As interest rates increased in the second half of 2022 to levels not seen in over a decade, certain trends in deal-making began to appear. With continued uncertainty over higher interest rates and fear of economic downturn, those trends may continue in 2023.
More RWI Please!
While Reps and Warranties Insurance (RWI) has been widely accepted in M&A transactions for over a decade, the availability of policies for smaller deals has increased. As a result, more deals are utilizing RWI (including some structured as non-recourse deals). As economic uncertainty increases, both buyers and sellers are looking to RWI to provide more certainty in their post-closing operations.
Buyers seem to appreciate knowing that they can collect on a claim if they have RWI. Sellers are placing a higher value on increased cash at closing (rather than funds in escrow) and the certainty of holding or investing their proceeds without fear of post-closing claims. When both sides know there is market risk that could affect post-closing operations, both sides look for certainty. Because of this, there has been an increase in the number of deals where buyer and seller are willing to split the costs of RWI.
Less Guaranteed Money
After several years of earnouts decreasing (both in quantity and dollar value), as economic uncertainty has emerged, earnouts have once again become prevalent. Buyers have attempted to mitigate their risk by pushing for larger contingent payments while sellers seem to be accepting the fact that if they want to get a deal done right now, they will have to agree to some portion of the purchase price being deferred and contingent.
One unique aspect to this latest push for earnouts is that parties are utilizing a variety of metrics, rather than just EBITDA or net income. Both sides seem to be flexible in the structure of the earnout (sometimes using customer retention or even revenue as the metric) because they realize that with higher interest rates and negative economic signals, everyone needs to readjust expectations for post-closing performance of the business. Some buyers have even required the sellers or owners to be employed upon the final measurement of the earnout or risk forfeiting their portion of the earnout.
Diligence Kills Deals
The old cliché that “time kills deals” should probably be revised to “diligence kills deals”. In the latter half of 2022, a trend arose where buyers became increasingly concerned with diligence issues much later in the transaction process.
On a number of deals, operational issues with the target business that had been disclosed and discussed early in the due diligence process suddenly became “hot button” issues as interest rates increased, the stock market declined and general uncertainty prevailed. These issues typically arose well after definitive documents had been traded and negotiated close to a “final” form. Diligence issues that would have been worked through in a better economic environment have now been used as reasons for buyers to stop the negotiations or re-trade deals.
In 2023, sellers (and their advisors) should be aware of this risk and put greater effort on the front end of addressing potentially risky areas such as environmental, employment and benefits matters. By dealing with these issues up front, sellers should be able to work though those risks with buyers.
No More Non-Competes?
Although this has not been a trend yet, with the FTC’s announcement that it may ban non-competes for employees, deal makers should be aware of the rulings and how this can affect certain deal terms. Any bans on non-competes will not likely apply to sellers/owners, but they would affect whether a buyer can enforce restrictive covenants against the employees of the target business.
With the expected macro-economic struggles in 2023, it is easy to project that deals may be more difficult to close this year. However, by looking at the trends of late 2022, buyers, sellers and their advisors can find ways to mitigate (or reallocate) risks. If both sides will be flexible on deal structure and then show a willingness to work through potential road blocks, parties should be able to continue to pursue and close deals in 2023.
