Transactions Blog

In deals, Buyers will in a lot of cases drive their target business valuation off a maintainable level of EBITDA.  As the term suggests, EBITDA is calculated ‘before any cost related to the financial structuring of the target business’.

Therefore any debt and/or cash freely available in the business results in an adjustment of the Buyer’s valuation.  In addition, when using EBITDA as a value driver the Buyer is assuming that the infrastructure to deliver this level of profit is in place.  Infrastructure can relate to sufficient working capital as well as tangible operating assets. Therefore, any shortfalls (or indeed excesses from the Seller’s viewpoint) against ‘expected’ infrastructure levels need to be addressed in the valuation.  

Further, the Buyer will want to know that it has the rights to the profit it is paying for and that any indebtedness (in addition to ‘normal’ bank debt) related to historical trading results is at the cost of the Seller.  Therefore, the initial valuation driven off EBITDA (or pre-financing cash flows) does not (necessarily) represent the ‘true’ value of the target business.  

So, a mechanism is needed to move from Enterprise Value to Equity Value.  There are the traditional mechanisms with a completion accounts process or a ‘Locked Box’ whereby the Equity Value is known when the deal is signed, without involving completion mechanisms.

As some hesitation still prevails regarding the application of Locked Boxes in Belgium, let’s try to clarify how the Locked Box process works and what considerations are relevant from either Buyer or Seller side.

In the United Kingdom and other places abroad, dealmakers’ use of the Locked Box in place of the more conventional completion mechanisms has become more accepted.  In Belgium, the application of Locked Boxes to determine the Equity Value of a deal are not yet that common, but gain ground.  The Locked Box is a tool most commonly employed by private equity (‘PE’) firms and other financial buyers to effect a clean separation at the conclusion of a transaction.  Recently, we also observe a greater uptake of the Locked Box by non-financial Buyers.  In addition, the Locked Box is viewed as a means of adding certainty of price, and thereby saving time and money associated with prolonged post-acquisition negotiations.

The Locked Box is a simple mechanism designed to remove the requirement for the parties to a deal to prepare and negotiate completion accounts.  It does this by basing the mechanism off a historical balance sheet where all items of debt, cash and working capital are known at the date of signing.  This contrasts to a standard completion mechanism where the amounts of cash, debt and working capital are not known until after completion.

How does a Locked Box work?

The Seller will ask Bidders for a fixed price for the target shares (‘Equity Value’) based on a known historical balance sheet (‘the Locked Box balance sheet’).  This Equity Value represents the debt-free and cash-free price after adjustment to reflect external debt and cash in the Locked Box balance sheet, a level of working capital at the Locked Box date compared to the Bidder’s assessment of the ‘normal’ level of working capital to be agreed upon by both parties for the purpose of pricing, and some other indebtedness or due diligence findings relating to historical trading results at the cost of the Seller.  This Equity Value is then specified in the SPA.  There is no post-completion mechanism and no completion accounts are prepared, thereby removing the costly completion accounts process and post-completion price adjustments.

The graph above shows the relationship between working capital and debt in a ‘proper’ locked box transaction.

The Seller warrants that, between the Locked Box balance sheet date and the completion date, no ‘Leakage’ of value from the Target to the Seller will occur (other than Permitted Leakage, as agreed by both parties).  Leakage broadly represents cash flows or other value transfers to the benefit of the Seller, such as dividends, management charges, other payments to or for the benefit of other members of the Seller group, waivers of amounts due from the Seller to the Target, etc.

In effect, the Buyer takes over ‘economic ownership’ of the Target from the Locked Box date, before it legally owns the business.  The profits or losses made by the Target after the Locked Box balance sheet date will arise to the benefit/detriment of the Buyer.  In theory, between the Locked Box balance sheet date and the completion date, if no value can leak out of the Target, any changes in working capital will be balanced by an equal movement in net debt.  Therefore, payments in the ordinary course of business are allowed (e.g., staff wages and paying trade creditors).  The only other change in net debt should be limited to any cash profits or losses between the Locked Box balance sheet date and the completion date.

As noted above, the cash profits of the business accrue to the benefit of the Buyer.  Should the Seller wish to retain the profits between the Locked Box date and the completion date, the Seller should consider making an interest charge (or a ‘daily profit rate charge’) on the Equity Value that will result in a payment by the Buyer in respect of the period between the Locked Box date and the completion date.  The Seller would argue that the interest charge reflects the fact that the Equity Value is calculated and economic interest passes at the Locked Box date but the Seller is not paid until Completion.  As such, the interest charge compensates the Seller for the opportunity cost (‘time value of money’) of not having received the cash at the Locked Box date.  Buyers will often compare the amount payable under the interest charge to the ‘cash profits’ generated by the business after the Locked Box date (e.g., EBITDA less interest charges, less tax charges, less depreci­ation or replacement capital expenditures).

