Private Equity Dealmaking Outlook for the Remainder of 2024

EMS:

Hi Mike. Thank you so much for being with me today.

Michael Petrizzo:

Thank you for having me, Elana.

EMS:

Absolutely. To kick off the conversation, tell us a little about your professional background and your transaction practice at Saul Ewing, including your client base and the types of transaction-related services your group provides to your clients.

MP:

Sure thing. I'm a partner in the corporate practice group of Saul Ewing. We are a full-service national law firm of 450 attorneys spread across 18 offices. I practice out of our Philadelphia and our New York office. We have approximately 80 attorneys in our corporate practice group. Of those, approximately 50 of us are M&A attorneys. We, me personally and the firm generally represent clients in over 40 industries, so we're industry agnostic in that regard. We represent clients of biotech, energy, financial services, government contracting, health care, a broad array of industries. Our clients also include everyone from entrepreneurs and family-run businesses to public companies, as well as private equity and venture capital funds. I've been practicing for almost 30 years. My focus is on M&A, joint ventures, reorganizations, and other corporate commercial transactions, again, like I said, across a broad spectrum of industries. Of note is I have particular expertise in financial services, M&A and capital market transactions. I've done approximately 60 insurance, M&A, capital market and alternative risk transfer transactions throughout my career. I also serve as outside general counsel to a number of companies, both early-stage companies as well as more established companies in that middle market, but don't have the finances to hire a full-time GC. So, I serve as their outside general counsel. On the security side, I advise on securities offerings, assisting underissuers and underwriters with private placements as well as public offerings of debt and equity securities. And on the M&A front, I assist private equity and venture capital investors with respect to the acquisition and disposition of their portfolio of companies from the fund formation to the acquisition of that portfolio company to everything underneath it, as well as help with the integration and operation of acquired portfolio company so that when a company comes in, we also typically represent that company throughout its life cycle. In addition, I also handle the corporate side of restructurings, including companies that are buying or selling assets as part of a bankruptcy proceeding.

EMS:

Mike, it's definitely an interesting time right now with respect to dealmaking with the time taking longer for deals to prepare for and complete. So, I wanted to ask you, what trends are you seeing in your practice with respect to dealmaking? And you could touch on planning, valuation, due diligence, structuring, compliance, and more.

MP:

Well, let's talk about timelines. I just got back from lunch with a colleague who's on the investment banking side, and what we're seeing is that even when the parties are motivated, when they're solidly motivated, they want to get a deal done, we're seeing deal timelines be extended by 25-50%. So even those 30 to 45 aspirational sign to close, those aren't happening. We're seeing deadlines get pushed out farther and farther. And I think part of that is because buyers are becoming more thorough in their analysis and scrutiny of target companies and sellers are having a tough time keeping up. What's becoming clear is that financial due diligence, while it's always the cornerstone of what the private equity firms, venture capital firms are looking at, it's not enough to fully vet a deal. Buyers and sellers are really coming to understand that just performing financial due diligence does not provide the level of insight into a target needed to both price the deal appropriately and decide whether or not to close it. For example, we're seeing increased scrutiny and analysis of everything from supply chains and workforce issues on the workforce side, things like retention of key talent, compliance with increasingly complex HR requirements. It's come down the pike lately, non-competes for employees may go bye-bye. So, that's giving everybody pause on how they retain talent, how they motivate talent, how do they keep talent? And second, additionally with technology becoming more and more of a differentiator in certain industries, there's an increased scrutiny on IT systems and their capabilities. Are they scalable? What investments are we going to have to make? And equally important, there's data protection and cybersecurity controls are going right to the front of that. So, in a nutshell, buyers are working, they're looking at operations and they're even looking at the softer cultural fit considerations in determining whether to proceed with a deal. And again, that's both in the depth and breadth of their due diligence.

