PE investors strengthen due diligence amid a cooling deals marketDecember 5, 2022 View comment (1)
Buyers have been taking more time to dig into a target's financial standing and, in some cases, have been negotiating stronger indemnity provisions to protect themselves against downside risks facing the assets they are looking to buy, lawyers involved in private equity deals said.
In recent months, investors have been more often advocating for provisions to indemnify themselves from losses that could arise from specific liabilities discovered during the negotiation and due diligence process.
To backstop these indemnities, sellers sometimes set up a separate escrow to withhold proceeds from the sale for a set period of time. The funds in the escrow could amount to between 7.5% to 12.5% of the purchase price, according to Morley Fortier III, a partner at law firm Reed Smith. In the case when the seller is an operating business and has sufficient assets to cover the liability, the buyer may not require a separate escrow.
In the last two years, it was unusual for buyers in the auction process to require an indemnity provision seeking recourse from a private equity seller, according to Fortier. Their recourse was typically limited to the reps and warranties insurance, which has grown in popularity as a tool to transfer risks to third-party insurers and mitigate the liabilities that sellers shoulder when they fail to appropriately disclose information about their business.
Justin Macke, a partner at law firm Sidley Austin, agrees that such practices were uncommon in PE-backed transactions closed in recent years, but since the end of September, he's noticed more financial buyers negotiating for specific indemnity clauses to protect against known liabilities and seek recourse from sellers.
"Contracts have become more bespoke," Macke said. "Buyers are specifically identifying items of potential risk and allocating responsibility for those risks [to be shared] between each party."
As the deals market has cooled amid lowering deal valuations and rising borrowing costs, sellers in today's market may see a smaller pool of suitors, making it easier for buyers to negotiate better legal terms.
"If you were buying an asset in an auction in 2021, you didn't have the ability to say 'I would like to have a stand-alone indemnity for a specific environmental risk,' because if you asked for that, you were likely to lose the assets to somebody who was willing to inherit that risk," Macke said.
Less competition also allows investors to spend more time digging into the ins and outs of a target's business.
"Buyers are taking more time looking at documents and data rooms, evaluating potential risks and liabilities of the target company," said Kip Wallen, a senior director at SRS Acquiom.
Compared to 2021, buyers' due diligence is more robust, he said.
In addition, some buyers are trying to price in potential risks early in the negotiation as they evaluate the uncertain economic outlook.
These indemnity provisions could serve as the bridge on valuation between what the seller is hoping to be paid and what the buyer is willing to spend on a business navigating an economic environment that may not be as favorable as last year's.
Apart from asking for specific indemnity provisions, buyers are also pushing for other favorable terms such as separate escrows for potential tax obligations or purchase price adjustments, according to Wallen.
Another sign that suggests negotiating power has tilted toward buyers is that the survival period—the time after the deal is closed during which the buyer may make claims for breaches of the seller's reps and warranties—is getting longer. In the first three quarters of this year, the median survival period for buyers tracked by SRS Acquiom rose to about 15 months from the 12 months recorded last year, Wallen said.
"It's starting to shift away from being a 100% sellers' market, especially with increasing interest rates and more expensive financing costs," Fortier said. "The pendulum hasn't swung to the other direction yet, but it's showing signs of being less seller friendly."
Featured image by Proxima Studio/Shutterstock
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