What are the typical methods and constructs of how risk is allocated between a buyer and seller?
Private Equity (2nd edition)
Risk allocation is a key factor in various aspects of an M&A transaction. Some of these and the way they are addressed are:
(a) Deal certainty and MAC: Clear conditions precedent are included. Any adverse changes between signing and closing are dealt through MAC clauses; the more quantifiable and linked to specific results these are (i.e. amount of loss, EBITDA hit etc), the less controversial their interpretation will be. The Seller may ask for guarantee or equity commitment letter in case the Buyer is an SPV
(b) Closing and price adjustment: a clear definition of cash, cash equivalent, debt and debt like items is included for the purposes of price adjustment in case a closing account mechanism is used. In case the parties find this too complicated and resort to a locked box mechanism, a clear definition of ‘leakage’ and ‘permitted leakage’ is required.
(c) Due Diligence and disclosure: Vendor’s due diligence are getting more popular. sellers aim to include in the ‘disclosed’ definition any items included in the data room, whereas buyers want to limit such definition to any items included in a Disclosure Letter.
(d) Warranties: Warranties insurance becomes more popular. Sellers use customarily limitations of liability (cap of liability, de minimis, time limitations); ‘fundamental’ or ‘core warranties’ (i.e. good title and non-encumbrance of shares to be sold, as well as, capacity to sell) are usually not subject to the above limitations.
(e) Pre-closing period: seller’ covenants will typically be inserted so that the target continues to operate as a going concern but there is no leakage or unnecessary increase of liabilities.
(f) Seller’s guarantees for target’s performance: Purchase price deferred payment or earn-outs are used from a buyer’s side. An escrow mechanism may be asked from the seller in such cases.
Common to other jurisdictions, the standard way of allocating risk between a buyer and seller in Luxembourg is through use of warranties and indemnities in the acquisition agreement.
Financial sponsors are reluctant to give anything other than the basic warranties upon sale (i.e. as noted in the response to question 2 above, it is sought to limit warranties to warranties as to title, capacity and authority).
The ultimate approach agreed to the level of warranty and indemnity protection is very much dependent on the relative bargaining power of the parties involved.
As noted below, W&I insurance has become increasingly popular where anything other than fundamental warranties are given.
Private M&A transactions in the Norwegian market are customarily structured as a sale and purchase of shares in the target company, except in circumstances where the parties find it more beneficial to structure the deal as an asset transaction.
The share purchase agreement or the assets purchase agreement, as the case may be, sets out the terms and conditions of the transaction amongst the parties. Such agreements customarily contains all the typical provisions on risk allocation as you would find in Nordic and European transactions, such as purchase price mechanism, pre-closing covenants, closing conditions, representations and warranties and specific indemnities.
It could be noted that general disclosure against the warranties of the dataroom is the market norm, but the warranties customarily also include sweeping provisions on the accuracy and completeness of the dataroom. The representations and warranties are normally given both at signing and closing, without disclosures after signing being permitted except in insured transactions. On the other hand, it is increasingly uncommon to permit the buyer to withdraw from the agreement on basis of material adverse changes between signing and closing.
The risk allocation in the individual case depends on the market conditions, nature of the transaction and the parties bargaining power. The recent years it has however generally been a fairly seller friendly environment in Norway, which also impacts the terms of the transaction agreements favorably to the seller.
The full range of methods and constructs typically seen are available.
For a buyer these include:
a. negotiation on the concept of and level of disclosure;
b. escrow arrangements;
c. purchase price reductions;
d. representations and warranties are typical devices in SPAs;
e. indemnities, in particular relating to tax, litigation and environmental risks. They are also being increasingly requested in relation to data protection;
f. for transactions governed by Polish law, contractual penalties and submissions to enforcements (a form of pre-agreed judgment) are also available.
For the seller the protections available would include:
a. quantum and timing limitations of liability;
b. caps, de minimis and basket clauses;
c. specifically negotiated disclosure and exclusions;
d. procedural clauses dealing with third party claims.