EMS:

Mike, I wanted to shift gears and talk about preparing for an M&A transaction and wanted to ask, what are some best practices companies should implement when it comes to both the buy-side and sell-side transaction?

MP:

So, the first order of business is to get the right team in place, the proper team in place. Whether you're on the buy-side or the sell-side, that rule applies. You want to make sure you have your internal and external advisory teams in place, online, engaged, talking to each other and sharing the same information and having access to the same information at the same time. That's the core of your team. That will allow you not only to anticipate issues that pop up, but also deal with issues that come up, both pre-transaction planning and of course throughout the course of a transaction once you've decided to proceed with one. The first set of questions I have when I get involved in a transaction are, who are those key internal personnel, finance, accounting, operational, legal, that's going to form that core internal team. Who are your external accountants and auditors? Who knows your numbers? Who's preparing your financial statements or who are you going to use to clean up the financial neglect for the past several years, which is typically the case with either early-stage or founder-led or entrepreneur-led companies, and who's your banker? If individual sellers are involved, we want to know who's their wealth advisor or estate planner to help them deal with not only the tremendous amount of money that's coming in, but also potential transaction structuring issues, which will allow us to structure the transaction that makes that type of generational planning easier. On my end, when I think about a transaction, when the call comes in, I call my tax colleague, and if it's in a particular industry that requires some regulatory expertise, I'll get a regulatory colleague online. This is because obviously having tax, legal sing with tax advisory helps structure the transaction in the most efficient way, and obviously we want to know any kind of regulatory hurdles that may come up. Those are the core members of the deal team and structuring due diligence, drafting, all flow naturally from having that deal team in place. Second, on the sell-side, we've really encouraged sellers to take an inventory of their business as soon as possible, ideally before a deal is on the table. Think of the M&A process of selling a house, right? When you're about to sell your house, do you just open your door and say, “Oh, everybody come in and take a look.” No, you don't do that. When you're selling your house, you don't just throw your doors open. You look at your house, “Okay, well, what do we doing here? What does the house look like? What do we need paint over here? Do we need to replace something?” Right? You want to take an inventory of yourself. So, using that same core team, the outside accountants and advisors, valuation professionals and outside legal advisors perform a thoughtful review and analysis of your accounting and finances. This doesn't need to be a full-blown audit, but it should be a fresh look at it by your outside advisors. Look internally at our operations. How are we operating? Who's in charge of operations? What are the controls around our operations? Do they make sense either in connection with the industry that we're in and applicable regulatory requirements? Get your arms around contracts. For example, we've had companies say, “Well, we don't have any contracts.” And they think of contracts as these documents that are outside of the ordinary course. You have sales agreements, lease agreements, et cetera. Get your arms around those. And finally, what I encourage clients to do is get an independent valuation. If you're going to put up something for a sale, at least internally have an idea of what somebody else tells you the value is before you start going to a banker for their opinion and/or getting opinions from third parties. So, knowing what you're selling, cleaning up loose ends and having a good idea of what your company is worth, at least at a very, very high level, is the best ammunition a seller can have before entering a process.

EMS:

Mike, I wanted to shift gears a bit and talk about the terms of a letter of intent, which are nonbinding and subject to negotiation and clearly sets the tone and expectations of the parties upfront. So, wanted you to take a deeper dive into some of the more critical terms and issues that you advise clients to consider before executing on a letter of intent.

MP:

