Shrinking PE Deal Indemnity Caps Signal M&A Uptick

By Jake Simpson

Law 360: published Law 360, New York (March 25, 2013, 4:10 PM ET) — Indemnification caps for lower- and middle-market private equity fund transactions have decreased to their lowest levels in five years, according to a recent report by GF Data Resources LLC, signaling a more aggressive attitude toward mergers and acquisitions in the sector.

 

GF Data, which provides information on private equity-sponsored M&A deals with enterprise values between $10 million and $250 million, received transaction information from more than 200 North American PE firms earlier this year. The company found that the average indemnification caps on those types of deals fell to 16.9 percent in 2012, down 2 percent from 2011 levels, according to its Spring 2013 M&A Snapshot.

Indemnification caps correspond to the maximum amount of damages the buyer can receive from the seller for breaches of representations and warranties in a transaction, usually expressed as a percentage of the deal’s enterprise value. Lower caps signal increased confidence in the quality of the businesses in private equity-sponsored deals and a less hesitant attitude toward M&A generally.

“Market conditions in the fourth quarter of 2012 made for the highest deal volume for any quarter in our [10-year] data collection history,” said GF Data Principal Bob Wegbreit. “At the same time, we were able to see indemnification caps go down, as the quality of deals as measured by growth and [earnings before interest, taxes, depreciation and amortization] margins grew.”

The cap levels are the lowest since 2007, before the global financial crisis put a clamp on both the global M&A market and private equity activity.

Larger middle-market deals are getting comparatively lower caps, according to GF Data. The firm found that caps in deals with enterprise values between $50 million and $100 million were less than half the cap size as a percentage of enterprise value compared to deals of $10 million to $25 million in value.

In certain industries, indemnification cap levels remain high. Distribution industry businesses reported the highest cap averages in 2012, GF Data said, followed by the business services and health care services sectors.

The report “also cites [that] businesses with above average financial characteristics … [are] showing higher indemnification cap levels than average private equity acquisitions,” GF Data said.

Separately, GF Data found that the duration period for most small- and middle-market private equity transactions in 2012 was similar to 2011. Deals with enterprise values between $10 million and $25 million had the longest duration periods, according to the report.

The global private equity market will continue to pick up in 2013, according to several recent surveys and reports by industry consultants. A survey by Preqin Ltd. released earlier this month found that nearly all private equity limited partners expect the sale of private fund stakes on the secondary market to increase in 2013, suggesting investors are looking for liquidity as the market rallies.

Roughly 43 percent of LPs surveyed by Preqin said they expected private equity activity on the secondary market to increase this year. Another 55 percent said they believed it would remain at or near 2012 levels.

A survey of 40 investors in January found that 57 percent of LPs believe Latin America is presenting more attractive investment opportunities than other emerging markets, according to a separate Preqin survey announced this month. And a report released on March 4 by investment advisory firm Bain & Co. posited that the outlook for private equity in North America is rosy for 2013, with buyout deal values rising.

GF Data provides information and databases on private equity-sponsored M&A transactions with enterprise values between $10 million and $250 million. The company also publishes reports on valuation, leverage and key PE deal terms.

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