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Loyens & Loeff China Team Practice Notes Controlled auctions: defining aspects of a controlled auction process and what Chinese buyers should be aware of
This issue of the Loyens & Loeff China Team Practice Notes describes the key features of the so-called controlled auction sales process. A controlled auction is a divestment method whereby the seller aims to maximize the sale
proceeds (purchase price) by creating, through a privately regulated process, competition
among interested parties and achieve a sale with the highest possible purchase price
available in the market. Controlled auctions are commonly used in today’s private M&A
practice.
Controlled auctions are not specific to any particular jurisdiction – the type of process is
common in the US and European markets.
Given the popularity of controlled auctions in today’s markets, buyers from China are
likely to be confronted with this type of transaction process when acquiring businesses
abroad. Because of the strict rules of play, the specific expectations of sellers and their
advisors, and the typical negotiation dynamics which result from the controlled auction
process, it is critical for Chinese buyers, in order to be successful, to have a thorough
understanding of what the controlled auction process entails.
This document by way of general introduction outlines the key features of the controlled
auction process and provides a summary of key differences between controlled auctions
and privately negotiated transactions (so-called one-on-one transactions).
Key objectives of the controlled auction The overall purpose of selling a company or business by way of a controlled auction is to
help the seller in achieving the highest available purchase price and the best available
terms and conditions of sale in the market. This is achieved, in essence, by creating
competition among two or more buyers in a strictly regulated sales process which the
seller aims to control as much as possible. Also, the risk for the seller of a transaction
being aborted is far less likely in a controlled auction, given that there will be multiple
bidders. On the seller’s side an investment bank or corporate finance adviser is commonly
involved as intermediary whose task it is to coordinate the entire process on behalf of the
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seller. Contacts with the sell-side (including the management team of the target company)
actually take place through this intermediary as the sole communication channel among
seller and bidders (for example, bidders will also be prohibited from seeking direct contact
with the seller and strict non-disclosure commitments will have to be agreed to by the
bidders).
This is essential: bidders are prohibited from communicating about the target, the sales
process and deal terms with any third party, including each other. Logically, the
uncertainty about the position which other bidders may be taking increases the chances
of out-bidding (competition among bidders offering a higher price to win the auction). For
this reason also, bidders may find that the seller organises a number of subsequent
bidding rounds in which bidders are given the opportunity to raise their bids and change
the terms and conditions of the bid in order to “stay I the race”. Due to the competition
which is created by multiple bidders simultaneously participating, the eventual purchase
price may be pushed beyond valuation levels which would otherwise not be attainable for
the seller.
Shifting M&A practice: controlled auctions,
faster deals, and cash-flow based valuations Traditionally the belief was that strategic buyers would be able to offer higher prices
because of the synergies that could be implemented post completion. During the past 10
to 15 years, this has changed considerably, as financial buyers (such as private equity
firms) started to dominate the M&A market (both on the sell-side as well as on the buy-
side) applying high gearing methods (financing the transactions with debt).
Valuation became almost entirely cash-flow based and this replaced the typical valuation
basis of net asset value which was used in earlier days. In a cash-flow based valuation,
the target is valued based on a multiple applied over the yearly EBITDA (Earnings Before
Interest and Taxes, Depreciation and Amortisation) of the target (the so-called enterprise
value), from which the debt of the target is deducted (to arrive at the so-called equity
value). Notably for Chinese bidders, it is relevant to understand that net asset value, a
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valuation method often applied in Chinese M&A transactions, is rarely seen in the
European and US markets anymore.
Over the past years, controlled auction deal processes were completed in ever shorter
time-frames, and typical terms and conditions such as those pertaining to deal risk and
residual liability of the seller, changed fundamentally as well. Where previously sale and
purchase agreements (“SPA’s”) were normally drafted by the buyer’s advisor and often
buyer-friendly, as a result of controlled auctions this has changed fundamentally and in
practice, sellers take the initiative in drafting and will present a seller-friendly SPA as the
opening proposal for bids and negotiations.
However, we now witness that strategic buyers return to the market, and that the rather
extreme pressure on the controlled auction transaction process (some major deals were
closed in a few weeks from start to finish), is easing somewhat. Further, recently we see
again more variation in deal terms such as price / valuation, risk allocation, etc. Having
said this, the controlled auction of a cash-flow based valuation remains still very much the
type of sales process most frequently used. And indeed, not all controlled auctions are
concluded with lightning speed: just as easy a controlled auction process can become a
drawn out, very time-consuming affair. Particularly so, if it is not tightly and properly
managed by the seller; this can exasperate bidders and turn the controlled auction into
failure.