So, I advise clients to focus first and foremost on structuring and money issues. The more detail on those, the better because they're going to serve as the party's moral guiding light or moral hammer, depending on your view as the transaction proceeds. For example, what's the structure of the transaction and how and whether any tax benefits or burdens are going to be shared. Are we going to make any special kind of tax selection? Are we going to do any kind of pre-closing reorganization of the company? You also want at least agreement on the underlying valuation rationale of the company. How are you valuing the company? You want to look at the money issues such as working capital methodology, including any collars on adjustments to understand what that's going to look like from an adjustment perspective, whether it makes sense. You're going to look at definitions of transaction expenses and indebtedness, those items which are going to result in adjustments to purchase price. You also want to think about, well, when we're thinking about indebtedness, what exclusions fall out of indebtedness and into another bucket because maybe those aren't going to get paid off at closing. They're going to be a knock on another item. So again, getting as clear as you can on those financial items will help set the tone for the transaction because those are the ones where buyers and sellers try and renegotiate as the transaction proceeds. So having a moral guidepost is helpful. Secondarily, get your arms around and address execution risk and lifestyle and liability items. For example, ask the parties what are your key conditions precedent to the consummation of the transaction? Are there any third party or governmental consents required? Are there any key customer or key client consents that you absolutely must have? Any supplier consents that you must have? Employment agreements in place with key employees, et cetera? You want to also try and flesh out the nature and scope of any restrictive covenants that you're going to put on individuals if individuals happen to be sellers. You also want to get your arms around the terms of any rollover equity, any earn out or any type of seller financing to understand what that looks like. And also, as important the nature and scope of indemnification provisions. Okay, well, if something does go wrong, what does my liability look like? How long does it go for? What are the limits on it, et cetera. Buyers, as you can imagine, generally prefer to be as vague as possible at the LOI stage because that gives them the maximum flexibility, at least from a moral hammer perspective as you move forward. Now, sellers of course, especially first-time sellers don't appreciate that. So, we have to coach them and say, “Hey, look, you really want this information in there. Yes, it's not binding. Yes, it's the subject of a negotiation, but it sets your baseline. It sets your baseline.” So, we try and get as much of that in the letter of intent as possible. However, there are instances where, hey, we just want to rush and get it signed. And in those instances, what we'll do is instead of negotiating provisions, we'll say, “Well, okay, buyer, if you're going to expect our client to sign restrictive covenants or employment agreements, send us an example of what you would typically request. What did you do in your last deal?” or “What's your form? If we're doing rollover equities, send us the existing stockholder agreement or the existing operating agreement so we could see what our equity looks like.” And typically, if you get copies of those documents, even if you don't have the words in the letter of intent, you can get some insight into what a buyer is thinking. And failing all of that what we'll do is we'll actually do some due diligence. We'll go on third party websites. Bloomberg Law is an excellent tool. It's a very, very robust precedent database, which allows you to search by industry, transaction type, law firm, lawyer. So, I could say, “Well, I'm doing a deal in the transportation space. It's going to be a stock purchase with X, Y, and Z law firm. And Ms. Smith was the attorney that handled the deal.” I can pull up if she's done anything that's publicly available, I can pull that up, and I can give my client some insight into how she conducts her negotiations.

EMS:

Mike, we found that some of the key deal points have been evolving with the overall economic regulatory financing and M&A environment. And I wanted you to discuss what are some of the most significant changes in deal points you're seeing in both buy and sell-side transactions?

MP:

Two things stick out. One thing driving deal structuring is the significant cost of debt acquisition financing, which is in addition to stringing out the amount of time it takes to get a transaction done, it's causing buyers and sellers to rethink how to get financing to get a deal done. We're seeing larger rollovers where 10-15% was the norm. We're seeing larger rollovers, 20%-25%, some 30%. I did one last year that was 45% rollover. We're seeing earnouts. So, we're seeing financial earnouts, financial targets that go anywhere from one year to five years. And occasionally it hasn't come back as much as it has in the past, but we're also seeing some seller financing where the seller actually takes paper back from the buyer to fund the acquisition. And essentially all of those things that they're trying to do is instead of playing with other people's money, now the seller has more skin in the game for the continued operation of the company. And that could be a good thing for some sellers because they're now linked, at least conceptually linked with the buyer. So, they both succeed going forward. The other thing is, given the general slowdown in deal work, we're waiting for it anxiously to pick up. I know we all are. There's significant capacity in the representation and warranty insurance market, which allows parties to lay off a lot of the risk transactional, the operational risk to an insurance company. So, what does that do? That allows for parties to focus more narrowly on the things that really matter financially, integration, et cetera. And while they can't completely ignore them, reps and warranties become more of a closing condition issue and less of a financial issue for a seller. And because not a lot of deals are going on, whereas representation of warranty insurance used to be for the $50 million deals and above, we're seeing that dip down as low as $10 million deals. So, we're seeing smaller deals get the benefit of a financial product that was typically only for larger deals. That helps speed transactions a little bit and help focus attention on the money matters.

