South Africa is not immune to the global mergers and acquisitions (M&A) valuation gap between the price sellers are willing to accept and that which purchasers are willing to pay. In a stretched financing market and a strained broader global economy, one solution to the valuation gap may lie in implementing a contingent value right (CVR).
The boards of target companies and purchasers have long been divided on the appropriate valuation for a takeover of a target company. The target board seeks to maximise shareholder value and will be reluctant to sell in a downcycle when valuations are low, even if the price is reasonable, given the prevailing economic circumstances. The purchaser's board, on the other hand, will generally be looking to invest against the cycle or to merge for long-term strategic reasons, and is likely to be looking to do so at a time when the lower valuations favour its proposal or strategy. While the purchaser will likely be viewing the acquisition with a longer-term lens, it will nonetheless be concerned with overpaying in the downcycle, especially if the purchaser's valuation (and cash flow) is also adversely affected by the cycle. The converse is equally true at the upper end of an upcycle (e.g. tech stocks).
When it comes to M&A, this can lead to a marked difference between the purchaser's and seller's price expectations, particularly at the deep end of a downcycle or the peak of an upcycle. Looking at the downside case, certain target boards will reject offers that they believe are too low or opportunistic, while purchaser boards may be reluctant to stretch the offer price or even make an offer in these circumstances. Ultimately, the heart of the disconnect between them is that neither party can be exactly certain where in the cycle they are, or how soon and how sharply the cycle will reverse. Each party risks judging this incorrectly, with potentially significant adverse impacts on their respective financial outcomes. Aside from the numbers, there is also the human psychological factor – since criticism outweighs praise, where there is material uncertainty on the merits of a proposal, the natural bias of both boards (but especially the target board) is towards a 'safe', status quo decision, which usually favours saying 'no' to the deal, rather than 'yes'.
While various factors contribute to a widening valuation gap, the volatile political and macroeconomic environment in which we find ourselves is a significant factor. With over ten significant elections worldwide in 2024, as well as international upheaval due to ongoing wars in the Middle East and Ukraine, many deals hinge on the outcome of these uncertain geopolitical events.
The same is true for South Africa, where, aside from an uptick in M&A activity in 2021/2022, there has been a significant slowdown in the post-pandemic years. New listings are one measure of market activity and price confidence, commonly reflecting sell-side activity from private equity or a company positioning itself for acquisitive growth (and the corollary for delistings). South Africa has seen both an increase in delistings and a slowdown in new listings, accelerating in 2023 and 2024. On the political front, since the announcement of a Government of National Unity in June, South Africa has seen an uptick in investor confidence, with the JSE All Share Index returning 5.6% in Rand terms and 8.3% in US dollars, comfortably outperforming the S&P 500, the MSCI World Index, and emerging market peers. Yet, this has since slowed as the initial optimism has been tempered by the inevitable, but no less disappointing, teething issues that have emerged.
Considering these prevailing challenges, purchasers and sellers around the world are seeking different M&A strategies or looking to supplement existing approaches. For purchasers, these may include a strategy centred on direct engagement with key target shareholders in formulating their 'bear hug' price – an offer to buy a publicly listed company at a premium to 'fair value', or avenues such as CVRs to land on a price that will have clear shareholder support. With wide valuation gaps, more innovative deal structures are also being proposed, including the use of CVRs. A CVR is an instrument that commits purchasers to pay a target company's shareholders additional consideration for their shares based on a future contingency, in addition to the initial baseline purchase price paid to them (reflecting a conservative valuation). As the triggering contingency can be any event, and the resulting consideration is similarly flexible in both amount and nature, CVRs offer the parties a flexible, highly customisable solution to the unknowns and risks contributing to the relevant valuation gap.