The typical methods and constructs of how risk is allocated between a buyer and seller in Korea is generally consistent with the practice in other jurisdictions (e.g., use of representations and warranties, covenants, closing conditions, indemnification and post-closing price adjustments). Furthermore, there have been an increasing use of W&I insurance in M&A transactions in Korea.
It varies, but it is more common that warranties are given both at signing and completion so that the risk actually remains with the seller until completion. Swedish law and market practice puts a lot of responsibility on the buyer to perform proper due diligence and everything that is fairly disclosed in the data room will be considered disclosed against all warranties (normally) and any specific diligence findings will need to be negotiated as specific indemnities.
The typical methods and constructs for the risk allocations are representations and warranties for general (unidentified) risks as well as indemnities for specific risks identified during due diligence (such as a pending litigation). In the current sellers' market, we see a shift from indemnities to so called "quasi indemnities", i.e. representations and warranties which are excluded from disclosure but which are still subject to the other limitations such as the notification obligation, de minimis, threshold/deductible, damage definition etc. In addition, risks can be allocated through the purchase price mechanism as well as certain covenants.
In Belgium, risk is most commonly allocated between a buyer and a seller through warranties and specific indemnities. In addition, parties sometimes allocate the risk of changes in circumstances between signing and closing by including a MAC clause.
In Belgium, the inclusion of warranties in the acquisition agreement is the most common method of allocating risk between a buyer and a seller in a M&A context. Practically all acquisition agreements contain warranties by the seller. In most cases, these contractual warranties are essentially based on a standard list. Typical standard warranties include a warranty with respect to the target company’s accounts, the target company’s compliance with laws, and the seller’s full and accurate disclosure.
The seller’s liability under the warranties is usually made subject to an exception to the effect that the seller shall not be liable for damages on the basis of facts that had been disclosed to the buyer. In Belgium, full data room disclosures are fairly common. Alternatively, disclosures are restricted to specific disclosure schedules or letters. However, based on the requirement to carry out an agreement in good faith, the Court of Appeal of Liège (2 April 2015, see also a similar decision by the Court of Appeal of Ghent dated 18 February 2013) has decided that a buyer cannot invoke the indemnification obligation of the seller in relation to facts that it was aware of (or should reasonably have been aware of) even if such facts have not been explicitly referred to as ‘disclosed’ in the agreement. Consequently, it cannot be excluded that a Belgian judge would consider the data room disclosed even if the agreement does not explicitly provide for a data room disclosure. Taking this into account, purchasers should push for a reduction of the purchase price or a specific indemnity to cover risks that are known to it (see further below).
The seller’s indemnification obligation under the warranties is, moreover, typically made subject to both limitations in time and of the amount of the indemnification obligation. A general limitation in time of the seller’s indemnification obligation for claims under the warranties is included in almost all acquisition agreements. Belgian acquisition agreements often provide for a time limit tied to a full audit cycle to give the buyer the opportunity to discover any problems with its acquisition (i.e. 18 or 24 months following completion). Time limits will generally be longer for claims for breach of certain fundamental or specific warranties: (i) for title warranties, the time limit is often tied to the applicable statute of limitations, and (ii) for tax warranties, this will typically be within a short period after the last day on which a tax authority can claim the underlying tax from the target.
Limitations of the amount of the seller’s indemnification obligation usually include both a de minimis threshold for individual claims as well as an aggregate de minimis threshold (“basket”) for all damage claims taken together. As a very general rule of thumb, the market usually refers to a basket of 1% of the purchase price and a de minimis of 0.1%. These thresholds do not typically operate as deductible amounts, and thus claims exceeding the thresholds are usually eligible for indemnification for the entire amount of the claim. As regards maximum liability, the seller’s liability is almost always capped. We often see ranges between 10% and 30% of the purchase price. The amount of the cap as a proportion of the purchase price tends to be inversely proportional to the deal value of the transaction.
Separate indemnification mechanisms are also usually included in acquisition agreements, although they are slightly less common in small transactions. The use of specific indemnities has increased during the last decade. These indemnities relate most commonly to tax liabilities, but can also cover ongoing litigation, environmental pollution as well as other risks identified during due diligence. Specific indemnities are usually governed by a separate liability regime, and are often not made subject to the general limitations concerning claims under the warranties. In most cases, however, indemnity claims are made subject to a separate maximum liability cap.