EMS:

Mike let's talk about the due diligence process on deals, and I would love to hear your thoughts on the top financial tax, regulatory and legal diligence issues that you encounter in your transaction legal work.

MP:

So, this really depends on the target company's operations and industry, but the key ones, and I'm going from recent memory, tend to be first and foremost the quality of the historical financial statements and the underlying record keeping. I've seen everything from receipts in a shoebox to contracts written on the back of a coaster to audited financial statements. And fewer questions generally arise from the latter than the former. And secondly, we're also seeing more focus on compliance with applicable accounting policies, especially with respect to revenue recognition. We're seeing a lot, a lot of drill down on that. And all of this feeds into not only outside of the due diligence process, it feeds into discussions on working capital, identification of any non-recurring, non-operating personal or out of the ordinary income or expenses that should be added back to EBITDA and other type of valuation considerations. Secondly, we're seeing a lot more diligence on the technology and infrastructure, including on data security protocols and history. So, we're seeing a lot of that type of due diligence. On the software side, we're seeing a deep dive into social media presence, both as with respect to target companies itself and any key employees or owners. We're seeing a deep dive into those. I worked on a transaction two years ago where there were three sellers and one of the sellers had a social media presence under a pseudonym, and the buyer found out about it, and there was some fairly salacious stuff online with respect to that seller. And while it didn't tank the transaction, it caused the buyer great pause, and we had to restructure the transaction to deal with the fact that that one particular seller wasn't going to get any rollover equity, which caused some issues in the transaction. So that stuff does come up. Those are real life issues. We're seeing a lot deeper dive into relationships, contractual or otherwise with key customers and clients, vendors, distribution partners, in addition to just concentration risk, which is the obvious, but understanding the dynamics, whether they're significant or otherwise. Regulatory compliance and relationships with regulators is always a hot button in the insurance industry, banking industry, et cetera. People want to understand the relationship with their regulators. To the extent it's applicable for international businesses, we're looking at compliance with applicable trade restrictions. So, are you complying with the U.S. on the OFAC restrictions? Where that gets sticky sometimes is some countries actually prohibit their entities from complying with the U.S. trade restrictions. So, you're kind of left in this weird position. We have to try and diligence how the company has complied with it and how you can comply with it going forward. On a more basic level, restrictive covenants and contracts, those always pop up. Are we agreeing to anything or buying anything that's going to inhibit the business going forward? And finally, being politically agnostic on this. ESG and DEI initiatives, those are important considerations to a lot of buyers, to a lot of investors. So, we're seeing a lot of questions. Okay, what are your ESG and DEI initiatives? How are you executing on them and proving that you're executing on them? So again, it runs from the hot topics that we've been seeing run from the really hardcore financial issues to the more softer, I won't say touchy-feely, but the more softer non-financial issues.

EMS:

Mike, we've covered a lot of ground today and wanted to see if there are any final thoughts you'd like to share with us.

MP:

Nope, other than I'm keeping my fingers crossed that we get some clarity on which way the economy's going, which way interest rates are going, which way the government's going, the three-headed monster, which is causing significant uncertainty. Hopefully we get some clarity on those issues going forward, so the deal work starts picking up again.

EMS:

Mike, I wanted to thank you so much for joining me.

MP:

Thanks for having me, Elana. I appreciate it.

EMS:

And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.