In Brief:
- There are various global economic headwinds that have the potential to act as a drag on M&A activity.
- Interest rates have been rising in the UAE. This may make transactions more expensive and hence less attractive to buyers.
- In this article, we discuss some of the structures that can be deployed to enable M&A deals to proceed notwithstanding the rises in interest rates.
S&P Global Market Intelligence recently announced that global M&A experienced the slowest quarter in Q3 2022 since the onset of the pandemic in 2020. The aggregate deal value for the quarter was $443B, a -50% decline compared to Q2 and a -58% decline compared to Q3 2021.
There is a multitude of challenges facing corporates, investors, and advisors: global inflation and the knock-on effects of rising interest rates and tighter financial conditions, market volatility and the ongoing war in Ukraine.
Whilst the UAE economy has remained strong (according to the World Economic Outlook recently released by the IMF, the UAE’s gross domestic product is projected to grow by 5.1% this year), it is also affected by the challenges referred to above. Of particular relevance in an M&A context is interest rates, which have risen steeply in the UAE in recent months. For deals funded by bank debt, this may make transactions more expensive and hence less attractive to buyers. However, there are various structures that can be deployed by buyers to eliminate or reduce their reliance on debt financing and ultimately get deals done. Certain of these structures are discussed below. These are only examples as there are many different varieties.
Secured payments out of future profits
A buyer’s reliance on debt financing can be eliminated or reduced by creating a structure where all or part of the consideration payments are financed out of the future profits of the target business.
Given that this structure involves deferred consideration, it will be important for a seller to ensure that it has appropriate security for such deferred consideration and other key protections. A well advised seller would typically benefit from the following protections:
- a share pledge, giving the seller the ability to resume ownership and control of the business if the buyer fails to make the deferred consideration payments;
- corporate guarantees from the target company and/or other group companies;
- personal guarantees from the buyer or the principal shareholders in any corporate buyer;
- corporate guarantee from a parent company (with sufficient financial substance) of a corporate buyer;
- rights to financial information (for example, audited accounts and management accounts); and
- veto rights over certain key matters which could affect the ability of the buyer to make the deferred consideration payments (for example, sale of assets and payment of dividends).
- Of course, if a buyer combines this structure with an element of debt financing, these seller protections would need to be considered alongside the lender’s requirements.
A buyer will be keen to ensure that the sale agreement contains robust non-compete and non-solicitation covenants from the seller. These are important on any acquisition, but are particularly relevant where this structure is used as any competition or solicitation could impact on the profitability of the target business and, as a result, the buyer’s ability to satisfy the deferred consideration payments.
Earn-out
An earn-out is an arrangement under which all or part of the purchase price on an acquisition is calculated by reference to the future performance of the business. It is commonly used as a management incentive where owner-managed businesses are sold and the managers continue to work in the business for an agreed period following the sale.
An earn-out structure reduces the amount of cash payable at completion and can, therefore, reduce or eliminate a buyer’s reliance on debt financing. It also protects a buyer from overpaying for a business that fails to grow to the extent projected by the seller. However, earn-outs may also benefit sellers given that they allow them to potentially obtain a higher consideration than would be the case if the entire amount had been paid at closing.
One must always bear in mind that earn-out payment terms are typically the subject of lengthy, and often contentious, negotiations due to the significant implications for both the buyer and the seller. This can have a time and cost impact. Earn-outs can also lead to disputes and claims in the future, although this risk can be mitigated by precise legal drafting which clearly sets out the commercial agreement between the parties.
Equity rollover
An equity rollover is where some or all of the sellers receive a portion of their sale consideration in the form of equity. Rollover participants usually include key management team members, and may also include founders and investors. When the sale closes, rollover participants shift from holding a controlling interest in the target company to being minority shareholders in the continuing business (whether by holding shares directly in the target company, or indirectly holding shares in the target company by holding shares in a holding company of the target company or the buyer).
An equity rollover reduces the amount of cash consideration which a buyer needs to pay at completion. It can, therefore, reduce or eliminate a buyer’s reliance on debt financing.
In addition, equity rollovers are an effective means of aligning the interests of buyers and management, with management having “skin in the game” and being personally invested in working towards a profitable exit.
Equity rollovers are often combined with earn-outs. Where this is the case, earn-outs may be paid in cash or in the form additional buyer equity, or a combination of both.
Partial acquisition
The amount of cash consideration which a buyer needs to pay at completion can also be reduced by structuring the deal as an initial acquisition of a partial stake together with a call option to acquire the remaining shares at some point or points in the future. On any such transaction it will be important to ensure that the call option and certain other key buyer protections in the shareholders’ agreement are enforceable (there can be challenges in enforcing these types of provisions in an onshore UAE context and in certain free zones). Where a buyer has a call option, a seller will typically require a put option (i.e. the right to require the buyer to purchase the seller’s shares at some point or points in the future).
Conclusion
The recent rises in interest rates in the UAE can dampen M&A activity. However, where there is reluctance to effect a proposed debt-funded M&A transaction given the rise in interest rates, there are ways to re-structure such a transaction to enable it to proceed without reliance on debt, provided that the parties are motivated to get a deal done and are willing to be flexible. The most appropriate structure will depend on the specific circumstances of each transaction and it is important to proceed on a case-by-case basis and discern the best structure for each deal. The parties should consult closely with their legal and financial advisers who will be able to guide them through this process.