At Completion, the Buyer is required to pay the Equity Value plus any interest charge on the Equity Value and eventually to re-finance the debt outstanding at the completion date.

In spite of the seemingly Seller-friendly nature of the Locked Box, the benefits of simplicity can translate into a mutually beneficial arrangement if certain questions are answered by both the Buyer and the Seller.

Seller considerations:

• Whether the Locked Box balance sheet is ‘anchored’ (e.g., no carve-out to be done anymore), can be relied upon and can be warranted without inviting litigation – to what extent can the business to be sold be accurately separated from retained operations?
• If the Seller wishes to retain the profits after the Locked Box balance sheet date, what interest rate or daily profit rate should be used?
• What warranties should be given in respect of leakage and the Locked Box balance sheet?

Buyer considerations:

• The Locked Box balance sheet on which the Buyer is making pricing decisions needs to be sufficiently reliable and supported by appropriate warranties;
• The Buyer needs sufficient time and access to management to identify pricing issues in respect of cash, debt, working capital, capital expenditures, and other indebtedness related to historical trading results;
• The possible routes of leakage are comprehensively identified, defined and warranted;
• The business continues to be properly run after the Locked Box balance sheet date;
• Whether to pay an interest charge on Equity Value or whether the profits between the Locked Box date and the completion date have already been factored into the Buyer’s assessment of the cash-free, debt-free price;
• Assuming the Buyer has agreed to pay an interest charge on Equity Value, assessing whether the interest charge or daily profit rate due to the Seller is supported by the results of the business after the Locked Box balance sheet date to counter risk of business deteriorating between locked box date and completion; and
• A Buyer must also consider whether it has the resources and access to information to perform the necessary due diligence on the pre-acquisition balance sheet (e.g. sometimes already commitment to price before a Buyer gets exclusivity).

A Locked Box can drive value through simplicity and certainty of price, yielding time and cost savings.  However, as noted above there are a number of considerations that both the buyer and the seller must contemplate before executing a transaction.

To conclude: in any transaction, the Sale and Purchase Agreement represents the outcome of key commercial and pricing negotiations.  The financial aspects of the SPA are key to ensure that the Buyer is buying (and the Seller is selling) what they expect, for the price they expect and without undue residual risk.  All this can be reached not only through the traditional completion accounts mechanism, but also through a Locked Box, if well considered by both Seller and Buyer.

“The private equity industry is back.” That was the announcement from Carlyle Group founder Rubenstein during the PE Analyst Conference in New York on Thursday 17th. But is it?

Based on the Global M&A Monthly article from Baird, the current economical crisis has caused a record amount of $400 billion unallocated capital that is waiting within PE firms to be invested. Currently most PE firms are taking smaller stakes due to, on the one hand, the poor credit capacity in the market and, on the other hand, lower visibility into the portfolio companies.

The announced revival of the PE M&A activity will ultimately be driven by the provision of debt capital. Currently, the revival is taking a prudent start as signs of improved liquidity are popping up, including new records low for interest rates and reduced spreads on new issuances.

However, it is believed that the key to further revival is still in the hands of the banks, who could be encouraged to provide more easily (high yield and leveraged) bank debt. This reluctance is especially the case in Europe, while in the US, debt financing is already becoming more available for acquirers.

As a consequence of this immobile bank debt, equity financing is has gained importance again over the past months. A related significant trend is equity financing through stock offerings by companies, e.g. the AB Inbev underwriting. In the long term however debt financing is bound to regain market share as, in general, it is still a cheaper way of funding.

Under the Belgian Companies Code (“BCC”), public limited liability companies wishing to buy back their own shares are required to make a bid to all shareholders and, where appropriate, to all holders of certificates. This obligation is aimed at ensuring the equal treatment of all shareholders.

Section 620(1), first paragraph (5°), of the BCC provides for an exception to this rule for listed companies whose securities are admitted to trading on regulated market or on a multilateral trading facility system (“MTF”) that meets certain conditions. These companies are permitted – subject to a number of special rules – to buy back their own shares or certificates without having to issue a takeover bid to all their shareholders. It is assumed that compliance with the above rules ensures equal treatment, even without an offer being made to all the shareholders.

These rules have changed with the transposition into Belgian law of EU Directive 2006/68/EC on the incorporation of public limited liability companies and the maintenance and alteration of their capital. Other changes have been made in relation to the acquisition of own shares when implementing this EU directive. This includes for example the following changes:

• the validity period of the “authorised capital” (i.e. powers granted to the board of directors by the general meeting in order to redeem shares) has been raised from 18 months to 5 years; and
• companies can now acquire own shares up to 20% of their corporate capital (this threshold has been raised from 10% to 20%).

