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Kip Wallen, SRS Acquiom

Valuation Disconnects Driving a Spike in Earnouts

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Amid a material drop in deal volume, the 2023 private M&A market is seeing more and bigger earnouts. Earnouts can help bridge valuation gaps as strategic buyers get more active. Higher interest rates and uncertainty over future Fed rate increases are key drivers in the disconnect of valuation expectations.

The 2023 M&A market to date is in many ways a continuation of 2022, with a few notable exceptions. U.S. public and private strategic buyers have a larger piece of the buy-side market share compared to the midpoint of last year. Buyers are using their equity more to finance acquisitions (more than two times the number of all stock deals compared to this time last year). There are double the number of deals with management carveouts (7.2% compared to 3.4% in 2022); although these carveouts are not quite as big on a median basis (7.2% of transaction value compared to 10% in 2022). But perhaps the most notable trend is the prevalence of earnouts in 2023 private M&A deals.

SRS Acquiom has observed a 62% increase in the number of deals with earnouts in 2023.

Buyers active in the 2022-2023 M&A market are strategically opportunistic in selecting potential targets and thoroughly diligent throughout the dealmaking process. This appears to include a focus on smaller (and more likely domestic) acquisitions, which may also have the added benefits of avoiding regulatory scrutiny and a reduced need for interest rate sensitive financing. Gone are the fast-paced, high-value, relatively seller-favorable deals of 2021, at least for now.

Nonetheless, many sellers struggle to accept that the value of their business has declined, especially if it continues to perform well. Hence, the valuation disconnect. Heavily negotiated earnout provisions can sometimes help get the parties across the finish line. This is manifesting itself in the data. SRS Acquiom has observed a 62% increase in the number of deals with earnouts in 2023. Nearly one-third of 2023 deals (excluding life sciences deals) have an earnout, compared to 21% in 2022 and 17% in 2021.

In addition to frequency, the amount of deal consideration tied up in earnouts also went up. Prior to the pandemic, the median size of earnouts was approaching as low as 18% (as a percentage of the up-front consideration paid at closing) and for the last two years, plateaued around 30% after a COVID peak of 38% in 2020. 2023 deals with earnouts come in higher—somewhere north of 40% to date.

18% of deals with a private-equity fund as the buyer included an earnout, compared to 30% of deals with a U.S. public buyer.

The shifting of the legal terms of the earnout provisions is another sign that parties are working hard to get these deals across the finish line. This is an area where strategic buyers may be leading the way. Only 6% of 2023 deals with an earnout included a covenant that buyers operate the target business in accordance with past practices, compared to 23% in 2022. Some decrease here makes sense given the higher number of strategic buyers, whereas financial buyers are more likely to keep the target’s existing management team in place and, therefore, more often agree to this operational covenant language. However, given this significant decrease (nearly 75%), the increase in strategic buyers is likely not the only factor driving this shift in earnout provisions.

Interestingly, frequency of certain efforts language for earnouts held steady with about 85% of deals in both 2022 and 2023 including language along the lines of “Buyer shall not take any actions the primary purpose of which is to prevent achievement of the milestone payment.”  Nearly 40% of 2023 deals included “commercially reasonable efforts” (CRE) language, compared to 30% of 2022 deals. Strategic buyers are more likely to agree to CRE language, and the higher percentage of strategic buyers in 2023 likely explains most or all the increased inclusion of a CRE standard.

There is optimism for increased deal activity in the fourth quarter among M&A practitioners. 

Generally, financial buyers tend not to push for earnouts as often as strategic buyers. For example, in 2022, 18% of deals with a private-equity fund as the buyer included an earnout, compared to 30% of deals with a U.S. public buyer. The slow return of strategic buyers to the M&A market in 2023, valuation gaps, low deal volumes, and macroeconomic conditions are all factors driving more and bigger earnouts.