CVRs can generally be categorised as either price protection or event-driven mechanisms. Price protection CVRs can be applied in an exchange offer to guarantee or underpin the value of the purchaser's shares that are issued as acquisition consideration in the transaction. This underpinning can take a variety of forms, including a top-up issue of shares (much like a payment-in-kind loan note), or a special dividend or series of dividends. Event-driven CVRs entail a commitment to pay additional consideration to the target shareholders, depending on the occurrence of future events. Typical examples include a value linked to future profits, the resolution of a material litigation claim, and profits realised from the on-sale of a specific asset or business of the target. The latter can be particularly relevant where the sell-side considers the asset to be significantly more valuable than the valuation attributed by the purchaser (e.g. a project in development) or where the asset is non-core to the purchaser or not one for which it is willing to pay an acquisition premium. The commonality among these scenarios is that the purchaser pays less upfront (and thus lowers the risk of its buy decision), and the seller exits with a reasonable, though not optimal price, but with an upside case should the factors which it feels justify a higher valuation come to pass (and thus lowers the risks of its decision to sell). Similar mechanisms, including earn-outs and/or deferred payment structures, are a staple of private M&A deals.
In some ways, a price protection CVR is similar to a Material Adverse Change (MAC) clause in an M&A deal, but focused on the purchaser and not the target. An event-driven CVR is the inverse of a MAC, with the triggering event being more focused on the upside rather than the downside. A MAC is a contractual mechanism that allows the purchaser to terminate the acquisition agreement and withdraw from the transaction if, before the deal is closed, a material adverse change occurs – one that has a significant, negative effect on the target's business, assets or profits. A CVR reflects a similar idea, but instead of being a contractual condition that allows the whole deal to collapse, it enables the deal to proceed, but to be adjusted later, based on the relevant event occurring or not occurring.
A CVR can be structured and offered as a listed instrument tradeable on a securities exchange, or on a privately held basis (transferable or non-transferable). A listed CVR allows shareholders who have differing risk or time-value profiles to hold or exit their CVR to match their respective preferences. The value and price of a CVR at any given time will depend on several factors, such as the probability of the event's occurrence by the expiration date, the remaining time to maturity (and thus payment), the performance and volatility of an underlying asset, and the risks of default and dispute.
While CVRs have increasingly been applied in mid- and small-cap life sciences and healthcare transactions in the United States, they are presently less common in the public M&A market in Europe. Although there has been a recent uptick in CVR negotiations in these markets, few have yet been implemented. We have not yet observed one being used in public transactions in South Africa.
Price considerations aside, a CVR will often also have to address two key considerations. The first is the risk of a dispute arising over whether the trigger event has occurred, or the extent to which it has occurred, and how such a dispute will be resolved. The second consideration is the degree of alignment (or misalignment or indifference) between the occurrence of the future event and the impact such an event will have on the purchaser. An earn-out style provision, for example, likely has a fair degree of alignment between the parties as it represents a win-win scenario for both. On the other hand, the successful resolution of a tax dispute may have no alignment, or even misalignment, between the parties, especially if the base acquisition price is already factored into the worse-case outcome or if the purchaser's ongoing relationship with tax authorities is placed at risk. In such instances, the CVR will need to include appropriate terms (such as an all-reasonable endeavours undertaking), or a specific mechanism (such as appointing a neutral party to have carriage of the dispute), to address this.
Not only can a CVR be used to bridge a typical buy/sell valuation gap linked to market cycles, but it can also be used to close a deal when the valuation itself has a significant inherent uncertainty or complexity. Some examples of this include where the valuation is significantly influenced by:
- the occurrence and value of an anticipated future disposal;
- the success of ongoing research and development activities (e.g. a breakthrough medicine at its trial stage);
- industry-specific events (e.g. regulatory reviews or approvals);
- impending potential legislative changes or the timing and form of their implementation (e.g. National Health Insurance, emission standards, required rehabilitation provisioning); and
- unresolved disputes or specific, but difficult to assess or quantify, risks with a wide range of potential outcomes (e.g. class action claims or significant tax disputes).
While, for many market participants, CVRs have mainly been a point of discussion rather than a done deal, increasing examples have been seen through to completion. We believe that a CVR can be an effective alternative mechanism for closing public M&A deals where valuation gaps exist or are dependent on specific, uncertain outcomes. Considering their flexibility, CVRs can be customised to best serve specific requirements of the deal, thereby helping to get more mutually beneficial deals over the line.
