European M&A: On the road to recovery? Insights from the United States

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Significant investment opportunities In the first half of 2013 the Economist Intelligence Unit carried out a global survey on cross-border M&A on behalf of Clifford Chance. The focus was on Europe - it explored M&A opportunities and current perceptions of key risks, against the backdrop of the complex political and economic environment. 370 Board-level executives and Heads of M&A from companies with annual revenues in excess of US$ 500m were surveyed, from across Europe, Asia Pacific, the Americas and the Middle East, and from across a range of industry sectors, including 60 respondents from US corporations.

The size of Europe’s economy, its central location and the quality of its assets mean it still is a key market for deal-making, in spite of the economic and political uncertainty. Among Europe’s strengths, US respondents cite its highly developed infrastructure, skilled talent and technological know-how. However, several recent high profile failed deals, such as the EADS and BAE Systems merger and the Yahoo purchase of Dailymotion, make executives wary of entering the European M&A market. In addition, US respondents remain cautious in their M&A strategy generally with 81% saying they are focused on organic growth, 62% on established markets and 73% on their core business.

Almost 60% of US respondents say that socio-economic uncertainty has increased their company’s appetite for M&A deals in Europe. US respondents are increasingly eyeing acquisition targets available for a bargain as the euro zone crisis depresses assets valuations. Low valuations, however, are deterring companies (including US companies) from selling their crown jewels – only 12% of US respondents say that their companies might sell assets in Europe in the next two years.

US respondents recognize that challenges and opportunities in Europe vary by country or sub region and report a clear preference for deals in the bigger and more stable economies of Western Europe and the UK over countries in Southern Europe or Central and Eastern Europe.Two recent deals by US bidders for UK targets illustrate this preference: Liberty Global’s bid for Virgin Media – Europe’s largest deal to date at US$ 23 bn – and Actavis’s bid for Warner Chilcott for US$ 5 bn.

The European M&A market remains weak, with the economic situation and political landscape continuing to negatively impact growth prospects in many parts of the continent. Despite this, we are seeing interest from US companies in accessing strong European brands and technologies, as well as some appetite for opportunistic deals where valuations are seen as favorable.

40%Over 40% of US respondents say Europe offers the most attractive growth and M&A opportunities for their company (higher than Asia Pacific and Africa/Middle East)

25%Almost half of US respondents will focus at least 25% of their M&A strategy on Europe over the next two years (as acquirer)

60%Almost 60% of US respondents will consider making an acquisition in Europe in the next three years

40%Over 40% of US respondents say that a recovery in the global M&A market will only happen after the European economy has recovered

European M&A is an important element of M&A strategy for US respondents

Craig Medwick, Head of Corporate – Americas

The European M&A market

Following a slowdown in European M&A in 2012, Q1 2013 deals in Europe totalled US$ 116.1bn, making Q1 the slowest quarter since Q2 2009, although inbound investment into Europe remained relatively strong. European M&A activity fell 6% in 2012 to US$ 678.7bn-worth of transactions and would have been significantly lower absent the Glencore/Xstrata deal and the sale of TNK-BP to Rosneft which together accounted for more than 15% of European M&A. Compared with the pre-financial crisis highs of 2007, the value of deals in 2012 was down by 54% (and the volume by 22%).

Non-euro zone M&A amounted to 56% of European M&A in 2012 – the highest proportion in more than a decade. 2012 was the worst performing year for euro zone deals since 2009 and the best one for European deals outside the euro zone since 2008.

In 2012, there were 1,000 private equity (PE) deals worth US$ 51.2bn and the number of PE-backed deals was down by an annual 17% in Q1 2013. In 2007, there were over 1,300 PE deals valued at US$ 117.9bn – in value terms, 2012 represents a plunge of 57% over 2007.

Although the value of M&A into Europe in 2012 fell by 16% over 2011 volumes were only down 6%, suggesting that while most “bet the firm” deals may be off the table for now, smaller deals are still getting done, and also that assets may be becoming available at more attractive valuations.

