News & Analysis

As private equity deal financing gets harder, sellers are granting favorable deal terms to buyers, such as deferred or performance-based payment, in order to close transactions.

Dealmakers say these structures also help bridge a growing valuation gap created by growing economic uncertainty and a tighter debt market. 

"People find ways to get the transactions done," said Markus Bolsinger, co-head of law firm Dechert's PE practice.  

One solution has been to include one or multiple provisions known as earnouts that allow buyers to defer a portion of the purchase price and make the remaining payments only when the purchased company meets certain milestones, such as reaching an earnings target, getting a regulatory approval or accomplishing a strategic sale. 

Last year, 21% of private mergers and acquisitions in the US contained earnout provisions, up from 17% in 2021, according to an upcoming study from advisory firm SRS Acquiom. Twenty-three percent of these deals incorporated an earnout measured on EBITDA target—a performance metric more favored by buyers than revenue—an increase from 16% recorded the year prior. These numbers don't include life sciences deals, because SRS Acquiom tracks the sector separately. 

About 18% of M&A deals involving PE buyers had earnouts last year, up from 15% in the previous year. Among these deals, 44% had earnout provisions measured on EBITDA growth last year, compared with only 10% in 2021.

Offering notes to finance sales

Another structure appearing more frequently is the so-called seller note: a form of financing where the seller agrees to receive a portion of the acquisition proceeds as a series of debt payments. 

A seller note ranks below the senior debt provided by banks or nonbank lenders to fund the acquisition. While the note is a form of subordinated debt, and hence carries more risk, it typically carries a lower interest rate—in the range of 5% to 8%—than mezzanine debt, said Reed Van Gorden, managing director and the head of origination at Deerpath Capital, a lower-middle-market private debt firm. 

In a recent example, industrial company Emerson Electric sold a majority stake in its climate technologies unit to Blackstone. The $14 billion deal included $4.4 billion in equity; $5.5 billion in debt funded by commercial banks and private debt lenders; and a $2.25 billion 10-year seller note supplied by Emerson at 5% interest.  

Emerson, which still owns a 45% stake in the business post-close, will get additional cash proceeds upon repayment of the seller note when it exits from its noncontrolling interest, according to an earnings presentation from the company. 

Bridging the gap

Why are these structures gaining popularity now? 

One reason is to bridge the valuation gap. To make a buyer comfortable with a higher valuation, sellers would agree to delay receiving part of the sale proceeds or make some of the consideration contingent on post-close performance. 

A discernible difference exists between a buyer's and seller's expectations of what a company should be worth, a reverberation from higher interest rates and murkier economic outlooks. 

"In today’s market, buyers are worried about paying too much and sellers are worried about selling for too little," said an industry expert who works with PE firms to fund buyouts. 

As the Federal Reserve sharply increases rates to cool inflation, the rate that investors use to determine the present value of future cash flows also climbs higher. Future earnings are worth less in today's dollars than if they were calculated at a lower rate, which brings down investors' valuation estimates for the target company. 

"Because the cost of capital is higher, buyers are expecting that sellers will cut the price if they want to get the deal done," said Mitch Berlin, accounting firm EY's strategy and transactions vice chair for the Americas. "The deal is only worth so much. If the interest rate goes up, then the cost of the target has to go down if they want to transact."
At the same time, investors are placing less credence in the forecast of a company's future earnings due to a lack of certainty over the direction of the economy and the markets. 

"If the buyer is unsure about the acquired company's future earnings and wants to hedge a bit—especially now, because of the economic environment—they can do an earnout with the goal of holding back some [proceeds] of the deal," Berlin said. "Ultimately, if the acquired company doesn't hit certain metrics, the buyer gets to keep what it’s holding back through an earnout."

Another factor contributing to the greater use of these structures is the tight credit market. Debt for funding leveraged buyouts has grown scarce as banks and nonbank lenders toughen lending standards. If buyers cannot fetch all the leverage they want from lenders, they have to commit more equity to the deal. Some buyers would turn to sellers in the deal to fill the funding gap.

While it is favorable for buyers to have some kind of seller participation in deal financing, these convenient measures eventually have to be paid off. 

"Earnouts and seller's notes are not free money; they are real debt on the business as someone has to pay the contingent payments when they are due," Van Gorden said. 

Kip Wallen, SRS Acquiom senior director, expects these structures will stay if adverse market conditions persist. 

"If deal activities start to take off, we might start to see sellers have more negotiating leverage and we will see fewer earnouts and fewer seller notes," he said. "But if we don't get that hockey stick moment, we will continue to see buyers make headway in that area and those types of deals tick up."

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