Key differences among controlled auction
sales and negotiated acquisitions Negotiating balance The main difference when comparing the auction process and the privately negotiated
process is that the seller takes more control over a number of important aspects of the
transaction such as timing, due diligence and information sharing, the first draft of the
Share Purchase Agreement (“SPA”) and choosing the ultimate winning bidder. To a
considerable extent, the bidder will have to play by the rules of the game as determined
by the seller, at the risk of being disqualified for a next round. By contrast, in a privately
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negotiated transaction where just one purchaser negotiates with the seller, the process
often is much more balanced looking at the respective starting positions of seller and
buyer.
Risk allocation in contract The controlled auction process has also led to a shift in deal risk from the seller to the
buyer. Where typically sellers used to provide rather extensive warranties about the target
and were accustomed to accept relatively substantial maximum liability thresholds, in
controlled auctions this fundamentally changed. Sellers will at an early phase of the
process distribute to the bidders a proposed SPA on which bids are invited (with mark-ups
requested to be kept to the very minimum). That first document may be extremely seller-
biased or, within reason, clearly in favour of the seller. In either case, the idea is that
bidders will in principle have to accept the terms proposed. For the buyer, this means that
either the bid price is adjusted downward to reflect that more liability is taken on board
than perhaps anticipated (so additional risk assumed equates a reduction of the bid
price), or to submit a mark-up and hope to thereby “regain some ground” in the
negotiations, if not refused to proceed to the next round.
Due diligence reversed Rather than responding to the due diligence request of a buyer in a one-on-one
transaction, the seller in a controlled auction will in advance gather from the management
all information relevant to the target and its business in order to prepare for a structured
form of information sharing with bidders. In order to get comparable bids it is obviously
important to the seller that all bidders obtain the same information. This may take the form
of documents brought together in a so-called data room (often virtual, so electronically
accessible), and/or the preparation of an Information Memorandum, and also the making
available of so-called Vendor Due Diligence reports (by legal, tax and financial advisors).
Thus, the seller seeks to disclose at an early stage all facts and issues which may be
relevant to the bidders, subsequently reasoning during negotiations that the bidder’s
valuation took into account all that was already disclosed in advance. Therefore, buyers
will need to factor in to their bid (and notably the purchase price) as much as possible any
negative value elements and risk factors which are disclosed to them up-front. In the
definitive SPA, the seller is highly unlikely to accept any residual exposure for those
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items. Generally in M&A, undertaking proper due diligence is of critical importance to any
prudent buyer, but this all the more true in controlled auctions.
Confidentiality Sellers also need to be careful of public exposure and confidentiality issues, which are far
greater in auctions. Substantial amounts of company private information may be disclosed
to a number of bidders, albeit under strict confidentiality undertakings (and sometimes the
more sensitive information is only made available at a later stage in the process and to
the ultimate bidder only). Note that it is usual to see the strongest imaginable non-
negotiable confidentiality undertakings being put forward by sellers in auctions, serving
the purpose of scaring away those bidders that are mainly interested in just “having a look
around”. If too many bidders are involved, the risk of competitors gaining important
insights will be high.
Prospective bidders need to pay special attention to the non-compete, exclusivity and
non-solicitation agreements that may at times restrict the future activities of the bidder
even if the bid does not cross the first round.
Timing and resources committed It certainly should not be underestimated that bidders will need to apply significant
resources and incur considerable expenses to participate in controlled auctions, and this
during a phase of negotiations where it is far from likely that they will be selected as
winning bidder. For this reason also, bidders aim to be granted exclusivity prior to
undertaking a full-fledged due diligence and prior to engaging in detailed negotiations
about the SPA.
Role of target’s management The management team of the target business obviously plays an essential role in the
controlled auction. For the seller, it is necessary to prepare management properly for the
role it needs to fulfil. It takes a substantial effort from the seller in preparing and managing
the entire transaction process. This results in management of the seller and the target
having to spend far more time in the early preparatory stages of the process than they
would in a negotiated acquisition. The seller will also need to put in place imaginative
solutions to keep management focused and motivated on both the day to day business
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and the auction process, as well as to keep their loyalty with the seller until the deal
closes.
