The Revival of M&A: Sidestepping Transition Service Agreements for Acquirer Advantages
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After a subdued year for M&A activity in 2023, a growing consensus asserts that the trend will reverse in 2024 and beyond, let’s delve into the exciting world of M&A and explore what could happen next!
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By now, we’ve all heard that Private Equity is sitting on record amounts of ‘dry powder’ to the tune of $2.39 trillion by the end of December 2023, according to S&P Global Market Intelligence.?
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Why did M&A stall and how has so much capital amassed?
Arguably the main driver is inflation; this is because higher interest rates (used by Central Banks to douse the flames of inflation) generally increase the cost of borrowing money, which can reduce the amount of investment and spending across a given economy. For a Private Equity (PE) firm, higher interest rates can make leveraged buyouts more expensive due to the higher cost of debt financing. This can directly affect the potential return on investment, as higher interest expenses may reduce profitability.?
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And of course, inflation did hit a 40-year high of 9.1% in June 2022, so this has naturally disincentivised Private Equity firms and businesses from purchasing other businesses or assets because of the aforementioned. In the meantime, trillions of dollars in capital have amassed and been described as ‘dry powder’, which simply means cash drawn from investors in the PE fund – which in some cases needs to be deployed within a specific timeframe.?
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In an interview last week, Federal Reserve Chairman, Jerome Powell mentioned that the majority of the 19 committee members agree that lowering interest rates this year would be appropriate. This consensus is based on the strength of the US economy and an inflation rate that is currently around 3%. Powell indicated that should the data flowing through in the Spring be “good”, it will be appropriate to make a cut to the interest rate. As we know, once the US makes a move on Monetary Policy, other countries follow suit.?
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Does this mean it’s open season for Mergers & Acquisitions? Who knows, one would think so, but it’s exciting to see what happens next nevertheless!?
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Mergers or Acquisitions?
For those of us that don’t go around deploying 2.39 trillion in capital, purchasing businesses and what not, the terms Mergers and Acquisitions can seem fuzzy and mesh or blur into one.?
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Merger?
A merger is when two companies decide to join together and operate as one new entity instead of being separately owned and managed; sometimes you’ll hear a merger described as a ‘partnership of equals’ but in reality, there is usually a more dominant or larger party. In a merger process, the assets, stocks, and operations of both companies are merged, potentially under a new name or retaining one of the original names – hence the term, merger! Control of the newly formed company is typically shared, with a combined board of directors and management team drawn from both companies.
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Acquisition
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An acquisition occurs when a company, known as the acquirer, buys another company, referred to as the ‘target’. This is typically done through purchasing a majority of the target's stock, assets, or both, thereby gaining control over it. Despite this change in ownership, the target company might retain its name and legal structure, either operating as a subsidiary within the acquirer's portfolio or being completely integrated into the acquiring company. Control over the target, including decisions regarding its future, assets, and employees, shifts to the acquiring company.??
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The key difference between the two terms is that a merger is more collaborative and a blend of two companies whereas an acquisition is where a company absorbs another into its group structure of portfolio of companies – in some cases there is no friendliness about it, hence the term ‘hostile takeover’!
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Executing M&A: From Strategy to Reality – What Happens when the Rubber Hits the Road?
When the taps turn on and the M&A activity hots up, things get both complicated and exciting simultaneously. Broadly speaking the following (simplified) steps will be taken:?
Target Identification: With a strategy in place, potential acquisition targets or merger partners are identified through market research and financial analysis.?
Preliminary Valuation: The value of the target is assessed using financial models, public financials, and cash flow projections.
Due Diligence: A thorough review of the target's financial, legal, and operational aspects identifies risks and liabilities before deciding to proceed with purchase.
Financing the Deal: Financing methods are determined, involving assessments of the company’s financial health and potential negotiations for funding.
Negotiation and Deal Structuring: Terms, including price and structure, are negotiated to reach an agreement.
Legal and Regulatory Approvals: Necessary approvals are sought to ensure the deal complies with regulations and does not harm market fairness.
Closing the Deal: The deal is finalised through legal document signings, fund transfers, and ownership transfers.
Integration: The challenging task of merging operations, cultures, and systems begins!?
Post-Merger Integration: The entities work on harmonising operations to achieve the deal's envisioned value and ‘synergies.
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What Is a Transitional Services Agreement??
To facilitate the integration between companies an agreement is put in place, if for example Company A acquires Company B, there will be a ‘transition period’ which is typically a period of 6 months. During this time the acquiring Company A has announced its intention to purchase Company B, as you can imagine this is an uncertain time between the companies.?
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So, a Transitional Services Agreement, or TSA is effectuated; this is an important part of the process when a company buys another company. After the sale, the company that sold the business agrees to keep providing certain necessary services for a pre-determined set of time — e.g. managing employees, payroll, looking after IT & Accounting & Administrative functions. This help is given for a certain time so that the company that bought the business can keep it running smoothly and not suffer from financial losses before it can fully integrate the operation within its own existing corporate structure.
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So Far So Good, But Are There Any Challenges with This Approach??