The value of transactions involving European targets comprised 30% of total global M&A in 2012, representing the second largest region behind North America, with a 40% market share. This is down from 50% in 2007. The most significant investment cross- border flows were from North America into Europe (US$ 147bn) followed by flows from Asia Pacific into North America (US$ 112bn). Bidders based in North America were responsible for 68% (by value) of inbound M&A into Europe.

Europe is the largest destination for US bidders representing over 65% of US outbound M&A activity (by value) in 2012, followed by Asia Pacific with 11% and Central/South America with 10%.

Clear divergence across regions/jurisdictions

Though Europe sometimes gets painted as a single investment destination, US respondents to our survey were more sophisticated in their approach, being able to differentiate between the opportunities arising in different regions of the continent.

Non-euro zone countries (including UK, Switzerland and Scandinavia)

n These countries provide platforms for European access with reduced euro currency risk

n Favored by US respondents to the survey, particularly the UK as illustrated by the recent bids by Liberty Global and Actavis

Western Europe

n Germany/Benelux/Austria – Strong balance sheets/cash reserves and relative immunity from the distress in other parts of Europe mean sellers’ valuations remain high and there are limited distressed opportunities

n France – Market remains somewhat paralyzed due to fiscal and economic policies introduced following the 2012 presidential elections and the consequent refocus of economic strategy

n US respondents are highly interested in Germany and the Netherlands

Central and Eastern Europe

n Russia – Concerns over fallout from presidential elections in March 2012 and perceptions of anti-foreign investment bias and general economic factors hindered M&A activity in 2012

n Robust activity is being seen across Czech Republic, Romania and Poland, in part caused by significant infrastructure investment from China

n Within this region, Poland and Russia are seen by US respondents as creating most significant investment opportunities

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European M&A: On the road to recovery?

Southern Europe

n Portugal/Greece – Sovereign divestments are underway and creating opportunities for inbound investments e.g. airports. Sellers have reduced price expectations, and this has led to increased deal flow – Portuguese deals rose to nearly US$ 20bn in 2012 (a five-fold increase on 2011 levels). In Greece, corruption concerns, low levels of tax collection, high labor costs and the continued risk of sovereign default/euro exit are key risks deterring investment

n Italy/Spain – Distressed assets are on the market. Sovereign divestments/privatizations are also creating opportunities for infrastructure and strategic investment. A wave of disposals of non-core businesses by large corporates/financial institutions continues. Brands and industrial assets are being targeted by foreign/local competitors; financial investors are also interested in assets generally. Risk factors include political instability in Italy, and completion of banking system reorganization in Spain. Company valuations are low and interesting targets are available at attractive prices

n US respondents are wary of the risks in this part of Europe

More and more of our clients believe that the current economic turmoil in Europe offers attractive opportunities for them to buy highly-coveted European assets at great value particularly in Western Europe. If the US Dollar strengthens against the euro this will also positively affect the prices of European assets.”

Reasons why US respondents are making disposals in Europe

Focus on core business

European assets are under-performing

Move into markets with better opportunities

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

European regions offering most attractive M&A opportunities to US respondents

Western Europe (including Germany, Benelux and France)

UK and Ireland

Northern Europe (including Scandinavia)

Southern Europe (including Spain and Italy)

Central and Eastern Europe (including Russia)

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 55%50%

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European valuations are beginning to rise: in the first quarter of 2013, the average price/earnings (p/e) ratio increased to 9.3 from 8.3 in 2012. However, that remains well below the pre-crisis highs in p/e multiples (12.7 in 2007).

