Partner Piece – Dentons
June 25, 2019
Private Equity Transactions in the UK and US
A Brief Comparison
by Geraint Steyn, Dentons UK and Middle East LLP
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INTRODUCTION
The growth of transatlantic private equity transactions leads to many examples of how two nations can be divided by a common language.
Doing deals in the United Kingdom is quite different than doing them in the United States and generally speaking the UK is considered to have a more seller-friendly approach.
The key difference in market practice revolves around risk allocation. In the UK, even where there is a gap between signing and closing, economic risk passes from a seller to a buyer at the time of executing the share purchase agreement (SPA) whereas in the US market risk is typically considered to pass upon closing of the acquisition of a target company. This difference is demonstrated in the following areas:
- The degree of deal certainty.
- The approach to pricing mechanisms.
- The scope for post-acquisition liability.
DEAL CERTAINTY
An SPA in the UK typically contains only those closing conditions required by law or regulation, i.e. anti-trust clearances. In contrast, US deals are more likely to have greater conditionality and provide for a longer period between signing and closing, known in the US as the marketing period (the period required by the buyer to obtain acquisition financing).
The UK has a culture of “cash confirmed” deals. Aside from regulatory requirements, there is no material adverse change or other “out” prior to closing. In particular, there are typically no conditions relating to financing and sellers will want to satisfy themselves that buyers have unconditional financing available.
It is unusual for UK deals to be subject to a Material Adverse Change (MAC) condition. If included it is usually by reference to a high specified financial threshold in terms of the impact on the financial position of the target. MAC clauses are more common in the US which fits in with the position that risk is not considered to pass to the buyer until closing.
PRICING MECHANISM
While some English law private transactions contain purchase price adjustment provisions (known as a “Completion Accounts” process) it is common in English law SPAs for the acquisition price to be structured on a locked box basis. This is certainly true in auction processes where, particularly in this buoyant market, the bargaining position is weighted towards the seller
The basic concept of a locked box is that the target is sold as at an agreed balance sheet date prior to signing, called the “Locked Box Date”. Financial statements are prepared as at that value date, from which point the economic risk of the business passes to the buyer and the buyer gets the benefit of all cash flow. Interest will typically be added to the agreed value from the Locked Box Date to closing to compensate the seller for the cash flow accruing prior to closing.
In return, the seller undertakes that there will be no “Leakage” of value from the locked box to the sellers in that period in the form of dividends or otherwise. This is in keeping with the philosophy that risk passes to the buyer from signing. The SPA will allow for certain payments (typically known as “Permitted Leakage”), including the scheduled payments on related party debt, director and management fees consistent with past practices, and, where the management team are also sellers, the payment of salaries and other management compensation consistent with past practices. Any payments that are made to the sellers and their affiliates that do not constitute Permitted Leakage are reimbursable to the buyer on a £-for-£ basis with certain other agreed-upon payments being a reduction in the overall purchase price.
Sellers, particularly private equity sellers which will be distributing the net proceeds from the sale back to their investors, also seek certainty that, absent Leakage (as discussed above) or a breach of warranty, they will not have to return any portion of the purchase price that they received at closing. The elimination of any post-closing adjustment eliminates the need to hold back funds in case the adjustment works against the seller.
When utilizing the locked box approach, a buyer is relying upon the warranties and the covenants relating to the pre-closing operation of the business in the ordinary course as its primary means of redressing any extraordinary changes.
POST CLOSING INDEMNIFICATION
In the UK post-closing claims are typically brought as a breach of warranty claim. A breach of warranty claim is similar in many respects to a US claim for indemnity in that the party claiming the breach has the burden to prove that the breach occurred and resulted in damages which were reasonably foreseeable. In addition, the party seeking damages has an obligation to take reasonable actions to mitigate those damages.
However, under UK law, in order to recover for a claim based on a breach of warranty, the party seeking damages must also demonstrate that, not only was there an actual loss suffered, but that the loss also resulted in a diminution in value of the target as a going concern. Accordingly, when viewed from the perspective of how a particular loss impacts the financial health of a company, losses that only have a one-time direct impact on the balance sheet, compared to those that have a continuing impact on the income statement, are less likely to be recoverable in the UK transactions.
In a US transaction involving the purchase of a privately held company, after closing, the sellers ordinarily agree to indemnify the buyer for all losses arising from breach of warranties and covenants. Indemnification becomes the sole remedy available to the buyer absent fraud and other equitable remedies (e.g., specific performance) for breaches of restrictive covenants.
The most important difference between warranties and indemnities is that warranties are qualified by disclosures whereas indemnities are not. This means that the purpose of warranties is generally to elicit disclosure, although they do afford substantive protection in relation to financial statements, trading and material liabilities where proper disclosure has not been made.
Indemnities are designed as a pure risk allocation mechanism. If the defined liability arises the indemnifier pays, irrespective of either the buyer’s knowledge or whether there has been a diminution in the value of the business acquired. Unlike the UK, in the US the practice is for all the warranties to be given on an indemnity basis which is why so much debate arises around the UK practice of disclosure.
CONCLUSION
For the reasons outlined above, US sellers may prefer that international deals are done under UK law which favours a seller in terms of deal certainty, price certainty and potentially reduced liability after closing.
Geraint Steyn is an Associate in the Corporate team at Dentons UK and Middle East LLP.
