Key Deal Points: Beyond Comparison?

by Andy Greenberg, CEO GF Data

: published PEP Digest — About three years ago, GF Data began asking private equity contributors to provide information on key deal terms other than price, in addition to the valuation and leverage data they have provided since 2006.

As with the financial data, we set out to provide a more granular view of trends in the $10-250 million swath of the M&A market.  Unlike our experience with the financial data, though, we’re finding that the key deal term data raises more questions about what we are collecting and what it means.

Our universe of more than 1,100 transactions now includes 184 completed in 2008-10 for which the acquirers provided these metrics:  (1) cap for indemnification against breaches of general reps and warranties; (2) survival period for that cap; (3) escrow or holdback amount; (4) escrow/holdback period; and (5) basket or deductible.

Let’s begin with a contrast. The headline metric in our report is Total Enterprise Value (TEV) to Trailing Twelve Month’s (TTM) adjusted EBITDA.  We guide our data inputters on the judgment calls that go into this calculation – TEV includes seller financing, but not earnouts contingent on post-closing performance.   Trailing Twelve Months means the most recent period prior to closing, not necessarily year-end.  EBITDA adjustments are the ones the buyer credited in valuing the business. Buyer’s transaction costs are provided separately so they can be excluded from calculations of valuation multiples corresponding to seller expectations, but then added back in when we reconcile sources and uses of capital.

And that’s it. With little additional guidance, we produce valuation multiples that are literally comparable.  A user may choose to give data more or less weight in a given situation, but we all know what it means when we say the average multiple for HVAC and Plumbing Contractors (NAICS Code 23822) is 5.4x TTM Adjusted EBITDA.

In the key deal term data, indemnification cap is the most prominent term.

Here is the guidance on indemnification cap set forth within GF Data’s on-line template:

Indemnification cap refers to the general indemnification provided by the seller to the buyer against breaches of reps and warranties.  This does not include carveouts for specific issues or items. For example, parties often will agree that the general cap will not apply in the event of fraud.”

Indemnification cap as a percentage of purchase price averaged in the mid teens in 2010 and closer to 20 percent in 2008 and 09.

This suggests that as the market and general economy have improved, buyers have required  – or have only been able to obtain – lesser protection against breaches of general
reps and warranties.

But what does this data mean as a matter of comparability?

Richard Jaffe, a leading M&A/private equity lawyer with Duane Morris, observes that an external reference point is an indispensable part of the eventual negotiation over what terms are “market” in relation to a particular transaction. “It’s compelling to have that external data point,” Jaffe said, “and then you look at the circumstances of the transaction, and at some point the leverage the law  firms are able to bring to bear based on their own experience also becomes relevant.  All of these factors matter, but you need a benchmark as a place to start.”

We set out to provide information on deals in a tier of the market not systematically covered by other data sources – transactions with private sellers and buyers in the lower middle market.  It’s interesting to look at our data in relation to other, complementary resources.

Probably the best — and best recognized — is the American Bar Association’s key deal points study, a bi-annual survey of deals reported by public acquirers.

Ashley Hess of Baker Hostetler is one of the organizers of the ABA effort.  He points out that in the most recent ABA Study, the average cap was 21.72%, with a median of 11.19%.  (The average was skewed by four or five deals that each had a cap equal to the purchase price.)

The upshot is that the indemnification caps are not – as one might expect – higher in a sample that includes generally larger deals and exclusively consists of public acquirers.

Ashley’s response in part: “I would be interested in knowing if you see many deals with financial buyers that demand the cap be equal to the purchase price (cash component at least).  Perhaps it is more likely for a strategic buyer to negotiate for a larger cap, but it would be good to know the spread in the indemnification caps from the data you collect. “

Of the 184 deals meeting our parameters , only three have caps equal to the purchase price.

While the selling businesses being captured in our data may be smaller than those in the ABA sample, experience suggests several forces that would tend to pull down indemnification caps in private equity-sponsored deals in the lower middle market:

1. While these businesses may be smaller, they tend to be less complex and therefore easier subjects of due diligence;

2. Private equity firms are – whether they do the work themselves or outsource it – are due diligence machines.  The risks covered by the general cap (as opposed to carveouts) are usually well understood by closing.

3. Smaller middle market companies today are more likely to employ sophisticated transaction counsel, and this operates as somewhat of an equalizer in negotiating deal points once the larger economics are set.

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