Key drivers

Better values in Europe than in the US or emerging markets

n Over 35% of US respondents think assets in Europe are undervalued

– Approximately 20% think assets in the US and emerging markets are undervalued

n Factors depressing values – Exchange rate drop in euro – Default/distress under existing debt facilities – Debt repayment with no obvious means of refinancing

Top 5 reasons for US respondents to make acquisitions in Europe:

Secure unique know-how/expertise/technology/ eliminate emerging IP risks

Investing in new markets with good long-term growth prospects

Gain market share in existing markets

Acquire strong brands

Diversify product and/or geographic mix

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Top 5 features that make Europe an attractive place to make acquisitions:

Highly developed infrastructure

Availability of skilled talent

Access to developed technological know-how

High consumer spending levels

Size of European market

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Top 6 political and economic concerns

Economic growth rates

Labor regulations and industrial relations

Euro zone economic instability

Rising costs (labor/tax)

Weak European consumer confidence

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Currency risks6

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Deal execution concerns

n Euro zone/currency risks

– In the event a state exits the euro

– Exposure to sovereign debt or debt of euro banks exposed to sovereign debt

n Lack of IP protection

n Integration challenges – Easier in some jurisdictions (e.g. Ireland, Luxembourg,

Switzerland) than others (e.g. Greece, Ukraine) as a result of closer political and cultural affinities

While political and economic conditions are viewed as challenges to M&A transactions, they also open up opportunities. Remarkably, almost 60% of US respondents say that Europe’s socio-economic uncertainty has increased their appetite for M&A in Europe. However, almost half say that the risks of doing M&A in Europe far outweigh the rewards at the moment.

Key challenges

US respondents – European M&A in 2013

At the deal execution level, parties can minimize the transaction risk through deal structures and contractual mechanisms. In our 2012 survey of global corporates, Cross-border M&A: Perspectives on a changing world, we noted that three quarters of US respondents preferred partnerships and joint ventures to traditional M&A for their cross-border M&A. However when asked the same question about deal structures for European M&A, only 23% of US respondents preferred partnerships and joint ventures, while 50% preferred traditional M&A.

While we are seeing some use of US style acquisition agreements in some regions (e.g. Germany), generally European style acquisition agreements are used. A few differences in market standards between the US and European deals are worth highlighting:

n MAC clauses - over 90% of US deals include them while only a minority of European deals do

n earn-outs are also more common in US deals than in European deals

n the ‘locked box’ approach to transactions is prevalent in Europe (see page 8)

n arbitration clauses are more prevalent in Europe

n break fees are more common in US deals than in Europe, and when found in Europe, they rarely exceed 1% of deal value (see page 9)

of US respondents say that a closer fiscal and economic union in Europe would increase their interest

The value of European M&A is down significantly, in part because few very big strategic deals are being done. We expect the European M&A market in 2013 to consist mainly of acquisitions that are not material to the health of corporate balance sheets. In the short-term, deal flow will continue to be characterized by bolt-on acquisitions, non-core asset sales and bargain hunting.”

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Euro zone issues in M&A documents

Partly due to the uncertainty over euro exit scenarios, there are no wholesale changes to standard form documents to deal with euro exit. However, careful attention must be paid to the following provisions in acquisition agreements, which may be implicated by the exit of a euro zone member:

n Jurisdiction submission

n Governing law of contract

n Place of payment and performance

n Currency of payment definition

n Inclusion of ‘euro event’ clauses

– Non-payment

– Material adverse change

– Unlawfulness

– Breach of representation

– Indemnification

In addition, acquisition financing agreements need to address ongoing exposure.

When will the European M&A market recover?

When asked to consider when the European M&A market would recover, almost half of the US respondents think that it will take a least a decade to fully recover from the financial crisis.

Europe as a region is very diverse. The UK, Scandinavia, Benelux and the German-speaking countries will remain a refuge of stability where caution may prevail. The remainder of Europe will be more dependent on the sovereign debt crisis trajectory and more volatile, hence providing significant opportunity for the bold.”

