Buyers in M&A must take into account indemnification issues when dealing with private equity

Buyer beware

22 January 2008 00:00  [Source: ICB]

Acquisitive chemical companies must consider indemnification aspects when negotiating deals with private equity sellers

Bruce Chalmers and Paul Criscuolo/ PricewaterhouseCoopers

MANY IN the chemical industry have now grown accustomed to dealing with private equity firms. But now, as these entities begin to exit their substantial investments, buyers will need to adapt to negotiating with them.

These negotiations can be different from those with traditional corporate sellers because of the unique nature of private equity firms and their business model.

Private equity funds typically have a relatively finite lifespan, with funds raised, invested, investments exited, and capital returned, all in less than 10 years.

One of the key differences encountered in the negotiation of private equity deals relates to the indemnification of liabilities.

Many chemical transactions have significant valuation issues related to risk exposures that may take many years to manifest to a point that would allow them to be quantified with any reasonable level of accuracy.

Historically, the buyer's method of dealing with these issues was to gain comfort on the exposure through due diligence and valuation, and to manage any uncertainties through indemnification language in the purchase agreement.

In the latter, the seller retains responsibility for at least a portion of the exposure, thus allowing the purchaser to mitigate the risk associated with the deal.

Similarly, corporate sellers have often been willing to accept indemnification of many of these exposures in order to facilitate the transaction.

The merit of the seller's indemnification must be weighed against its ability or posture toward indemnification. And the length of time the seller's indemnity will cover must also be considered.

And buyers, too, may find negotiating indemnification from private equity sellers is different from their experience with corporate sellers.

Understanding this difference and the reasons for private equity sellers' limitations on indemnifying exposures will help companies prioritize their due diligence procedures.

If the buyer wants the seller to pay certaincosts related to uncertain exposures, it is im-perative that they agree on how to deal with these costs, which could range from cost sharing to limited or full indemnification.

As long as the exposure can be delineated and the cost clearly identified when incurred, this can be a straightforward solution to addressing exposures that could have otherwise become potential deal breakers.

TIME LIMITATIONS

But private equity sellers have an inherent difference that makes it difficult for them to indemnify exposures that may take many years to materialize.

More specifically, private equity firms make acquisitions with a discrete pool of funds that are raised, invested, liquidated and returned to their investors within a relatively short period of time.

During the life of a fund, private equity firms will buy and resell assets (or take the company public) typically within a three to five-year period. Once all funds are returned to the investors and the fund is closed, there is nothing of substance left to fund payments required, if any, under the terms of an indemnification.

This requires the buyer to determine how to value the risk of pretransaction exposures that will not materialize until sometime post-transaction, perhaps even after the private equity fund is closed.

For example, like many corporate sellers, private equity sellers saddled with environmental exposures often find them difficult to quantify, and a lack of relevant data creates uncertainty as to the extent of the issue, remediation requirements, and magnitude and timing of related costs.

Sometimes the triggering event for environmental exposures will not occur for several years, such as the closure of a landfill or a plant nearing the end of its useful life.

A TAXING ISSUE

Similarly, tax exposures are often difficult to quantify with any reasonable certainty due to the fact that the triggering event for any tax exposure will be a third-party audit

conducted by the related taxing authority.

Although the relevant taxing authority often has a limited number of years in which to perform these audits (for example, generally within three years after a return is filed in the case of US federal tax law) and identify any potential exposures, the ultimate determination of any liability may take even longer.

Note that certain tax exposures may be mitigated by the transparency created through the recent adoption of FIN 48 by the US Internal Revenue Service. Under FIN 48 standards, taxpayers are required to disclose and quantify uncertain tax positions.

One potential option is to negotiate that a portion of the purchase price be set aside in escrow to cover specific pretransaction liabilities that will not be settled until after the transaction.

However, even under circumstances where a seller agrees to escrow a portion of the purchase price, the seller's time frame for closing out its funds will only make this approach practical for liabilities that will be settled in the short term. It would be rare for a private equity seller to agree to escrow for more than a one-year period.

Buyers will need to estimate the valuation impact of longer-term exposures and deter-mine if such exposure fits their risk tolerance.

Taking this approach requires firms to prioritize their due diligence efforts to assess these exposures at the front end of the process, and determine whether enough information can be gathered to delineate the risk.

There is no substitute for robust due diligence, which not only identifies risks, but also quantifies the financial implications. This will certainly require technical reviews of environmental reports and possibly ­environmental reviews during the deal.

ADJUSTING FOR RISK

Once the buyer starts to get a rough picture of the potential risk, they will then need to determine if the risk can be properly dealt with in the purchase price.

If risk uncertainty does not fit the buyer's risk appetite, the buyer can decide to walk from the deal, attempt to secure indemnification or cost sharing, or insurance.

There is an environmental liability insurance market which provides coverage for first-party liabilities, that is, clean-ups, and third-party liabilities.

Several major insurers offer products to meet buyer needs for such coverage in the deal environment. This coverage is not cheap, and like all insurance coverage, it has limitations in terms and policy limits.

If insurance is deemed desirable, the insurer should be brought into the process as soon as possible, as their underwriting needs will be comparable to the buyer's environmental due diligence needs.

Insurance may not be a silver bullet, but it can be an important risk-mitigation device. One distinctly desirable feature of insurance is that it helps the buyer to ring fence exposure, and reduce uncertainty. The buyer can bear the cost of the premiums or attempt to negotiate cost sharing with the seller.

Any cost sharing or indemnification agreement needs a specified trigger as to when monies will actually be expended, or costs indemnified.

Will a post-deal wait-and-see approach be mutually satisfactory? Or should more determinant triggers such as Phase II environmental analysis conducted by mutually agreeable environmental engineers immediately post-deal be a more favorable way to deal with indemnification or cost sharing?

While a buyer may want certainty, so does the seller. The seller will need to know how much and when. As such, open-ended cost sharing, hold-backs or indemnification may not be acceptable, and may inhibit what each party desires - a consummated deal.

Additionally, the buyer should communicate these priority issues as quickly as possible to the seller in order to maximize the opportunity for finding a mutually agreeable solution early in the process, rather than finding it to be a deal breaker later.

Identifying these issues early on will allow the time required to engage the proper experts to assess the magnitude of the risk and value likely outcomes.

In addition to the technical expertise required, having financial, insurance risk management and legal resources with significant private equity expertise on the due diligence and negotiation team will ensure a successful deal process.

Bruce Chalmers joined Pricewater- houseCoopers in 2006 as a director in the Transaction Services Group focusing on the chemical and related industries.

Since joining, he has advised corporate and private equity clients, providing due diligence services for mergers and acquisitions. Prior to joining PricewaterhouseCoopers, Bruce was director of corporate development for Millennium Chemicals.

Paul Criscuolo has been a practicing state and local tax consultant for approximately 10 years. He specializes in state and local income tax consulting, including all aspects of planning and audit/controversy resolution. Paul obtained his bachelor of business degree and Juris doctorate from Seton Hall University School of Law in New Jersey, US, and his LLM in taxation from Georgetown University Law Center, Washington D.C.

For more information, go to www.pwc.com

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