The controlled auction process Several factors (such as the expected number and nature of bidders, the intended
timeline for closing, etc.) will play a crucial role when defining the process that the auction
process will follow. Generally speaking, the process will comprise the following main
phases:
(i) The process will be kicked-off by the distribution by the seller’s financial advisor of a
“teaser” including limited and usually anonym information regarding the target
company and a confidentiality agreement.
An invitation letter or process letter will be distributed to the prospective bidders that
have shown their interest in participating and that have signed the Confidentiality
Agreement. Usually the information memorandum will be sent together with this
letter. One very common fault to be found in the information memorandum is that it
contains optimistic information as regards certain key contracts or entitlements of the
target which cannot be supported, or even is contradicted, by the due diligence
information which is provided at a later stage. Always good for the bidder to point out
such inconsistencies once due diligence has been concluded – it is very important to
read the information memorandum thoroughly!
The process letter will mainly set out the prospective phases of the process and an
invitation to submit offers (in the form and manner delineated in such letter) for the
acquisition of the target company. The information memorandum will provide the
basic information on the target to enable the bidders to prepare their first offer,
subject to due diligence. The importance of careful legal language in these initial
documents cannot be underestimated, both from a seller’s and from a buyer’s
perspective in order to (i) ensure proper confidentiality protection and recourse for
breach of undertakings, and (ii) avoid “pre-contractual” commitments arising
inadvertently. The seller will need to keep sufficient discretion in the direction of the
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process, the selection of shortlisted candidates, the refusal of offers, etc. The bidder
will wish to specify the nature of the bid (in this phase: non-binding) as well as the
conditions precedent to any binding bid. The most essential element for both seller
and bidders as the process develops is to avoid being unwittingly bound to a contract
or to be obligated to continue negotiations or to compensate the other side its costs
or even damages in case of a decision to abort the transaction. The degree to which
this concern arises varies per country (in the Netherlands for example this is certainly
not a negligible risk which has to be specifically addressed).
(ii) The offers. The seller should set out in some detail the type of offers it is expecting to
receive. When describing the phased process, the invitation letter should also lay
down the rules for the offers. The seller progressively loses its enormous bargaining
power as the process develops so it will try to make the most of it while it lasts (which
sometimes goes on till the very end, as it is not unusual to see how final negotiations
are conducted almost simultaneously with various bidders). Generally speaking, the
seller should therefore try to close as many issues as possible earlier in the process,
while the Buyer will keep open as many issues as possible until the later stages. With
that aim in mind, the instructions would have to also detail the information to be set
out in the offers, such as
(a) a description of the prospective purchaser and group and syndication, if at all
allowed;
(b) the prospective purchaser’s commercial rationale in making the acquisition;
(c) the consideration, funding, form, structure and value assumptions;
(d) the level of approval obtained for the offer, the principal conditions to which the
proposal would ultimately be subject and timeline for completing; and
(e) a description of the level and scope of due diligence the Purchaser would expect
to undertake prior to completion, additional to the preliminary investigation.
(iii) The due diligence investigation. The Seller will afford the bidders the possibility of
conducting due diligence investigations into the affairs of the target company. The
Seller may also provide a Vendor Due Diligence Report (see above). The amount of
information given and moment in which such investigation will take place will depend
on the strategy and particularities of the transaction. Generally, the bidders will be
given access to some preliminary information to prepare their first non-binding offers
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and shortlisted candidates may be given broader access to information in a
subsequent round of investigation. Sellers may be conducting very aggressive due
diligence tactics, which combined with the usual request of general disclosure
against the warranties, puts a lot of burden and risk on the buyer and its advisers.
For example, virtual data rooms are constantly updated with tons of information and
keeping a proper track of all information disclosed is an arduous and very complex
task for the buyer and his team.
(iv) The acquisition agreement (SPA). At some point of the process, either together with
the information memorandum or, at a later stage, as a specific distribution to
shortlisted candidates, the seller will submit the form SPA that the seller is willing to
enter into to sell the target company. The bidders will then be asked to comment
upon on it (usually by way of a mark-up rather than a list of comments, though many
bidders will basically ignore this rule). Generally, the first draft SPA submitted by the
seller will be a clear “seller’s model” while giving way to some balance according to
the strategy defined in the particular transaction. The bidders will normally try to get
by with general, politely worded comments rather than detailed comments. It may
prove to be a wrong tactic by the seller to put forward a ridiculously one-sided
agreement. If issues have been disclosed in the due diligence information, it may be
better to deal with them in the SPA rather than leaving it up to the purchaser to factor
them in the bids. For instance, a litigation which the seller believes has no merit may
be better off being kept by the seller rather than transferred with the business and
having the buyer discount the purchase price for the maximum exposure that the
litigation may result in.
