After a turbulent 2023 characterized by high interest rates, persistent inflation, and geopolitical uncertainties that led to a sharp decline in deal volume and a cautious approach from buyers, 2024 has brought several positive developments that suggest a potential rebound.
As we progress through 2024, the middle-market mergers and acquisitions (M&A) sector is navigating a landscape marked by significant challenges alongside emerging signs of recovery. After a turbulent 2023 characterized by high interest rates, persistent inflation, and geopolitical uncertainties that led to a sharp decline in deal volume and a cautious approach from buyers, 2024 has brought several positive developments that suggest a potential rebound.
During 2023 and into 2024, amid a challenging M&A environment, private equity firms turned to lower middle-market add-on acquisitions as these smaller, strategic transactions allowed them to enhance their portfolios with reduced risk and cost compared to larger deals. This shift reflected a strategic adaptation to the economic conditions, laying a foundation for future growth.
While the pace of private equity exits remains slower than ideal, optimism is rising for the latter part of 2024 and into 2025. Increasing pressure from limited partners for firms to generate returns, and the stabilization of EBITDA multiples, which have been volatile in recent years, are fostering optimism for a market recovery.
Furthermore, many financial analysts view the Federal Reserve's recent interest rate cut as a potential catalyst for middle-market M&A activity, as lower borrowing costs may stimulate deal-making. However, some experts contend that the impact of the rate cut may be limited, as lower rates have been anticipated and factored into pricing for months. Moreover, the high cost of borrowing is just one of several challenges confronting the M&A market.
As in past years, Seyfarth Shaw (Seyfarth) recently published the results of its middle-market M&A deal term survey. The survey reviewed 130 publicly available middle-market M&A purchase agreements executed during the period from 2023 through the first half of 2024 (2023/H1 2024), focusing on key deal terms, particularly those comprising the "indemnity package" included in most private target acquisition agreements. This article will delve into certain findings from the survey, exploring trends in middle-market M&A.
Representation and Warranty Insurance
Representation and warranty insurance (RWI) has become a consistent element in middle-market M&A transactions, offering essential risk management for buyers and shifting risk from sellers to insurers in the event of breaches of a seller's representations and warranties in a purchase agreement. The survey confirmed that RWI was utilized in 57% of the 2023/H1 2024 transactions surveyed, which is consistent with the survey Seyfarth conducted for the period comprised of 2022 and the first half of 2023 (2022/H1 2023). Notably, according to recently published data, the decline in overall deal volume has led insurers to compete more aggressively to place RWI policies, resulting in more favorable terms, such as expanded coverage, lower retentions, and narrower exclusions.
When utilized, RWI has a notable impact on the structure of a deal's indemnity package. For instance, RWI deals typically feature lower indemnity escrow amounts and caps compared to those without RWI. For this reason, the survey tracks and analyzes data from deals with RWI separately from those without RWI, providing valuable insights into how this tool impacts market practices and deal dynamics.
No Survival Deals and Survival Periods
Historically, public and private M&A deals have differed significantly in their treatment of post-closing seller liability for breaches of representations and warranties. Public company transactions follow a "no-survival" structure, where representations and warranties terminate at closing, effectively leaving buyers with no post-closing recourse for breaches of representations. Private M&A deals, by contrast, have traditionally included seller-provided indemnities to address potential breaches post-closing.
In recent years, however, private M&A transactions have increasingly adopted the public-style no-survival model, particularly in deals involving RWI. Data from SRS Acquiom indicates that such private-target, "no-survival" deals reached a high of 48% in 2022/H1 2023, reflecting a strong sellers' market. In such deals, the RWI policy replaces traditional seller indemnities related to breaches of representations, becoming the primary or exclusive remedy for buyers in the event of a breach. However, new data provided to us by SRS Acquiom for 2023/H1 2024 marks for the first time a shift in the opposite direction, with only 25% of RWI deals utilizing the no-survival model, presumably showing more buyer strength.
The survey also revealed that, outside of no-survival deals, the survival period for general representations post-closing has remained consistent over the last several years. In 2023/H1 2024 deals involving RWI, 92% featured survival periods of 12 to 18 months, while 82% of non-RWI deals fell within the same range. The median survival period for 2023/H1 2024 RWI deals surveyed declined slightly to 12 months, down from 14 months during 2022/H1 2023, while non-RWI deals maintained a steady median of 16.5 months. Deals with extended survival periods were typically shaped by unique, deal-specific factors, underscoring the flexibility parties exercise in customizing terms to address particular circumstances, even when these adjustments deviate from standard market practices.