It is important to note that early trends in deal-term data may not hold going forward, particularly with optimism for increased deal activity in the fourth quarter among M&A practitioners. Time will tell. For now, we know the first part of 2023 saw a higher prevalence of earnouts on private M&A deals, as deal parties found ways to close deals in a tough market.

SRS Acquiom is a provider of services used for the administration of complex financial transactions including paying and escrow agent services, online document solicitation and reporting, professional shareholder representation, and virtual data rooms. In addition, for loan and credit transactions, SRS Acquiom provides independent administrative, collateral, and sub-agent services. SRS Acquiom was founded in 2007 and is headquartered in Denver, Colorado.

About the Author
Kip Wallen is a senior director leading the SRS Acquiom thought leadership practice. He leverages his extensive expertise and SRS Acquiom proprietary data to produce resourceful content regularly utilized by market practitioners. Kip has broad experience in M&A and provides guidance on market standards and trends.

Previously, Mr. Wallen was a Director with the SRS Acquiom Transactional Group, where he collaborated with clients and counsel to negotiate M&A documents including purchase, escrow, payments, and other transactional agreements. Before joining SRS Acquiom, he was an attorney with a Denver-based boutique business law firm where he assisted clients with M&A transactions as well as general corporate governance and securities matters.

© 2023 Private Equity Professional | October 17, 2023

Five Risk Management Techniques to Help PE Firms Navigate the Financial Markets Storm

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Increased volatility in financial markets as a result of higher interest rates has revealed fault lines in banks and lenders, sparking concerns about liquidity among a wide range of investors, including private equity fund managers. The unpredictability of financial markets should serve as another reminder for financial sponsors to anticipate new perils and actively manage a broad array of risks.

Looking for potential exposures and addressing them ought to be an ongoing effort, but this exercise has spurred a greater sense of immediacy in the wake of recent U.S. bank failures and stress within European financial institutions. Without previous dedicated diversification strategies, many institutions were caught flat-footed and experienced huge challenges in managing cash flow and analyzing information from disparate sources. Makeshift treasury management systems based on multiple spreadsheets and scattered reporting proved to be inadequate and left many scrambling.

The challenges facing private equity firms in undertaking
risk assessments and managing transparency are far and wide.

Riding out a storm in financial markets involves not only diversifying funding sources and avoiding concentration risk with key liquidity providers, but also implementing the systems and processes that empower firms to manage cash flow, risk and diversification.

The heightened need to employ robust risk management practices as part of overall liquidity management takes on greater meaning for private equity funds. These investors face market conditions which no longer assure portfolio investments can be easily monetized and fundraising efforts continue to be difficult. It’s an environment in which fund CFOs are increasingly focused on liquidity and modern treasury management systems as part of their efforts to be nimble in a rapidly changing global economy.

The challenges facing private equity firms in undertaking risk assessments and managing transparency are far and wide. Many firms may have become accustomed to relying on one bank because working with multiple institutions requires more advanced tools and processes especially when it comes to managing funds in various markets and across multiple legal entities and currencies. Gathering information from multiple banking counterparties that can be readily scrutinized is also challenging, and most home-grown solutions aren’t suited to manage this level of complexity.

A financial wellness check to ensure that liquidity remains intact and available includes the ability to conduct a broad review of a private equity firm’s counterparties, ensuring that a fund is not overly exposed to a single bank, asset class or industry. It’s an effort that involves ongoing monitoring of financial markets for any signs of stress among counterparties and employing sophisticated tools to track ratings and exposure status in real time.

Five Risk Management Strategies
Private equity firms will want to consider the following risk management strategies as they look to anticipate, and mitigate, a range of risks that have surfaced in what promises to be a protracted period of elevated interest rates:

1 – Diversify Liquidity Sources
While many private equity firms have traditionally come to rely on one financial institution because having a single banking relationship has been simpler, market participants need to be aware of concentration risk within their banking relationships.

In the first quarter of this year, investors were reminded of the pitfalls of relying on a single bank or banking group for liquidity. Funds with too much concentration in one source could face significant liquidity shortfalls when a bank, or group of lenders, encounter financial difficulties and need regulatory intervention.

