers, began to see the benefit of closing transactions without having to proceed through a potentially contentious purchase price adjustment process lasting many months after closing.
Clearly, with a post-closing adjustment mechanism, the risk that the target suffers a downturn in fortunes before closing lies with the seller, but with locked box, the risk is allocated to the purchaser. It is no surprise, therefore, that in a seller’s market, locked box mechanisms have become prevalent in the UK. More surprising is that while locked box mechanisms have become more common in US private equity in recent years, post-closing adjustments are still king, even though a seller’s market has similarly developed. This is not simply a case of ‘You like tomato and I like tomahto’. In my paper, I note other critical market differences between UK and US M&A. In particular, material adverse change clauses, which give the purchaser the right to terminate the transaction prior to closing if the condition of the target company has deteriorated materially, are more common. Additionally, earn-outs which tie consideration to the future, post-closing, performance of the target, and escrows, which require the seller to place part of the purchase price in a protected account to satisfy post-closing claims, are more likely to be negotiated in US M&A deals than in the UK. Furthermore, in the US, warranty protection is more extensive, breaches of warranty are satisfied on an indemnity basis (rather than a claim in damages as is more usual in the UK), and warranties are often ‘brought-down’ at closing enabling a purchaser to terminate a transaction upon a breach of warranty before closing. In contrast, in the context of private equity, UK private equity sellers rarely give warranties at all. All these differences point toward a very different culture in the US, where risk allocation is driven in the direction of the seller. In such circumstances, the imposition of locked box, which allocates risk in the direction of the purchaser, flies in the face of US M&A market standards, making it a more challenging negotiation for private equity sellers.
However, as I argue in the paper, perhaps the UK and the US are not quite so divided by a common language as it first seems. Delaware Courts rarely sanction the triggering of material adverse change clauses and purchase agreements are usually drafted such that brought-down warranties only present a walk-right if breaches are material. Although risk is allocated to the seller, it is not general risk of a downturn that is so allocated, but more the catastrophic risk that the target company is no longer the long-term asset that was the subject of the original deal. Furthermore, US private equity sellers frequently only acquiesce to a nominal percentage of the purchase price to be placed into escrow, and it is no longer rare for them to only give warranties on a no-recourse basis, such that warranties only constitute walk-rights (upon material breach) with no recourse against the seller if the purchaser wishes to make a claim for breach of warranty after closing the transaction. Finally, although earn-outs more commonly feature in US M&A than in UK M&A, in many cases they represent an incentivisation mechanism for management rather than a risk allocation tool between purchaser and seller.
Market standard private equity terms in the US have led to the perception that the industry is purchaser-friendly. However, when one looks under the hood, it becomes apparent that, conceptually, locked box mechanisms are not wholly misaligned with other market standards, and the US and UK are not as divergent as some may think. In the US private equity sphere, it is perhaps therefore time to box clever and to consider the merits of locked box mechanisms more readily.
Bobby V. Reddy is an Assistant Professor at the University of Cambridge.