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Representation and warranty insurance

While representation and warranty insurance has been available for many years both in Europe and in the US, premiums have significantly decreased in recent years and a claims history has developed. Although it is increasingly considered on a number of transactions, its use continues to be the exception rather than the rule in both regions. It can, however, be a useful tool to bridge a warranty gap, for example, when a financial seller will not give warranties or a distressed seller cannot. Either the buyer or the seller may be the insured, but it is the target’s representations and warranties that are the subject matter of the policy. The policies are drafted to be compatible with the transaction documents and can be issued in a timely fashion.

Buyers are using representation and warranty insurance in a variety of ways to their strategic advantage. In a highly competitive deal climate, it can allow a buyer to offer a more competitive indemnification package to the seller while still having the level of protection it would otherwise require. Representation and warranty insurance also is an attractive option for buyers dealing with financially-distressed sellers, as an insurance policy is likely more secure than a seller indemnity when the seller has credit or other financial difficulties.

Sellers seek representation and warranty insurance to eliminate or reduce the need for an escrow of sale proceeds after the closing. The insurance can also be particularly attractive to private equity funds looking to exit a portfolio company. It allows a fund to reduce the risk of contingent liabilities associated with the sale, allowing it to distribute to investors almost all of the proceeds or apply them to a new investment.

Locked box

The ‘locked box’ approach is more common in Europe than the conventional completion accounts approach, as sellers are unwilling to bear risks that could influence post-closing purchase price adjustments. The primary difference between the two mechanisms is the date of transfer of economic risk. When a completion accounts mechanism is used, the buyer will pay for the actual level of assets and liabilities of the target as at completion in accordance with a post-completion pricing adjustment. The final price is not known for some time after completion. In contrast, a locked box mechanism involves the parties agreeing a fixed equity price calculated using a recent historical balance sheet of the target prepared before the date of signing of the sale and purchase agreement. Cash, debt and working capital as at the date of the locked box reference accounts are therefore known by the parties at the time of signing and there is no post-completion adjustment (other than for agreed ‘leakage’). The economic risk and benefits of the business pass to the buyer from the date of the locked box reference accounts.

As the perceived risk of a major euro failure diminishes, inbound investors into Europe still face challenges around the continued economic slowdown, and increased political, regulatory and media focus. Despite these challenges, we expect that 2013 will see increasing opportunities opening up across ‘old’ Europe as sellers, including highly-leveraged sellers, dispose of non-core assets.”

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Break fees

In the US, termination or ‘break’ fees are widely used. They generally provide for compensation to the bidder (or, in a ‘merger of equals’, to either party) if the merger does not occur because of a competing bid or a failure of the other party’s shareholders to accept the offer. Break fees typically range from 2% to 4% of the value of the acquisition.

‘Reverse break fee’ provisions, requiring the bidder to pay liquidated damages if it fails to close, have become fairly frequent in transactions with private equity bidders. Reverse break fees typically range from 2% to 6% of the value of the acquisition, though recently we saw larger reverse break fees for failure to timely obtain antitrust clearances – Google/Motorola Mobility (20% of deal value) and AT&T/T-Mobile (15% of deal value in cash and assets).

In the UK, break fees are prohibited on public bids under the UK Takeover Code, except in very limited circumstances, while reverse break fees and shareholder break fees are occasionally agreed, at around 1% of the offer value. On private M&A transactions in the UK, break fees are used infrequently and when they are used, they range between 1% and 3% of the equity value of the target.

It is not market practice to find break fees on M&A transactions in France, Germany, Hungary, Ukraine, Belgium and Luxembourg. In France, a target may agree a break fee with a white knight on a hostile bid and, although while rare, if agreed, break fees do not generally exceed 2% of the deal value. In the Netherlands and Spain, break fees are used and are typically limited to 1% of deal value.

