As the M&A landscape continues to shift towards equilibrium after the GFC, recent international trends have emerged in the New Zealand market. Specifically, the increased use of:
- locked box pricing mechanisms;
- warranty and indemnity insurance; and
- the "fundamental warranty" exclusion for vendor warranty limitations.
Locked box pricing mechanisms
Historically in New Zealand, completion accounts have been the favoured pricing mechanism in sale and purchase agreements. Under completion accounts (also known as a "wash-up" or "true-up"), the purchaser pays an estimated value for the business on completion, but this amount is later adjusted based on actual accounts prepared as at the completion date.
Increasingly, however, the locked box style pricing mechanism is being deployed, particularly in secondary private equity buyouts and auction sales. The structure locks in a sale price before the agreement is signed, based on a set of historic accounts prepared as at a specific date (often referred to as the "locked box date").
By adopting this mechanism, economic risk for the business is assumed by the purchaser from the locked box date, even though legal ownership will not pass until completion. There is no post-completion price adjustment, although the purchaser will be afforded protection to prevent "leakage" of value to the vendor between the locked box date and completion. Common forms of leakage include:
- waivers of debt;
- asset disposals; and
- bonus payments.
The locked box structure has some obvious benefits for both parties. It provides price certainty and avoids the costs and potential for disputes often associated with finalising completion accounts. These benefits are particularly important for private equity vendors who will usually want to distribute or re-invest sale proceeds without restriction.
The primary downside for vendors is that their control of the business will be more restricted during the period between signing and completion due to the inclusion of anti-leakage provisions. The main downside for purchasers is that they will need to conduct enhanced financial and commercial due diligence to ensure they are satisfied with the purchase price.
While locked box style agreements remain the exception to the rule in New Zealand, there has been an increase in the number of transactions where this pricing structure has been adopted, especially in circumstances where a private equity vendor is involved.
Warranty and indemnity insurance
Although the use of warranty and indemnity (W&I) insurance is by no means anything new in New Zealand, the general consensus is that W&I insurance is becoming more commonplace in M&A deals.
W&I insurance affords a level of cover against financial loss resulting from warranty and indemnity claims in a sale and purchase agreement. There are a number of reasons why cover of this nature is increasingly being sought:
- It is a useful circuit breaker where deal negotiations reach an impasse. A vendor may be more inclined to give certain warranties and indemnities if they know their risk will be underwritten.
- Cover has become cheaper, with premiums generally ranging from 1% to 3% of the deal value (depending on the extent of cover and deal size).
- Policy wording has become more flexible as underwriters become more inclined to tailor policies to the particular circumstances of the deal.
- It allows vendors a cleaner exit, enabling sale proceeds to be distributed more promptly following completion. This is because retention amounts are less likely to be necessary to cover warranty and indemnity claims.
Where previously W&I insurance was sought late in the negotiation process to break deadlocks, in recent years it is now being included in term sheets, with brokers often being engaged at the early stages of negotiations.
Ultimately, when the cost of premiums is measured alongside other transactional costs, W&I insurance can be a viable means of mitigating risk and getting deals over the line that may have otherwise failed. This, against the backdrop of a more buoyant M&A market and greater risk aversion following the GFC, means that the use of W&I insurance will likely continue to trend upwards.
The "fundamental warranty"
Vendor warranty limitations are always a key negotiation point in M&A transactions. Such limitations generally relate to:
- Financial liability, with a minimum limit for individual claims (a "de-minimis threshold") and aggregate claims (a "basket") by the purchaser, and also an aggregate liability cap for the vendor.
- Time, to set in place the period for which a claim may be brought by the purchaser.
- Awareness, where warranties are qualified to the vendor's knowledge.
- Disclosure, where the vendor will not be liable for a claim if the information giving rise to it is disclosed to the purchaser.
With purchasers ever keen to maximise stakeholder value in deals, we are increasingly seeing warranty limitations disapplied for certain fundamental warranties that go to the heart of the bargain. These usually relate to warranties regarding title and the vendor's ability to transfer the assets or shares free of encumbrances, but they can include other warranties that in the circumstances are of paramount importance to the purchaser. Most commonly, fundamental warranties will either not be subject to financial liability caps or the vendor's liability will be capped at a higher level than the other financial liability caps.
Though the use of fundamental warranty exclusions is not uncommon in New Zealand, they may become a more standard feature of sale and purchase agreements for M&A transactions, given their frequent use in the European M&A market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.