How to bridge the valuation gap in Ireland’s thriving PE market

Challenges to deal-making remain, though – including how to reconcile the different valuations would-be sellers and buyers are placing on target companies.

Market overview

Ireland has many robust businesses with the potential to expand internationally in high-growth sectors such as financial services, technology, life sciences and healthcare. This has been long recognised by domestic PE houses on the island but is increasingly acknowledged by US- and UK-based PE investors too.

The Irish economy is not immune to the challenges and uncertainty impacting elsewhere. In its annual global CEO survey, PwC Ireland found that 83% of respondents from Ireland expect global economic growth to decline in 2023. Yet, other findings suggest that the outlook in Ireland remains more positive than in other jurisdictions.

For example, the PwC survey found that 85% of CEOs in Ireland remain confident about their own company’s revenue growth prospects despite the wider economic challenges, and far fewer Irish CEOs appear concerned about the long-term viability of their company relative to CEOs elsewhere – 21% versus 39% globally.

That PE investors view Ireland as an attractive jurisdiction is no surprise given this wider context, and the attitudes of potential target companies towards prospective external investment helps to reinforce this: Melior Equity Partners, a private equity investment firm headquartered in Dublin, surveyed SMEs in Ireland and found that 64% have considered taking on an investment partner – predominantly for the purpose of using the capital to grow their business.

Our view is that PE activity will be particularly strong in the second half of the year as macroeconomic factors that play into deal-making improve.

However, as in other jurisdictions, in many cases, would-be buyers and sellers take a different view on what a company is worth. This poses a challenge to deal-making, but there are structures and mechanisms that can be used to overcome this gap in pricing expectations if parties are willing to get creative.

Earnouts

An earnout pricing structure involves the payment of a purchase price in instalments, with the amount paid in each instalment being determined with reference to agreed benchmarks. They can be provided for in the sale and purchase agreement.

Earnouts can serve as an effective bridge between the different valuations given to companies by buyers and sellers by providing for increased consideration to be paid by the buyer post-acquisition where the company achieves certain performance targets, such as revenue or profit margins. Commonly, the level of consideration payable is determined on a sliding scale basis – depending on how performance tracks to the agreed benchmarks.

The period earnout mechanisms apply for vary, but they commonly are in place for one or two years only post-acquisition.

Similar to earnouts, ratchet mechanisms can also be used to compensate the management team and other shareholder investors at the target company if certain rates of return are achieved post-acquisition.

A risk with earnouts is the potential for mistrust to develop if buyers are perceived to take actions post-acquisition that limit the further consideration they are bound to pay, such as by diverting revenues away from the target group so as to make achievement of the benchmark more difficult. Protections against this can be provided for in the sale and purchase agreement from the sellers’ perspective.

It is imperative for parties to agree on not only the benchmarks but the methodology for calculating performance against them to avoid the risk of disputes arising post-transaction.

Rollovers

‘Rollover’ arrangements are where sellers invest a percentage of the proceeds from the sale of the business back into that business, effectively co-investing with the PE investors in the process.

These arrangements enable sellers to benefit from the growth in value of a business post-acquisition.

From a buyers’ perspective, the mechanism also helps address cases where they do not have access to all the cash necessary to meet a sellers’ valuation. Rollovers are a common feature of private equity transactions, as a tool for incentivising management shareholders who are remaining in the business post-acquisition. Where there is a valuation gap, the rollover can be used as a means of bridging the gap, by allowing management to take less cash off the table on completion, but giving them a greater equity stake in the business.

Minority deals

Where a valuation gap exists, some buyers may be attracted to make a minority investment in the target company and agree with sellers to put in place ‘put and call options’ over the remaining shares.

Under this arrangement, buyers will initially obtain a stake in the business of less than 50% alongside a contractual right to acquire the remaining shares at an agreed price. At the same time, sellers retain a contractual right to sell the shares at an agreed price.

This means buyers stand to benefit if the value of the shares increases above the agreed price post-acquisition, since they can acquire them for less than what the seller might obtain on the open market, while sellers stand to benefit if the value of shares falls below the agreed price. Risk is therefore shared. Vital for both parties is agreeing a future price that they can live with.

While from a company law perspective PE investors with a minority stake would not be considered to be in control of the company, in reality, coupled with the right to appoint directors to the board, the shareholders agreement typically provides for them to exercise negative control over the way the company operates post-transaction.

‘Anti-embarrassment’

‘Anti-embarrassment’ clauses can be inserted into sale and purchase agreements to effectively spare a seller from embarrassment in the event they sell the business at a price that proves, in a relatively short period of time, to be significantly under value.

This might happen, for example, where a business is acquired and wins a substantial new contract within weeks that is transformational in terms of its performance and value to third parties.

The anti-embarrassment clause provides that the buyer pays additional consideration to a seller in the event they sell on the business for a profit within a specified timeframe post-transaction, often a year.

Gerry Beausang and Lisa Early of Pinsent Masons, together with a panel of industry experts, will be discussing the valuation gap and other M&A market trends in the Irish private equity market at an event in Dublin on Tuesday 14 March. The event will also include an in-depth interview by Tom Lyons of The Currency with Eoin Goulding, founder of leading Irish cyber security business Integrity360. Registration for the event is open.