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“Lack of financing is not a problem for deal-making as cash remains the most popular currency for acquisitions. Cash has been accumulating on the balance sheets of global corporations, including US companies, as companies have been cautious in their approach to growth. The cash mountain has been a buffer against economic uncertainty, rather than a war chest for acquisitions. On the private equity side, we expect to see lower levels of leverage than they used to be.”

40%Almost 40% of US respondents say that cash is their preferred acquisition currency

Key global contacts

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Gary Boss T: +1 212 878 8063 E: gary.boss@cliffordchance.com

David Brinton T: +1 212 878 8276 E: david.brinton@cliffordchance.com

Joseph Cosentino T: +1 212 878 3149 E: joseph.cosentino@cliffordchance.com

John L Graham T: +1 212 878 4955 E: john.graham@cliffordchance.com

John A Healy T: +1 212 878 8281 E: john.healy@cliffordchance.com

Sarah Jones T: +1 212 878 3321 E: sarah.jones@cliffordchance.com

Steven T Kolyer T: +1 212 878 8473 E: steven.kolyer@cliffordchance.com

Craig S Medwick T: +1 212 878 8168 E: craig.medwick@cliffordchance.com

Robert Masella T: +1 212 878 8076 E: robert.masella@cliffordchance.com

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Timothy Cornell, Counsel T: +1 202 912 5220 E: timothy.cornell@cliffordchance.com

Daryl Fairbairn, Counsel T: +1 212 878 4960 E: daryl.fairbairn@cliffordchance.com

Ivan Presant T: +1 212 878 3154 E: ivan.presant@cliffordchance.com

Benjamin K Sibbett T: +1 212 878 8491 E: benjamin.sibbett@cliffordchance.com

Roger D Singer T: +1 212 878 3288 E: roger.singer@cliffordchance.com

Paul Meyer T: +1 212 878 8176 E: paul.meyer@cliffordchance.com

Robert Villani T: +1 212 878 8214 E: robert.villani@cliffordchance.com

Nicholas R Williams T: +1 212 878 8010 E: nick.williams@cliffordchance.com

Frederick Utley, Senior Counsel T: +1 212 878 8356 E: frederick.utley@cliffordchance.com

Our strength in Europe – US deals into Europe

Advised Motorola Solutions, Inc. on the takeover of Psion plc, a UK public company listed on the London Stock Exchange, for GBP 129 million

Advised Wellstream Holdings, one of the world’s leading suppliers of flexible pipes to the offshore oil industry, on its sale to General Electric for GPB 800million

Advised American Tower Corporation in its US$ 500 million acquisition of E Plus Mobilfunk, which includes 2000 mobile communications towers in Germany. This represents American Tower Company’s first investment in Europe

Advised MasterCard Incorporated on its acquisition of DataCash Group plc, a UK-based payment services business, for GBP 333 million

Advised EQT in connection with the sale of Kabel Baden-Wuerttemberg GmbH & Co. KG (KBW), the Germany based cable company offering television, broadband Internet and telephony services to Liberty Global, Inc., the US based international cable operator for EUR 3.16 billion

Advised Kraft Foods International on its GBP 11.9 billion takeover of Cadbury, and the subsequent spin-off of Kraft’s North American groceries business to create Mondelez International Inc.

United Kingdom

Advised Hearst on its US$ 1 billion acquisition of Elle, Elle Decor, Woman’s Day, Car and Driver and other magazines published throughout the world

France/Spain/Italy/Germany

Advised Textron subsidiary, Cessna Aircraft Company, the US based manufacturer of general aviation aircraft, on the acquisition maintenance, repair and overhaul facilities of Jet Aviation

Switzerland

Advised Citigroup in connection with its sale of UK-based EMI Group Limited, to Universal Music Group, Inc. in the US for GBP 1.2 billion

United Kingdom

United Kingdom

Germany United Kingdom

Germany

United Kingdom

This publication does not necessarily deal with every important topic or cover every aspect of the topics with which it deals. It is not designed to provide legal or other advice.

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© Clifford Chance US LLP, May 2013

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