These rules are laid down in:

• Section 620(1), fifth paragraph, (2) and (3) BCC as amended by the Royal Decree of 8 October 2009; and
• Sections 205 to 208 of the Royal Decree of 30 January 2001 implementing the Companies Code, as amended by a Royal Decree of 26 April 2009.

The new rules came into force on 1 July 2009 and apply to:

• Belgian listed companies whose stocks are admitted to trading on a regulated market (such as Euronext); and
• Belgian companies whose stocks are admitted to trading on an MTF (“multilateral trading facility”) that functions on the basis of at least daily trading and a central order book (currently Alternext and the Free Market).

These new rules govern (1) the procedures for reporting buy-back transactions to the CBFA, (2) companies’ obligations in relation to public disclosures of buy-back operations and (3) procedures aimed at ensuring the equal treatment of shareholders.

On 11 June 2009, the CBFA also issued a circular on the new rules.

 1. Procedures for disclosure to the CBFA

Listed companies and companies whose stocks are admitted to trading on an MTF that intend to carry out a share buy-back operation must now – before going through the buy-back procedure – send the CBFA a copy of the resolution by the shareholders in general meeting or by the board of directors and the relevant provision of the articles of association, if there is one, authorising the company to carry out such operations. They then have to notify the CBFA of actual consummation of the buy-back operation.

 2. Public disclosure of redemption operations

Greater transparency is now required in relation to buy-back operations: all operations for the redemption of own shares must be publicly notified. The information requiring to be made public includes details of the date of the transaction, the quantity of shares acquired, the price of the shares acquired and the method of trading used. The information has to be made public no later than the end of the 7th trading day after the date the buy-back is effected. This information must also be notified to the CBFA.

 3. Equal treatment of the shareholders

Previously, companies had to carry out their operations on a regulated market. Now, listed companies can purchase their own shares or certificates without having to issue a bid to all the shareholders. In order to do so, the redemption price has to guarantee the equality of treatment of all shareholders that are in like circumstances. Under this condition, therefore, the price offered must be equivalent.

The deciding criterion to ensure equality of treatment is therefore the price: the price offered under the buy-back operation must be equivalent to the price at which any other shareholder can, at the same time, sell his shares on a regulated market or an MTF.

Under the new rules, the price offered is regarded as equivalent and, thus, as guaranteeing the equal treatment of the shareholders or holders of certificates that are in like circumstances:

• where the buy-back is carried out through the central order book of a regulated market or MTF;
• if the redemption is not carried out through the central order book of a regulated market or MTF (say, a block transaction or a private deal), where the price offered for the buy-back is less than or equal to the highest current independent bid price in the central order book of a regulated market.

The new rules offer greater flexibility: listed companies or companies whose shares are admitted to trading on an MTF can now redeem their own shares:

• on the regulated market on which they are listed, or on the MTF on which their shares are admitted to trading;
• outside any market or organised trading system, through a broker or even by means of a private deal.

Thus, a company can also acquire its own shares by means of transactions called “crosses”, or via block transactions. In addition, it is possible for a company to acquire its own shares by way of a deal at the volume weighted average price (“VWAP”). In this case, a broker acquires shares on the market and, at an agreed time, the shares are transferred to the company at a weighted average price.

 4. Penalties

Breaches of section 620 BCC constitute a criminal offence. Moreover, shares, profit-sharing certificates and other certificates acquired in breach of section 620 are void ipso iure.

When listed companies acquire their own shares, they are also subject to the rules against insider dealing and market manipulation. Specifically, this means that companies may not acquire their own shares where they have information of direct or indirect concern to them that they know or ought to know is insider information.

Companies acquiring or transferring own shares are also subject to the transparency rules. In particular, where, further to a redemption, a company exceeds the statutory 5% voting threshold, it must notify the CBFA and ensure suitable public disclosure of the information. Failure to comply is subject to injunctions, administrative and criminal fines and/or imprisonment.

On 24 September, we hosted the first session of our M&A Academy season, which mainly dealt with access to the current debt market and alternative financing methods. Josy Steenwinckel , Financial Services Leader at PwC Belgium, introduced the subject before handing over to our guest speaker, Freddy Van den Spiegel, Chief Economist at BNP Paribas Fortis, who presented his view of the current economic situation and the possible challenges for companies and the banking sector in the coming years.

Download “Access to the current debt market and alternative financing methods“.

More info about the new M&A Academy season (programme, subscriptions, etc.).