It should also be noted that in transactions with a deferred closing, “Material Adverse Change” (“MAC”) clauses are sometimes used to allocate risks related to changes of circumstances in the period between the signing of the acquisition agreement and the closing of the transaction. Under a MAC clause, the buyer may terminate the acquisition agreement if there is a material negative change of circumstances during such period. MAC clauses are usually included as a condition precedent to closing, but sometimes also take the form of a “backdoor MAC”, i.e. a warranty by the seller regarding the absence of a material adverse change between signing and closing in combination with a termination right of the purchaser for breach of warranty. In Belgium, MACs are mostly used to protect against risks that are specific to the target company. General risks affecting e.g. the economy or the political climate in general are usually excluded.
Financial sponsor buyers are not sympathetic to assuming risks related to business before it becomes owner. They adopt the principle of “your watch/our watch” for all matters. However, the current climate has been a “seller’s market”, which has resulted in competitive processes and more tempered provisions. In such circumstances, financial sponsor sellers have successfully forced a more seller-friendly purchase agreement, with limited recourses available to the buyer post-closing.
In two step transactions, the closing conditions to the purchase agreement will typically include (i) a bring down of representations and warranties with a materiality scrape; (ii) no material adverse effect. In addition, interim period covenants will cover ordinary course operation of the business.
Risk allocation between a purchaser and a seller involves various aspects of the deal. For example, in a private M&A deal the purchasers usually conduct a thorough due diligence. However, in recent years, some large M&A projects were conducted through a public bidding process, and the sellers would control the process of due diligence, which would expedite the process and enhance the efficiency but increase the purchaser’s risk exposure. The two pricing mechanisms discussed in Question 5 also demonstrate different degree of risk allocation, with the locked boxed approach being riskier to the purchaser because it has to bear the risk of enterprise value decrease between the date of singing and date of closing. Regarding the transaction agreements, the sections of representations and warranties will significantly affect the risk allocation between the parties. A broader scope of the representations and warranties will impose more risks on the seller, and using the terms such as “Material Adverse Effect” and “to the best knowledge of the seller” will limit the scope of the representations and warranties and thereby reducing seller’s risks.
Under a customarily structured share purchase agreement, the risks attached to the business of the target company are mainly dealt with through interim covenants and leakages protection. Purchase price mechanism, closing conditions, representations and warranties and specific indemnities are also used to reduce the risks attached to the transaction.
For the past couple of years, due to the influence of private equity transactions, the French market has been more and more seller friendly. This is particularly tangible when it comes to closing conditions (that are limited to mandatory regulatory clearances) and warranties .
It should however be noted that recent evolutions in the French civil code impose to sellers a duty to provide to the purchaser all key information relating to the object of the sale. However, professional purchasers such as private equity sponsors are supposed to perform reasonable due diligence in the context of a transaction.
The focus of German private equity investors is to achieve a clean exit. As such, the locked-box structure is used as an important risk allocation technique by fixing the purchase price at signing. This aims to shift all risk after the effective date to the buyer. The effective date on which the fixed price is based is usually a historical balance sheet date for which audited accounts exist. Given the current sellers' market, private equity buyers often accept purchase agreements with few warranties and in some cases, none at all. Sellers may provide limited fundamental warranties (title, authority, no insolvency) but seek to minimise operational warranties (including financial statements and compliance). As such, buyers typically request comprehensive due diligence information and may attempt to use management participation schemes, including management warranties, as additional security. Private equity buyers usually arrange W&I insurance, with zero seller liability except for fundamental warranties, to cover their exposure. The scope of operational warranties depends on the nature and size of the target entity and W&I insurance. Costs of W&I insurance are usually assumed by the buyer.
Closing conditions, such as a Material Adverse Change clause, are uncommon, except for regulatory approvals, whereas private equity buyers are sometimes willing to accept strict hell or high water clauses for merger clearance and a corresponding contractual penalty/break fee.
