By Anand Bala and Cheryl Chua
Chief executive officers (CEOs) and institutional investors globally have a positive outlook for mergers and acquisitions (M&A) in 2024. The 2024 EY CEO Survey reveals that CEOs are looking at M&As as a key lever to address their near-term priorities, with deals largely driven by the desire to acquire technology, new production capabilities or innovative startups.
CEOs and investors see an M&A uplift in 2024, with increased acquisitions and divestitures. Over 79% of CEOs and 71% of private equity leaders anticipate an uptick in megadeals (of US$10 billion or more) as the M&A market bounces back.
In any M&A deal, a pivotal choice revolves around the selection of the completion mechanism. There are two that take centre stage: the locked box and completion accounts mechanisms. Each carries attributes and potential challenges, differentiated by their timing for price determination, post-completion adjustment mechanisms and the levels of risk and certainty they offer to both buyers and sellers.
For a long time, the most common option for M&A transactions has been the use of completion accounts that are still in use in large parts of the world. In recent years, the locked box mechanism has grown in popularity due to a strong sellers’ market, an increased market demand for high-paced M&A transactions, and the desire for clean-cut exits, especially when private equity investors are involved.
Understanding the merits and drawbacks of both mechanisms is crucial for navigating M&A transactions for success. This article aims to provide an overview of these mechanisms along with their respective advantages and disadvantages.
Locked box mechanism
The locked box mechanism involves setting the price based on a balance sheet that is established at a predefined date before completion or on the most recent audited financial statements. The primary advantages of this mechanism are certainty and speed. Both the buyer and seller are aware of the precise price in advance, which allows for a streamlined transaction process without any post-deal adjustments. The locked box approach is efficient, not necessitating a set of post-completion accounts and therefore, is less resource-intensive – a crucial advantage in competitive bidding situations.
However, the locked box mechanism is not without its drawbacks. One significant concern is potential value leakage, which might occur from the locked box date until completion, as the seller retains control of the business. The buyer also runs the risk of assuming unknown liabilities or dealing with events that affect the business while the seller is still in control, without the option for price adjustments.
In this regard, it is critical to achieve satisfactory due diligence results, particularly financial, prior to signing. Buyers are often advised to safeguard the value of the target company from the locked box date until completion by incorporating a provision in the share purchase agreement (SPA) that obligates the seller to indemnify the buyer for any unauthorised depletion or extraction of value from the business during the locked box period.
Completion accounts mechanism
The completion accounts mechanism determines any price adjustment based on the actual balance sheet at the time of completion. The initial purchase price is subject to adjustments for transactions and balances that occur between the due diligence date and completion date, which are determined once the final accounts have been prepared and agreed upon, often, several months later. This mechanism allows the purchase price to reflect the actual financial position of the business at the time of completion and provides the buyer with the flexibility to adjust the price in response to unforeseen events or liabilities, thereby mitigating risk.
Despite its advantages, the completion accounts approach comes with its share of challenges. The post-completion adjustments can be complex and time-consuming, potentially leading to disputes regarding the interpretation and preparation of the final accounts. The SPA must clearly outline the details of the adjustment mechanism. This method also requires considerable time and resources to prepare and review the final accounts. Lastly, the absence of price certainty until the completion accounts are finalised could disrupt the financial planning for both parties.
Conclusion
In the M&A world, both locked box and completion accounts mechanisms have their own advantages and potential downsides. The choice between the two largely depends on the specifics of the deal, the risk tolerance of both parties, and the depth of due diligence that can be executed.
It is important to recognise that a one-size-fits-all approach may not suit every deal, and it is essential to assess the characteristics of each deal before deciding. For example, the locked box mechanism is less appropriate where the working capital or performance of the target company is subject to volatility since this cannot be entirely hedged in the SPA. On the other hand, this mechanism tends to be more popular for transactions involving targets in industries characterised by stable cash flows and predictable earnings (e.g. power and real estate companies).
No matter which completion mechanism is chosen, whether viewed from the perspective of the purchaser or the seller, it is crucial to pay close attention to the mechanics and corresponding safeguards provided for in the SPA and to have the support of experienced financial advisors and legal counsels.
Anand Bala is Senior Executive Director and Cheryl Chua is Associate Partner at Ernst & Young PLT. The views reflected above are the views of the authors and do not necessarily reflect the views of the global EY organisation or its member firms.
This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Member firms of the global EY organisation cannot accept responsibility for loss to any person relying on this article.