As the competition for deals has increased during recent years, potential buyers
have sought ways to differentiate their offers from those of rival bidders. Buyers have
gone to unprecedented lengths to structure deals and agreements designed to
smooth the way to closing. Terms have become less restrictive, such as the buyer’s
willingness to waive provisions that would have made closing dependent on securing
financing for the deal. Buyers also have agreed to limited indemnification rights for
post-closing claims, such as higher deductibles, shorter survival periods for
representations and warranties, and lower caps and escrows. Again, buyers have to
rely more on due diligence rather on post-completion warranties, though,
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paradoxically, the due diligence exercise is conducted in less time and in more
difficult conditions. A bidder should be aware of the following “trick” often used by
sellers in an auction process. After receiving the bidder’s initial submission of a mark-
up or issues list, a seller may request modifications to the contract comments in
order to “put a buyer’s bid on equal footing with the other bidders.” Frequently, this is
a transparent attempt to have the bidder negotiate against itself, and if his indeed is
the case and the point has no merit, it should be strongly resisted by a buyer.
(v) Selection of the preferred bidder. Once the preferred bidder or bidders have been
selected, the seller will engage in final discussions with them with a view to signing
and completing the transaction. From that moment, as mentioned above, it is in the
seller’s interest to have most of the critical issues defined and agreed, leaving for the
last stage only the very final touches to the SPA. The seller will have, by then,
discarded the other bidders and the risk of breaking the negotiations with the
preferred bidder may well entail a difficult path to try to get one of the discarded
bidders back on board. The target is by then a “”tainted asset” and it will be very
difficult for the seller to achieve the same purchase price/ valuation again.
(vi) Signing and completion. The last phase of the transaction is one where controlled
auctions and private negotiated acquisitions are highly similar. In a so-called two-
step deal, the signing date and the closing date (which is the date on which legal title
to the shares in the target entity is exchanged for payment of the purchase price) are
separated dates. This to allow for conditions precedent to the transaction to be
complied with, such as anti-trust clearance, consent of important third parties,
regulatory approvals not yet obtained, and others. Having said this, in view of a
sellers desire to achieve as much “”deal certainty” as possible in an early stage,
controlled auction SPA’s are likely to contain fewer conditions precedent than the
SPA in a negotiated transaction.
Conclusion and recommendations Controlled auctions have become a standard type of sales process. Chinese enterprises
looking to acquire or European or American targets, will most likely be confronted with
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controlled auctions. A good understanding of the mechanics of this sales process helps to
identify the optimal bidding strategy in each individual case, and to prevent
disappointments.
Buyers should enter the process well-prepared and with the support of legal counsel,
knowing that time-lines will be short and that a loss of momentum, or exceptional
conditions to a bid, may put them at a considerable disadvantage to other bidders. Finally,
buyers should be aware of premature commitments, meaning that the precise language of
documents to be executed (such as offer letters, letters of intent, memoranda of
understanding, heads of agreement or otherwise), whether called non-binding or binding,
must be carefully reviewed by legal counsel to prevent premature commitments from
arising.
Loyens & Loeff China team The China Team of Loyens & Loeff, led by corporate M&A partner Ewout J. Stumphius
comprises a number of experienced M&A transaction lawyers (in combination with
Mandarin speaking qualified attorneys) with expertise in advising Chinese clients (on
European M&A transactions, tax structuring and otherwise). The China team (working in
tandem with the Loyens & Loeff Hong Kong and Singapore offices) will be more than
pleased to address any questions you may have or to assist in any particular transaction
you may want to look into.
For contact details, please see below or visit our website at www.loyensloeff.com.
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Annex – Contact details
Ewout Stumphius Attorney, Partner, Head of China Team
Rotterdam Office
T +31 10 224 66 07
F +31 10 224 61 83
M +31 651 28 94 12
Pieter de Ridder Tax adviser, Partner, Head of Singapore Office
Singapore Office
T +65 6532 3070
F +65 6532 3071
M +65 961 583 27
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Xian Kong Attorney, Member China Team
Rotterdam Office
T +31 10 224 67 09
F +31 10 412 58 39
M +31 653 37 79 09
Carola van den Bruinhorst Tax adviser, Partner, Head of Hong Kong Office
Hong Kong Office
T +852 3763 9300
F +852 3763 9301
M +852 9858 0861