Risk is usually allocated through the terms and conditions of the purchase agreement, mainly through:
- Representations and warranties.- These are given by the target company and seller, and are usually full-fledged when involving a material equity percentage, and include, among others, title to assets, capacity, compliance, due authorization, no contravention, tax, financial information, litigation, labor, etc. On the buy-side, these are usually limited to capacity, due authorization and financial solvency. Representations and warranties are also usually subject to the existence of a “material adverse effect”.
- Conduct of business.- In transactions where signing and closing are differed, conduct of business clauses, whereby the target company and seller agree to comply with certain positive and negative covenants to protect buyer, are common.
- Closing conditions.- In Mexico, once closing conditions are met, the purchase agreement becomes fully binding for the parties. Specific performance can be claimed by either party in such scenario.
- Indemnities.- Indemnity clauses are usually divided into those arising from breaches to fundamental representations and warranties, and all other breaches. The caps, baskets (deductible and de minimis) and claim periods will depend on such type of breaches. Breaches will typically be exempt if fully disclosed. “Sand-bagging” / “anti-sandbagging” mechanisms can also be included.
Sellers in competitive processes will usually propose terms where all risk relating to the target business passes to a buyer at signing.
In terms of deal pricing risk, the locked box mechanism at its heart is a seller friendly pricing mechanism as the buyer has virtually no opportunity to adjust the price following signing. The buyer will need to manage its risk by diligencing the locked box balance sheet and ensuring that the locked box is effectively ‘locked’.
Risks associated with operational matters of the business are normally only covered by warranties given by management and backed by W&I insurance. Material adverse change clauses are unlikely to be accepted and bring down of business warranties are also uncommon. Indemnities or escrows for contingent liabilities are normally strongly resisted by sellers and bidders in competitive processes often prefer to ‘price in’ any contingent liability to avoid appearing uncompetitive by requesting indemnities or escrows.
Risks associated with deal certainty are also usually for the buyer’s account and a seller will not accept conditionality to closing save for anti-trust or regulatory consents which are mandatory and suspensory in effect.
In respect of transactions with separate signing and closing dates, it is common for the buyer’s obligation to close to be conditional upon (a) compliance with pre-closing covenants in all material respects and (b) the accuracy of the target’s representations and warranties as at signing and closing dates. If any pre-closing covenant is not materially complied with or if any representation or warranty is materially breached, the buyer may generally refuse to close the transaction, alternatively exercise an indemnification claim against the seller following closing. The buyer also usually seeks to allocate pre-closing adverse change risk to the seller in the form of a closing condition and/or a seller representation that there is no material adverse change to the business of the target between locked box date and closing date.
In competitive auctions, sellers are increasingly able to obtain more favorable terms including that there is no conditionality to the transaction (except for required regulatory approvals), limited recourse against the seller (for example, with caps/limitations and minimal survival periods) or even no recourse against the seller (save for certain limited exceptions, such as breach of fundamental warranties and tax liabilities) following closing.
Purchasers usually mitigate risk in sale transactions by seeking adequate protection from the sellers as well as the target company, in the form of warranties and indemnities, which cover areas of litigation, environmental law, intellectual property rights, assets, financial statements, labour, employment and taxation, among others. However, it is possible for late-stage companies to negotiate agreements such that they are not bound to provide any warranties or indemnities to the purchaser. For the purpose of this query, we will limit the analysis of risk mitigation to the purchaser and the seller.
One way of allocating risk is by way of earnouts and holdbacks, in the manner and subject to the conditions set out in Question 2 and Question 5 above, where payments are either deferred or tranched, or allocated under escrow or indemnity arrangements, or subject to the achievement of certain milestones.
Further, for mitigating uncertainty in sale transactions, purchasers generally adopt clauses relating to the occurrence of any material adverse effect (MAE) during the period between the execution of the agreement and closing/completion of the transaction. In addition to this, and most commonly, purchasers use general and specific indemnities and warranties, against which, sellers generally make a disclosure of specific facts as specific carve-outs to such warranties. MAE clauses state that transaction documents can be terminated if there is a material negative impact on the target company or the seller’s title to the shares being sold, during the period between the execution of the agreement and closing/completion of the transaction.
