I. The German M&A Market – a Seller’s Market
Germany has long been an attractive market for both strategic and financial investors. This is due to a number of reasons. The German economy is traditionally shaped by highly regarded blue chips with strong brand recognition and “quality perception” as well as successful small and medium-sized companies (Mittelstand), many of them global market leaders in industrial niche markets. Germany is also considered as – and continues to prove itself to be – a stable and solid hub in a European market environment that, due to the never-ending Euro crisis, the Crimea/Ukraine crisis and other crises, has not ceased to be turbulent and volatile. More recently, the USD/EUR exchange rate has added to Germany’s attractiveness for inbound M&A transactions.
These positive characteristics of the German economy have, in the recent past, been coupled with attractive financing conditions. Low interest rates, cheap credit and a scarcity of potential investment targets (Anlagenotstand) for strategic and, more so, for financial investors such as PE firms have further accelerated M&A activity in Germany.
As a consequence, the market has become increasingly tight, attractive targets have become more scarce and multiples and, correspondingly, purchase prices ever higher – oftentimes boosted in auction processes orchestrated by PE firms or savvy investment advisors. As a consequence, attractive German targets are regularly only available at a premium valuation. The sale by two PE funds of the start-up 360T Trading Networks, a German-based operator of an FX trading venue, to Deutsche Börse AG (operator of the Frankfurt Stock Exchange) for reportedly more than 700 million euros is just one recent example. No doubt – the German M&A market has turned into a seller’s market. This development has not been without influence on the practice of M&A.
II. Locked-box as the new market standard
In parallel with the development of the German M&A market, the standards and customs in SPA drafting and negotiation have changed. While in the past, flexible and prospective mechanisms to determine the purchase price were used on a regular basis, the so called “locked box” has become more popular in Germany. This had been quite common in transactions involving PE firms on the sell-side for many years, but now is increasingly seen as market practice among strategic investors as well.
The “locked box” is a mechanism whereby the seller and the purchaser agree on a fixed purchase price, on the basis of financial statements prepared as of a specific date (the “locked-box date”) in the past, i.e., prior to closing. The purchase price is, hence, determined retrospectively, i.e., on the basis of financial information which is essentially outdated on or after the closing date. This allows the seller to calculate deal proceeds with a high degree of certainty, to promptly pocket the purchase price and to rule out potential purchase price adjustments in the future. The purchaser, however, is left with more uncertainty and risk in respect of the time span between the date of the financial statements and the closing date. This is even more true as the purchaser, in this phase, has no (statutorily guaranteed) influence on the management of the target company. Solid “ordinary course” and “no leakage” covenants offer some degree of protection, but fundamentally the business risk passes to the purchaser from the (retroactive) locked-box date.
III. Representations and Warranties – if any…
Pursuant to German statutory law, in principle, a seller owes warranties to the purchaser with respect to any deficiencies an object sold, including a company, may have. Consequently, the applicable statutory law imposes far-reaching obligations on the seller in the context of a purchase transaction.
However, since the applicable statutory provisions are subject to the disposition of contracting parties, German M&A has long moved away from this principle and it has become entirely standard to define the warranties contractually, not much different from what is customary in the U.S. The catalogue of warranties offered by a seller has successively become shorter and shorter, however, and now is often limited to little more than essential title guarantees in competitive deals.
In addition, representations and warranties are often heavily qualified, not only with materiality thresholds, but also by seller knowledge. Seller knowledge, in turn is then regularly defined as positive knowledge of a narrowly defined group of individuals, often not substantially connected to the business.
Further, de-minimis’, thresholds (deductible) and caps are at very low levels, with a de minimis of 0.1%, a threshold of 1% and a cap of 10% (or even less) of the purchase price not being uncommon, and short limitation periods of 12 to 18 months apply.
Regarding anti-sandbagging, it has become standard to attribute any and all information disclosed during the transaction process, and in particular the content of the data room to the purchaser, with the consequence of an exclusion of claims for any matters that the purchaser knew or could have known from analyzing such sources. This is then sometimes coupled with a late disclosure of large volumes of information, which puts a particular burden on the purchaser diligence team.
In making use of these techniques, sellers are put into a position where they can rule out post-closing liabilities to a large extent.
IV. W&I Insurance – a way out of the dilemma?
A potential way to deal with these challenges could be W&I insurance. While W&I insurance has a longer tradition in the U.S., it is a relatively new phenomenon in European M&A (maybe with the exception of the UK, where it has been more common for some years).
By way of W&I insurance, the purchaser can insure the potential financial loss that would arise from a breach of the warranties given by the seller in the SPA, where the damages from breaches of the warranties in the SPA are contractually capped. Of course, Sellers are expected to have some “skin in the game” by insurers. However, given the competitive market we currently see seller exposures limited to very low amounts, such as 1% of the purchase price, with the purchaser being expected to cover any additional risk through W&I insurance.
While W&I insurance can effectively address the uncertainties and risks laid out above in certain cases, the terms and conditions under which it can be obtained do oftentimes reduce its usefulness – and they are certainly no panacea.
First, W&I insurance is regularly based on the warranties given by the seller in the SPA. As a consequence, W&I insurance does not help in cases where the potential or actual financial loss of the purchaser arises from a matter which, from the outset, is not covered by such narrowly tailored warranties. As set out above, for key areas, the seller will often heavily qualify warranties by materiality and/or knowledge, or not be prepared to grant any warranties at all, and in such cases W&I insurance does not cover the matter either.
Second, there are certain risks W&I insurance is traditionally reluctant to assume and several limitations apply to W&I insurance, including, in particular, deductibles and caps. While risks related to the operation of a company are in general insurable, insurers are regularly not in a position to insure risks in the areas of compliance, regulatory, tax and pension liabilities – or are only willing to do so for an excessively high premium. The reason for this is that these risks are less factual and objective in nature and more open to interpretation and discretion. As such, they are more difficult to assess and quantify. Also, it is generally not possible to cover any known issues.
The most important aspect, however, is a process one: If a purchaser contemplates engaging a W&I insurer, this has to be considered from the outset of the transaction, as it is key that extensive due diligence materials are available that enable the insurer to assess that the parties have conducted adequate diligence of the target. Also, insurers will review potential exclusions to the warranty catalogue in detail, which is time consuming and often requires a separate workstream to be established for dealing with the insurer. Thus, in a very tightly timed and competitive auction process, a W&I insurance solution adds considerable complexity and increased challenges for process efficiency. It may prove to be impractical for this reason.
Being familiar with the basics of W&I insurance may give a purchaser a competitive edge in tightly run auction processes, so that a purchaser should focus on this topic in a timely manner.
V. Caveat Emptor – Due Diligence is Key
Against this background, due diligence is key and becomes ever more important. Given the increasing use of adverse purchase price mechanisms, the lack of effective warranties and the limited usefulness of W&I insurance, only a thoroughly performed purchaser due diligence can help to assess – and factor in – potential risks associated with the purchase of a company. Beyond that, for the time being, purchasers in Germany should be prepared to assume some risk.