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