Indemnity provisions are often fairly detailed and also cover third party claims. It is also common for sellers to negotiate a limitation of their liability under indemnity provisions, in the form of monetary thresholds and time periods for the survival of the purchaser’s indemnity claims against the sellers. In India, monetary thresholds, i.e., aggregate cap on the indemnity liability amount, get negotiated in a very wide range and are generally represented as a percentage of the total sale consideration involved in the transaction. Monetary limitations also include basket provisions and a de-minimis threshold. Based on the risk identified by the purchaser through its due diligence exercise, the time limitation for (i) taxation-related warranties is usually 7 years from the end of the financial year in which closing of the transaction occurs; (ii) fundamental warranties is usually unlimited, i.e., claims for the breach of fundamental warranties (like those relating to title and authority) could survive in perpetuity; and (iii) other warranties is usually anywhere between 1 year and 3 years.
Generally, specific indemnity provisions contain separate monetary and time limitations, given that they relate to specific and identified non-compliance risks, usually stemming from the purchaser’s due diligence findings, which could potentially affect the core business of the company, or the inherent title to the seller’s shares or some material litigation.
Another way of mitigating risk, or ensuring that adequate measures are taken to provide protection in the event of a claim, is that the purchasers and sellers negotiate the dispute settlement clause, keeping in mind factors such as the seat and venue of arbitration and the procedural law governing the arbitration. The choice of forum can be critical to the efficient resolution of disputes. In recent times, it has been seen that parties prefer institutional arbitration to ad hoc arbitration, given that it is the more cost-effective option.
The allocation of risk between a buyer and a seller is very deal specific in Ireland. However, the current market for sale terms are very seller friendly. The most important risk allocation method is the locked-box mechanism, which passes all economic risks and rewards following the effective date to the buyer. Caps on seller liability for breach of warranty of between 25% and 50% of the overall consideration are becoming common, whereas historically market practice in Ireland would have been for 100% of the overall consideration to be “on risk” for breaches of warranty.
In Ireland, a separate tax deed is typically used to allocate tax risk between a buyer and seller.
Hannes Snellman: In addition to tailored purchase price mechanisms (earn-outs etc.) designed to share risk regarding future performance or events, warranties and indemnities in purchase agreements are the main contractual means of risk allocation. The seller’s liability for unknown risks is covered by warranties, which are commonly subject to e.g. time and monetary limitations as well as the buyer’s knowledge based on the disclosure material in the data room. Financial sponsors typically endeavour to achieve a ‘clean exit’ with only limited fundamental warranties given by the seller, and operative warranties being covered by a W&I insurance policy paid for by the buyer. Risks related to known but contingent liabilities, such as pending litigations or environmental risks, are commonly dealt with by means of specific indemnities negotiated on a case-by-case basis depending on the bargaining power of the parties. In addition, post-closing covenants, such as confidentiality obligations, non-compete and non-solicitation and, in case of separate signing and closing, pre-closing covenants concerning e.g. seeking regulatory approvals or ordinary course of business, are generally agreed upon.
