Public M&A activity is up in the first quarter of FY21, with software and services deals leading the way by number and gold deals by value. Contingent value adjustments, reverse break fees and carefully drafted material adverse change conditions are increasingly being used to mitigate the ongoing uncertainty presented by the Covid-19 pandemic for control transactions for listed entities.
Q1FY21 Public M&A Activity
As we come to the end of the first quarter of FY21 and shift into a new phase of the pandemic we are seeing some of the trends that emerged towards the end of FY20 continue and some new themes emerging as well.
At the time of writing, 16 control transactions for listed companies have been announced since 1 July 2020 in Australia. Of these, two thirds are proposed to be implemented by scheme of arrangement. Large deals are now being announced too, which contrasts with the second half of FY20.
The largest listed control transaction announced so far this financial year is the proposed scrip merger between Northern Star Resources and Saracen Mineral Holdings. The scrip merger would create a top 10 global gold miner. Whilst the scale is in contrast to the mostly mid-market sized public M&A transactions seen previously during the pandemic, it bears out other themes we reported on in the Australian Public M&A Report for FY20 which showed that energy and resources deals represented 40% of public M&A deals in FY20, with many of them in the gold sector.
The number of listed control transactions announced since 1 July 2020 compares with 51 public M&A deals for the whole of FY20, where 9 of them were announced in June 2020 alone. This four month surge in public M&A appears set to continue, although we note there are a number of upcoming events with the potential to impact this trend, such as the US presidential election.
The standout sector for public M&A in the first quarter of FY21 is software and services, which represents about 40% of deals by number. With the scale of the Northern Star Resources and Saracen Mineral Holdings transaction, resources (particularly gold) is ahead by deal value.
Value and deal certainty in the current environment
Amongst the increased activity, the pandemic and its flow on impacts continue to present challenges for bidders in locking in the right bid pricing and for targets in ensuring deal certainty.
Material adverse changes … or are they?
At the start of the pandemic, we saw bidders encounter challenges in reneging from or renegotiating control transactions. In particular, whilst technically there may have been termination rights for specified ‘material adverse changes’, there was often difficulty in establishing or relying on them with certainty.
In a sense this is not a new issue. Historically the Delaware courts, UK Takeovers Panel and our own Australian Takeovers Panel has applied a high threshold for materiality.
In the Australian takeovers context, this is in part influenced by section 629 of the Corporations Act which prohibits, and renders void, conditions that are satisfied by the bidder’s subjective opinion. That is, if a material adverse change condition is construed too broadly or if the threshold is too low, it may allow termination in circumstances that in effect turn on a bidder’s subjective opinions.
In the first quarter of calendar 2020 we saw bidders trying to get out of deals where the implementation agreements did not directly address the Covid-19 pandemic. Identifying the material adverse change and terminating for its occurrence was generally not straight forward. For example, Scottish Pacific’s acquisition of CML was terminated by mutual agreement after Scottish Pacific raised concerns that certain events may have occurred which had a material adverse effect on CML’s business. Although CML disagreed with Scottish Pacific, it stated that termination was in the best interests of CML’s shareholders given the significant practical challenges that CML would need to overcome to progress a scheme transaction with a bidder which wished to terminate the scheme. The NZ listed Metlifecare’s revised implementation agreement with EQT removes the material adverse change condition entirely, noting the material adverse change condition was the subject of litigation about whether it was triggered.
More often we saw financing related requirements or conditions in implementation agreements were triggers enabling bidders to walk away, or the fact of the time being taken to resolve those issues meaning that the drop dead date for the deal would be reached (as in the proposed control transactions for Pioneer Credit, Oliver’s Real Food and LNG limited).
With the stage of the pandemic we are in now, we are seeing the situation evolve from interpretation of agreements that did not directly contemplate the pandemic to implementation agreements that address it head on. Material adverse change conditions with a Covid-19 related carve-out have appeared in a third of all implementation agreements announced after market crash on 20 February 2020 to 30 June 2020. Since 30 June 2020, many of the agreed control transactions included material adverse change conditions and of those, almost half have express exclusions relating to the pandemic and more still have more commonly seen exclusions for matters and circumstances known before the date of the implementation agreement.
Energy and resources deals in particular have been excluding pandemic related events from the definition of material adverse changes (including the deals for Saracen Mineral Holdings, Cassini Resources, Exore Resources and Zenith Energy).
Value is difficult to assess in this environment. Take for example the revised proposal by EQT for Metlifecare, where the Board announced a split recommendation in respect of the EQT proposal.
Bidders experience the same issue from the other side and a termination right is a blunt instrument they may not want to use when the actual situation is that the bidder still supports the strategic rationale for acquiring the business despite the short to medium term pandemic impacts, but cannot justify the value of the previous bid price.
These issues are addressed in the implementation agreements for the Abano and Village Roadshow transactions address where components of the scheme consideration is contingent on certain circumstances occurring or not occurring.
In August 2020, Abano announced a new scheme implementation agreement with a revised scheme price, which removed the right contained in the previous scheme implementation agreement for the bidder to terminate for a material adverse change. Instead the scheme price is subject to specified price reductions up to a specified cap if a number of events occur.
Similarly, the Village Roadshow scheme (discussed in the Australian Public M&A Report) took a similar approach, although using contingent consideration whereby additional amounts would be payable if specified events occurred relating to certain theme parts being operational for certain periods of time. The mechanism was designed to allow target shareholders to benefit from essentially the re-opening of the target’s main businesses that had been closed due to the impact of Covid-19 by certain dates. The arrangements accommodated the uncertainty in the operating environment caused by the pandemic and allowed target shareholders share to in the upside from favourable developments.
Reverse break fees
One other mechanism targets may seek to use to make it less attractive for bidders to walk away from agreed control transactions is a reverse break fee, whereby the bidder must pay the target an agreed fee if it does not proceed with the transaction in certain circumstances. As noted in the Australian Public M&A Report, we were surprised that in FY20 reverse break fees were not particularly popular, and the downward trend observed over the last five years in adopting reverse break fees continued.
The overarching theme emerging from the first quarter of FY21 in public M&A activity is an eagerness to transact, provided that objectives of appropriate value settings for bidders and deal certainty for targets are addressed. Increasingly these are being covered by more specific and nuanced value adjustments, reverse break fees and material adverse change conditions and we expect this trend to continue.
The best trend of all, is the one observed over the last few months, with the return of announced mega-mergers. The emergence of these announced deals bodes well for M&A markets in FY21.
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© Herbert Smith Freehills 2022