Indemnity Caps and Baskets
Indemnity baskets and caps are critical components in M&A transactions that limit a seller's liability for breaches of representations and warranties. Indemnity baskets serve as thresholds for buyers, determining when they can make claims against sellers. These can be structured as tipping baskets, which allow claims from the first dollar once a certain loss threshold is surpassed, or as true deductibles, where sellers are only liable for losses above a specified amount. Indemnity caps indicate the maximum amount a seller will pay for indemnity claims. The 2023/H1 2024 survey reveals that approximately 98% of transactions surveyed not utilizing RWI included an indemnity basket, with about 30% structured as tipping baskets and 70% as true deductibles, a shift from 17% and 83%, respectively, in 2022/H1 2023. The median basket size for non-RWI deals remained stable at 0.6% of the purchase price.
Approximately 76% of 2023/H1 2024 RWI deals surveyed included an indemnity basket, reflecting a decline from previous years (approximately 85% in 2022/H1 2023 and 94% in 2020/2021). Among these, around 26% were structured as tipping baskets and 74% as deductible baskets, compared to 6% and 94%, respectively, in 2022/H1 2023. The median basket size for RWI deals in 2023/H1 2024 decreased to 0.3% of the purchase price from 0.5% in 2022/H1 2023.
The increase in deals featuring tipping baskets over deductibles (in both the RWI and non-RWI categories) signals a potential trend toward a more buyer-friendly position with respect to this deal term.
Regarding indemnity caps, about 96% of both RWI and non-RWI deals in 2023/H1 2024 included a cap. Notably, the size of the cap varies significantly depending on whether RWI is used, with the median for non-RWI deals at approximately 10% (consistent with 2022/H1 2023), while it was 0.4% for insured deals (a decrease from 0.5% in 2022/H1 2023). The slight decline in cap size for RWI transactions may relate to the trend toward lower retention amounts in RWI policies.
Fraud Carveout and Definition
A common feature in private target acquisition agreements is the inclusion of fraud exceptions, which if not defined narrowly can serve as an escape hatch for the constraints placed on a buyer's indemnification rights and recourse mechanisms, such as survival periods, caps and baskets. Of the 2023/H1 2024 deals surveyed, approximately 95% incorporated some form of fraud exception.
We observed a trend toward increased sophistication among sellers in how they define fraud. In the 2023/H1 2024 survey, approximately 80% of deals specifically defined fraud (as compared to approximately 76% in 2022/H1 2023). Typically, these fraud definitions limited fraud to representations and warranties explicitly stated in the transaction agreement (around 92%) and included a requirement for actual knowledge of falsity regarding the breached representation, effectively excluding "constructive" or "reckless" fraud (approximately 94%). It is not uncommon for buyers to agree to narrower fraud definitions proposed by sellers' counsel because these definitions are designed to address genuine instances of fraud rather than serving as broad loopholes to circumvent the carefully negotiated liability limits established in the purchase agreement by sophisticated parties.
Escrow Amounts and Periods
In transactions that included escrows to secure payment for potential indemnity obligations, a vast majority (approximately 80%) of non-RWI deals surveyed had an indemnity escrow amount between 5% and 10% of the purchase price (with a median of approximately 8%). In contrast, all RWI deals surveyed had an escrow amount of less than 5% of the purchase price, with the vast majority (approximately 80%) being 1% or less (and a median of 1%). This is consistent with the prevailing RWI structure, which includes a retention (deductible) equal to approximately 1% or less of deal value.
While the indemnity escrow amounts varied significantly between RWI and non-RWI deals surveyed, the length of the indemnity escrow period showed no such discrepancy.
Approximately 81% of both RWI and non-RWI deals surveyed in 2023/H1 2024 provided for an indemnity escrow period ranging from 12 to 18 months, with a median escrow period of 12 months for both categories.
Conclusion
Despite ongoing challenges, there are promising signs for the middle-market M&A sector. Both buyers and sellers are adjusting to the shifting landscape, as demonstrated by the evolving deal terms revealed in Seyfarth's 2024 middle-market M&A deal term survey. This adaptability indicates a market that is increasingly attuned to current conditions, fostering a favorable environment for growth and new opportunities. Looking ahead, the question is not if the M&A market will bounce back, but rather when the inevitable resurgence will occur.
Originally published by 2024 ALM Global
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