- A strong vendor market has seen an increased prevalence of warranty and indemnity insurance and locked box transactions
- The scope of due diligence is becoming a source of tension between purchasers and insurers under insured transactions
- Technology has sped up the M&A deal process, which has in turn increased the risk of error
The way mergers and acquisitions (M&A) deals are conducted and structured is changing. A favourable market for vendors has seen an increase in structural tools such as warranty and indemnity (W&I) insurance and locked box transactions. Traditional approaches to price purchase allocation are changing as risk sensitivities heighten, and new technology is creating both benefits and challenges.
The changing scope of due diligence
Jessica Pritchard CA, Transaction Tax Partner at EY, and Graham Murray, Partner at Bell Gully have seen a variety of trends emerge in a market where vendors are increasingly looking to sell assets without lasting deal exposure to tax issues. A key change is the growing prevalence of W&I insurance, which has brought with it an increased focus on cover exclusions and residual liability for the vendor.
“W&I insurance will usually limit the purchaser’s recourse for tax claims under a sale and purchase agreement to the W&I policy, while releasing the vendor from liability for those claims. We’re seeing insurers excluding cover for high risk and known tax issues, and a lot of variation in the extent to which the vendor remains on the hook for these excluded risks. It’s a challenge that requires a strong understanding of the changing level of cover offered by the insurer and who takes the risk for excluded tax issues,” Murray says.
The increased popularity of W&I deals has had flow-on effects to other areas of M&A transactions, particularly for tax due diligence. As a result, Pritchard and Murray have seen tensions emerge between purchasers and insurers surrounding the required scope of due diligence.
“W&I insurance exclude known issues. As a result, purchasers have less incentive to do a thorough tax due diligence assessment, whereas insurers want to make sure a full assessment is completed. This creates tension and certainly makes for interesting commercial negotiations,” Murray says.
The rise of locked box transactions
A strong vendor market has also seen an increase in locked box transactions where purchasers accept the majority of the risk from the locked box date. Despite the inherent disadvantages, Pritchard and Murray argue it’s not all bad news for purchasers.
“The fact that economic interest passes to the purchaser at the locked box date gives the purchaser ‘skin in the game’ during the transition period to completion. This is particularly beneficial to both parties where there is a long settlement due to regulatory factors, for example Overseas Investment Office clearance,” Pritchard explains.
In recent times, Murray has seen purchasers regain some control in locked box transactions.
“Purchasers are now taking steps to address their lack of control over an asset they are economically exposed to in these transactions. There’s a stronger push for detailed covenants that require the asset to be managed as it would in the ordinary course of business during the locked box period. We’ve also seen heightened attention to the leakage indemnity which engages where a vendor extracts value from the asset during the locked box period,” he says.
Improvement through specificity
Purchase price allocation is another area undergoing change as parties are becoming increasingly aware of the inherent risk of unspecified allocations, and are opting to reduce risk through consistency.
“In the past, parties may not have wanted to specify allocations in an agreement, preferring to form their own view on how the price should be allocated. Now, sophisticated parties are detailing allocations and requiring each other to be consistent in their allocations for tax purposes,” Murray explains.
“There’s also been a more proactive engagement with Inland Revenue in cases where parties cannot agree on a specific allocation,” Pritchard adds.
Technology's role in transforming the industry
The introduction of new technology has had a major impact on M&A processes. According to Pritchard and Murray, virtual data rooms and advanced data analytics have significantly increased the speed of M&A deals, a trend that presents obvious benefits, but also some challenges.
“Overall, technology has had a positive impact, but the speed at which deals are now completed gives rise to concerns that issues may be missed, or not covered to the necessary extent. Technology has definitely created risks we need to be attuned to,” Murray says.
When these issues arise, Pritchard advises that businesses need to reflect on and adapt their processes to mitigate inherent risks.
“At EY we manage risk by having two partners sign off on all transactions, something you wouldn’t see on an ordinary tax project,” she says.
Pritchard and Murray see keeping up with technological change as a key challenge for the future focused professionals in M&A. They recommend investing in, and learning how to effectively leverage new technologies to ensure long-term success.
“Technology will be a dominant element of M&A practices going forward. The capability to operate different technologies should be an integral part of any finance and accounting professional’s skill set,” Murray says.