Financial institutions likely will continue to be tested by the sharp runup in interest rates so diversifying the pool of lenders or banks that serve as counterparties is a key risk management technique private equity funds will want to incorporate.

2 – Mitigate Exposure to a Single Asset Class or Sector
Managing risk through diversification also applies to markets and asset classes because the rapid jump in global borrowing costs has had a powerful impact on a wide range of investments. Fund managers should track exposure to avoid concentration risk in a particular asset class, sector, and geography.

Commercial real estate, for example, illustrates the dangers of having too much concentration in one asset class during a rising rate environment. Real estate funds have been hobbled by diminished liquidity tied to higher borrowing costs that have slowed property sales and have weighed on asset prices. Today, property owners have a tougher time financing commercial property loans because of the Federal Reserve’s rate increases and wider yield premiums, or spreads, on bonds pooling commercial real estate loans.

The challenges faced by participants in commercial real estate serve as an example of why it’s important for investors to diminish their exposure to a single asset class and broaden their portfolio’s risk concentration.

3 – Watch for Telltale Signs of Increased Risk Among Counterparties
Managing counterparty risk involves closely monitoring how counterparties are viewed by financial market participants. This means watching how securities issued by various participants trade in debt markets and keeping an eye on rating actions announced by credit rating agencies including Moody’s Investors Service, Fitch Ratings, and Standard & Poor Global Ratings.

Rating actions can reveal issues about the financial health of a counterparty that pose liquidity risks. And changes to yield premiums paid for a business’ debt signal how capital markets view a counterparty’s risk profile and how readily the counterparty can access funding.

4 – Consider Money Market Funds as a Safe Haven
For private equity fund managers who want a real-time view of cash holdings and a safe haven during volatile market conditions, sweeping excess cash directly into a money market fund or money market account is another risk management technique.

Ideally, any excess cash balances are automatically transferred into a money market fund or account, which provides an additional layer of diversification and liquidity.

Money market funds invest in short-term, low-risk securities such as government bonds and commercial paper. This is a relatively safe option for cash management that mitigates the risk of having too much cash sitting idle in a bank account and provides easy access to funds when needed.

Also, companies can potentially earn a higher rate of return on excess cash with a money market fund or account than they would in a traditional bank account.

5 – Manage Currency and Rate Risks with Financial Tools
The global effort to stamp out inflation with aggressive rate hikes by central banks has fueled volatility in foreign exchange and debt markets. Private equity firms can manage these sharp moves in financial markets with hedges in currencies and interest rates. This hedging of risk can be achieved through various techniques such as forward contracts, options, and interest rate swaps.

Hedging currency and interest rate risk helps private equity firms protect their portfolios from adverse market movements, mitigating the impact of sharp currency and interest rate fluctuations on their portfolio holdings. However, it’s important to note that hedging comes with costs and may limit potential gains. It is also crucial to strike a balance between risk management and investment returns.

Conclusion
Recent stress in the banking system has created fissures in global financial markets and broadened the scope of risks for private equity funds to consider and manage. A financial wellness check, for some, may be a new mindset that will require a multi-pronged approach to anticipate risk, bolster liquidity, and manage exposure to counterparties, assets, and markets.

The latest waves of volatility and concerns about liquidity likely won’t go away soon so it’s not too late to start reviewing counterparty risk and developing relationships with a wider pool of funding sources.

About the Author
Sol Zlotchenko is chief product officer and strategy lead for the private markets group at Hazeltree, a leader in active treasury and intelligent operations technology for the alternative asset industry.

Hazeltree’s treasury and portfolio finance technology solutions serve hedge funds, asset managers, private equity funds, private debt, real estate funds, infrastructure funds, pensions and endowments, and their service providers. Hazeltree is headquartered in New York City, with offices in London and Hong Kong.

© 2023 Private Equity Professional | May 9, 2023

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