TSAs are great for preserving operational continuity because they allow critical functions such as IT, HR, finance, and others to be maintained without interruption during the transition period. This is crucial for preserving the value of the business being acquired.
However, Company B will have to keep using their internal resources such as HR, payroll, and accounting to support the sold business until all aspects of the TSA are completed. Even after the business is sold, the seller is still temporarily providing these services. There can also be challenges around liability because Company B may be responsible for the employees they no longer manage, which can be a legal and financial burden.
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On the other hand, Company A – as the buyer – doesn’t necessarily have full control over the employees coming from the seller's company, nor can they hire new staff for these roles. Buyers must depend on the sellers to manage the employees that come with the acquired business, which adds complexity to the transition.
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As you can imagine this is far from ideal for either party and because this arrangement can continue for quite some time after the transaction has closed, it can cause significant friction, particularly where there are large cultural differences between Company A and Company B!
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Speed equals Greater Returns?
Speed is critical, Mckinsey found divestitures completed within 12 months had significantly higher returns than when deals dragged on farther into the future. So, with the TSA method not being wholly satisfactory, a new method has emerged to ensure M&A is completed in a timely manner, compliantly that provides a win-win situation for the parties involved in mergers and acquisitions.??
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Utilising A Global Employer of Record?
Employer of Record (EOR) services involve the EOR provider using their existing corporate and HR infrastructure to legally engage employees on behalf of their clients - where the clients do not have adequate corporate infrastructure to do so themselves.?
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EOR can be used in M&A as a TSA alternative whereby:
It should however be noted that not all EOR providers maintain an M&A practice or are able to manage the compliance and administrative complexity of M&A projects. This is because standard EOR projects and EOR in the context M&A differ fundamentally.
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Standard EOR projects typically involve onboarding employees as “net new” - meaning employees join the EOR provider as a new employee starting their first day of employment for a new job.?
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M&A EOR projects usually involve “transferring” employees - meaning employees need to retain the tenure and related benefits they were enjoying under their previous employment. It is in practice a continuation of employment - not a net new start.?
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The reason this distinction is so important is because there are often legal frameworks protecting employee rights when they/their company is acquired by another company - and they essentially have no say about this change in employer.?
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EOR M&A Legal Considerations:?
The legal protections of employees being transferred in the context of M&A can include:?
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Benefits of an EOR in M&A
As the summary above lays out, HR transfers in M&A are complex and can therefore require significant attention from buyer HR teams. An EOR solution, whereby a buyer can effectively outsource both the compliance management, as well as the HR administration (including transferring employee communications and onboarding) in a transaction, can therefore represent a very attractive solution to buyer HRM&A teams (especially where alternative TSA options are costly and restrictive).?
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EOR is often also used as a HR transfer tool in M&A beyond simply a TSA alternative, as a means of finding HR operational cost efficiencies (particularly for low headcount countries where direct infrastructure is not a business imperative), HR administrative efficiencies (where buyer teams are not familiar with the HR regulatory framework of countries in which employees are being transferred), as well as strategic flexibility (allowing buyers to compliantly maintain status quo in markets past the close date - giving themselves time to determine strategy for markets in scope in their own time).
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The value can be significant:
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·?????? Parties can save hundreds of thousands in operational costs
·?????? Transaction close times can be cut in half
·?????? Risk can be minimized from strategic and compliance perspectives
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Ultimately the use of a reputable Global EOR can facilitate a much faster and compliant M&A transaction whilst allowing buyers to act on M&A opportunities with more confidence and create greater value for shareholders. ?
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Conclusion
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In conclusion, the landscape of Private Equity, Mergers, and Acquisitions is poised for a dynamic shift. With a record level of 'dry powder' accumulated due to high inflation and consequent high interest rates, Private Equity firms have been cautious in their investment strategies. However, with potential interest rate cuts on the horizon, as indicated by Federal Reserve Chairman Jerome Powell, the M&A sector could see a surge in activity.
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The process of M&A is complex, involving steps from identifying targets to post-merger integration. Transitional Services Agreements (TSAs) have traditionally been used to ensure continuity during the transition period following an acquisition, but they come with their own challenges, such as maintaining operational continuity and legal complexities.
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Recently, the utilization of a Global Employer of Record (EOR) has emerged as an alternative to TSAs. EORs can offer a raft of benefits including compliance management, HR administration, and ensure the protection of employees' rights during the transfer process. This approach is more efficient, especially in cross-border transactions where legal frameworks like the EU's Acquired Rights Directive or the UK's TUPE regulations come into play.
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As the M&A landscape evolves, the key to maximizing returns lies in the speed and efficiency of deal completion. Companies are increasingly seeking innovative solutions such as EOR to navigate the complexities of M&A, ensuring not only a swift transition but also adherence to legal and regulatory requirements, and ultimately, achieving strategic goals in the competitive world of business.?
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If you have any questions about the content of this article, please feel free to drop a comment or message us directly, we will do our best to help.
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Peter Dixon & Mark Fielding, Velocity Global