Traditionally, there are three general criteria related to the risk allocation structure in M&A transactions commonly used in Brazil, each with different impacts on the pricing of the transaction, as follows:
i. "closed gate sale" criteria (also known as sale "as is"), according to which the buyer acquires the company subject to the transaction in the condition in which it is, without protection in relation to risks generated up to the closing date, materialized or not. In this structure, the buyer assumes, therefore, all risks of the target company, including those related to facts, events and omissions that occurred prior to the closing of the transaction, when the company’s management was still under the control of the seller. This structure is most commonly used in mergers transactions involving publicly held companies, since any risks tend to be diluted among the combined company's shareholders and the quality of the target company's public information is much higher, or in exceptional cases, such as when the target company is in a situation of severe economic and financial stress and the price to be received by the seller is a very low value – in this context, the seller tends to do not accept to risk compensation for losses that are likely to be greater than such nominal value received by him;
ii. "virtual company" criteria (also known as "purchase of a company without a past"), according to which the seller remains responsible for all risks related to facts that occurred prior to the closing of the transaction, regardless of whether such risks are disclosed by the seller through the statements and guarantees provided for in the contract and/or in a separate disclosure letter. This structure tends to facilitate price negotiation, as it prevents known and declared risks from being priced by the buyer, but increases the relevance of guarantees to be granted by the seller, since it is very likely that the company object will suffer indemnified losses in relevant amounts and, therefore, that the buyer will trigger the seller's indemnity obligation; and
iii. "violation of representation and warranties" criteria (also known as "compensation for hidden liabilities"), according to which the buyer – except exceptional risks, generally contractually treated as "special indemnification" – assumes all risks known and declared by the seller in the purchase and sale contract, with which the seller only remains responsible for the undeclared risks (also known as "hidden liabilities"). This structure creates greater balance between the parties, but significantly increases the need for the buyer to be comfortable with the risks identified in the due diligence phase and, at the same time, the probability that the buyer wants to discount the purchase price part of the value posed by the risks that will be assumed by him.
Regardless of the risk allocation criteria negotiated between the parties, the seller is often required to assume liabilities for unlimited indemnification in relation to representation and warranties generally referred to as "fundamental" (e.g., authority and power of the seller to negotiate the object of the transaction, ownership by the seller of the object of the transaction, existence of the object of the transaction, etc.). More recently, unlimited indemnification liability has also been extended to representations and warranties relating to compliance with anti-corruption laws.”
With locked box mechanisms being very frequent, the business risk between the last account date and closing is usually borne by the purchaser, who will have limited protection by way of ordinary course of business and no-leakage warranties and covenants.
Representations and warranties are usually qualified by matters that have been disclosed (in a certain manner) or are deemed disclosed by operation of the provisions of the acquisition agreement or the disclosure letter (e.g. information which can be obtained from publicly accessible registers). The seller will always push for general disclosure (i.e. everything disclosed to the purchaser and its advisors at whatever occasion qualifies all warranties) while the purchaser will push for specific disclosure (i.e. separate disclosure for each warranty) and try to introduce a disclosure threshold requiring that a matter must be “fully and fairly” disclosed. This is usually heavily negotiated. Disclosure letters are relatively rare.
Purchasers who have identified a risk as part of their due diligence which would be excluded due to the disclosure need to negotiate an exclusion or indemnity to have protection. Indemnities are generally not qualified by disclosure or knowledge. The tax indemnity is usually only subject to a specific tax conduct provision, a direct loss limitation and the overall cap. Other limitations are a matter of negotiation. If other indemnities (e.g. for contamination and environmental compliance or specific due diligence findings) are accepted, limitations are usually heavily negotiated.
Common limitations on warranties include:
- Time limitation for bringing claims:
- title and capacity warranties usually survive 10 years at the minimum;
- business warranties between 12 and 24 months;
- tax warranties typically around seven years; and
- environmental warranties five to 10 years.
- Financial limits, including:
- a cap on the total liability (where there are multiple sellers, each may seek to limit its liability pro rata);
- a minimum aggregate claims threshold (“basket”); and
- an exclusion of de minimis claims.
- Limitation to direct loss (as opposed to indirect and consequential loss).
- Exclusion of claims to the extent caused by:
- agreed matters;
- acts of the purchaser (outside of the ordinary course of business);
- change of law or interpretation of law; or
- change of tax or accounting policies.
- No liability for contingent liabilities.
- No liability if the purchaser knew or could have known.
- No liability for mere timing differences (e.g. if tax authorities request longer tax depreciation periods).
- Obligation to mitigate loss.
- No double recovery under warranties, indemnities and insurance policies.
- A conduct of claims provision.
MAC clauses are sometimes agreed, usually after heavy negotiations. Private equity sellers tend to avoid MAC clauses in order to have transaction security.
Bring-down due diligence is relatively rare.
The risk of regulatory approvals, such as merger clearance, is usually borne by both parties. While it is common for purchasers to agree on covenants with regard to prompt filings and reporting to and consulting with the seller, purchasers very rarely accept hell or high water clauses. In transactions which appear to be difficult from a merger clearance point of view, break fees are sometimes discussed, but only rarely agreed.
