Market trends: what you need to know
As seen in the American Bar Association’s private target M&A deal point studies.
- Over the nine ABA studies (2005-2021), compensation caps decreased as a percentage of deal value, either on average or median. This decline has been fairly consistent over the period of the ABA studies, although there was a slight increase in the average compensation caps following the 2008 financial recession, which was almost certainly the result of the private M&A market being intensely “buyer-friendly” during this period.
- The 2017, 2019 and 2021 ABA studies each show that compensation caps are lower in reported transactions where representations and warranties of insurance (RWI) are referenced in transaction documents.
In merger and acquisition (M&A) transactions, the definitive purchase agreement, whether it is an asset purchase agreement, a stock purchase agreement or a merger, generally contains representations and warranties made by the seller to the target company. Representations and warranties not only provide information to the buyer, but also serve to allocate risk between buyer and seller with respect to matters covered by the representations and warranties.
In addition to representations and warranties, M&A purchase agreements typically include indemnification provisions, under which any given party (indemnifier) agrees to defend, hold harmless, and indemnify the other party or the other parties (compensated) for the specified claims or damages. These generally include claims arising from a breach of the indemnificator’s representations and warranties or covenants set forth in the purchase agreement, or relating to other specific matters.
These indemnification obligations are generally subject to various limitations, in particular with regard to the period during which the indemnity is applicable, the amount of damages that must be suffered before the indemnification obligation is triggered, called baskets of indemnification, and caps on liability for indemnification.
This article examines how buyers and sellers negotiate compensation caps in private enterprise M&A transactions, as shown by studies of the American Bar Association’s (ABA) private target transaction points.
A typical indemnification clause in an M&A purchase agreement might read as follows:
Indemnification by Seller. Seller agrees and will defend and indemnify the Buying Parties and hold harmless each of them against, and pay on behalf of or reimburse such Buying Parties for, all losses that such Buying Party may incur, suffer or become subject to, as a result of, in connection with, related or incidental to or arising out of:
(i) any breach by Seller of any representation or warranty made by Seller in this Agreement or any Supplemental Closing Document;
(ii) any breach of any covenant or agreement by Seller under this Agreement or any Supplemental Closing Document;
(iii) one of the matters set out in Schedule [___];
(iv) any Taxes due or payable by the Company or its Affiliates in respect of any Pre-Closing Tax Period; Where
(v) any debt of the company or expenses of the company to the extent that they are not reimbursed or paid, respectively, in accordance with section [___] and not included in the purchase price adjustment pursuant to Article [___].
An indemnity basket and ceiling may be reflected in language such as the following:
provided that the Seller assumes no liability under clause (i) above:
(i) unless the aggregate of all Losses therein for which Seller would, but for this clause, be cumulatively liable exceeds on a cumulative basis an amount equal to $X (the “Basket”), the Buyer remaining responsible for these initial basket amount of $X; and
(ii) to the extent that the aggregate of all Losses for which Seller would, but for this provision, be liable exceeds, on a cumulative basis, an amount equal to $Y (the “Cap”);
provided, further, however, that the Basket and the Cap shall not apply: (a) to any breach of the representations and warranties set forth in Sections [X]; and (2) any breach of any representation or warranty that constitutes, or arises out of or relates to, fraud on behalf of the Company or Seller.
Positions of the parties on the compensation caps
Since the representations and warranties of the target company, or the selling shareholders, as the case may be, are likely to be much broader than the generally limited representations and warranties of the buyer, the buyer is more likely than the seller to be the indemnified and the beneficiary of the indemnity, and therefore has an interest in keeping any limitation of the indemnity to a minimum. The seller or the indemnificant, of course, has the opposite interest: to limit the circumstances in which he will have an indemnification liability towards the buyer or any other indemnified.
An indemnity cap is a typical limitation on indemnification liability in private enterprise mergers and acquisitions transactions. While a cap is common in M&A agreements, so are exceptions to the cap. The most common exceptions to an indemnity cap relate to violations by the indemnitor of its most critical or fundamental representations or covenants or agreements. The first exception recognizes that with respect to matters that are essential to the overall allocation of risk between Buyer and Seller, Seller or Indemnifier shall stand behind its representations and warranties without limitation.
The best example involves title to assets or equity acquired. A buyer will argue, not without reason, that if the seller’s representations as to ownership of the acquired assets or equity are false, the seller should be fully liable for any damages suffered by the buyer due to defects in title. The final exception, with respect to covenants, is based on the understanding that whether or not a party’s breach of covenants is wholly within that party’s control. Thus, the offending party should not be allowed to use the indemnification cap as a shield, but should instead be required to perform its obligations as stipulated in the agreement.
A common example is vendor non-competition covenants, whereby the vendor agrees not to compete, after closing, with the sold business. From the buyer’s perspective, the seller should be bound to its non-competition agreement and should not be given the opportunity to compete without liability beyond an indemnity cap.
Trends in compensation ceilings
Every two years since 2005, the ABA has published its Deal Points Studies on Private Mergers and Acquisitions (ABA Studies). ABA studies examine publicly available transaction purchase agreements involving private companies. These transactions vary in size but are generally considered part of the “middle market” for M&A transactions; the median deal size in the 2019 study was $145 million.
Over the nine ABA studies (2005-2021), compensation caps decreased as a percentage of deal value, either on average or median. This decline has been fairly consistent over the ABA’s study period, despite a slight increase in average compensation caps following the 2008 financial recession, which was almost certainly the result of the The private M&A market was intensely “buyer friendly” during this period. .
For reference, the mean represents the average of all data covered and the median represents the data point separating the lower and upper halves of the overall data. The median is often considered a more reliable indicator of what is normal or typical when the data distribution is skewed.
The chart below shows the downward trend in compensation caps as a percentage of trade values.
The Role of Representation and Guaranteed Insurance (RWI) in Compensation Caps
One of the biggest changes in private company mergers and acquisitions over the past decade has been the growth in the use of RWI. With RWI, buyers and sellers can allocate a portion of post-closing indemnification risk to third-party insurers. RWI has evolved from a differentiator offered by aggressive buyers to a much more common feature of private M&A deals. Since the risk of indemnification has been transferred by RWI from the sellers to third-party insurers, a buyer’s possibilities for indemnification claims against the sellers have narrowed. This narrowing includes lowering indemnity caps and even removing seller indemnity after the closing of representations and warranties, subject to narrow exceptions, such as fraud.
The 2017 ABA study was the first to examine the use of RWI in private M&A transactions and to examine the relationship between indemnification caps and transactions referencing RWI in transaction documents.
It should be noted that it is potentially imperfect to rely on references to RWI in M&A transaction documents as evidence of use of RWI, as RWI is not necessarily mentioned in an agreement of purchase, even if it was purchased for this transaction. It is possible that a significant number of M&A agreements with RWI make no reference in the agreement documents to the insurance policy itself.
As shown in the graph below, the ABA studies from 2017, 2019 and 2021 each showed that compensation caps were lower in reported transactions where RWI was referenced in transaction documents, compared to transactions without such. reference.
Compensation caps are often one of the most intensely negotiated provisions of an M&A buyout deal. The size of the market for compensation caps has always been a direct reflection of the relative strength of buyers and sellers in the private M&A market. More recently, however, RWI’s growth has had a significant impact on lowering compensation caps, and this trend is expected to continue and level off.
Reprinted with permission from Bloomberg Law. Copyright ©️2022 by the Office of National Affairs, Inc. (800-372-1033) http://www.bloomberglaw.com