The current market for sale terms tends to be more seller friendly, although in deals where R&W insurance is used, buyers are often able to obtain more buyer-favorable terms for insurable risks, including more comprehensive representations and warranties.
Two of the principal concepts of risk allocation involve deal certainty/closing risk (which is primarily addressed through closing conditions and a combination of termination fees and specific performance requirements) and business risk (which is primarily addressed through representations and warranties, indemnification and R&W insurance).
According to SRS Acquiom data, a reverse termination fee is used in approximately 15% of deals, with a median reverse termination fee of 6% of enterprise value (although we have increasingly observed lower termination fees as a percentage of enterprise value in larger deals).
The buyer’s obligation to close is typically conditioned upon the seller’s/target’s compliance with its pre-closing covenants in all material respects and the accuracy of the seller’s/target’s representations and warranties. The majority of transactions we have worked on required the representations and warranties to be true and correct as of closing subject to a material adverse effect qualifier (scraping the representations and warranties of materiality), with the balance subject to a materiality qualifier or no qualifier at all.
It is not market standard to include a condition that the buyer shall have obtained financing. However, the buyer and the seller typically allocate financing risk by agreeing to either (i) a “traditional” private equity deal model, which provides that if all the closing conditions are satisfied and the debt financing is available, the seller has a right to force the buyer to close and obligate the sponsor to draw down on its equity commitment, but if the debt financing is not available, the seller receives a reverse termination fee as its exclusive remedy, or (ii) a full equity backstop, which provides that if all the closing conditions are satisfied, the seller has a right to force the buyer to close (whether or not the debt financing is available) or sue for damages although a financial sponsor will typically seek a cap on potential damages claim equal to an amount lower than the purchase price (typically 10-20% of the purchase price).
Although a large majority of the deals use the “traditional” private equity deal model, a full equity backstop has become a useful option for financial sponsors willing to be aggressive and wanting to distinguish themselves in competitive auctions (and with sufficient equity resources or other borrowing capacity). We have seen an uptick in the use of full equity backstops in smaller and mid-market deals and expect that trend to continue for desirable assets.
A large portion of the sales by financial sponsors are run through a competitive auction process. For desirable assets, buyers are increasingly willing to forgo historically traditional, general post-closing indemnification from sellers and limit their recourse to an R&W insurance policy, although we’ve also seen an increase in limited, specific indemnification obligations for certain claims not covered by R&W insurance. In the deals where post-closing indemnification is provided, the limitations on indemnification obligations generally have become more seller friendly (which is a function of the availability of R&W insurance impacting deal terms more broadly). When buy-side R&W insurance is present, sellers’ indemnification obligations are overwhelmingly likely to be structured as non-tipping or “true” deductibles instead of tipping baskets, which mirrors the insurance retention under R&W insurance.
As R&W insurance use is prevalent in deals with financial sponsor buyers, escrows/holdbacks for indemnification claims quite often are eliminated entirely, although a separate escrow for purchase price adjustment remains in place in a majority of deals.
The typical methods of risk allocation between the buyer and the seller in transactions in which the targets are Japanese companies do not differ from the general practices elsewhere, which include provisions relating to representations and warranties, pre and post-closing covenants, closing conditions, indemnification, and closing adjustment of the purchase price.
Even when a financial sponsor is a seller of a target company, representations and warranties provided by the seller would usually include some representations and warranties about the target although the scope of such representations and warranties would be more limited compared to the scope a trade seller would provide.
With respect to closing conditions, the absence of material adverse effect and a financing condition would usually be among the most heavily negotiated between the seller and buyer.
Post-closing indemnification by the seller in favor of the buyer (for breaches by the seller of its representations and warranties and other covenants and agreements as set forth in the transaction documents) is a common means of risk allocation between the seller and the buyer. In going private transactions in which there are multiple shareholders of the target company, such indemnification is often provided by the sellers who are controlling shareholders of the target company under tender agreements executed between such controlling shareholders and the tender offeror.