What’s in the (Locked) Box ? : the difference in European and US pricing practices in times of COVID
By Louis NOIRAULT, Student in Economic Law Masters.
One of the most salient differences between the United States and Europe in private and public M&A deals is the pricing technique. In U.S. transactions, lawyers tend to adopt what is referred to as the “Closing Accounts Mechanism” (CAM), while European transactions are more frequently subject to the “Locked Box Mechanism” (LBM).
As explained in documents issued by Weil, Gotshal & Manges lawyers, using the CAM means that “equity value is determined by starting with an enterprise value and adjusting for debt, cash, working capital or other items at closing”. Prior to the closing, the Share Purchase Agreement (SPA) includes the methodology which is used to determine not only the value of the company when the SPA is signed but also the adjustments which will be made after closing to take into account how the enterprise value has changed between signing and closing.
On the other hand, under the LBM, the price is determined on the basis of a balance sheet dated from the “Locked Box date”, which is before the signing of the SPA. In the time between the Locked Box date and the signing, the due diligence is conducted on the relevant balance sheet. Together with the projection of cash-flows, this allows for the valuation of equity. The LBM differs from the CAM in that, after signing, the price is not subject to post-closing adjustments. Naturally, the seller is prohibited from “leaking” value out of the business, for instance through executive bonuses. In addition, LBMs are often accompanied by “Material Adverse Changes” (MAC) clauses which can allow the buyer to back out from the deal, should some pre-defined negative event occur before closing. These clauses are however usually subject to strong resistance and heavy negotiations which significantly limit their scope. The fundamental consequence of adopting the LBM is therefore that “the economic risks and benefits are passed from seller to buyer at a historical balance sheet date prior to signing”.
To have a clearer idea of the magnitude of the above-mentioned chasm between the U.S. and Europe in this regard, one can refer to the 2017 survey conducted by Latham & Watkins on more than 170 deals between July 2014 and June 2016. This study showed that 46% of these European transactions were under the LBM while CMS estimates that as much as 85% of U.S. transactions in 2013 included Purchase Price Adjustments clauses.
Much has already been written on the advantages and drawbacks for each stakeholder of one mechanism relative to the other. However, it seems that current economic conditions upend the way one should think about this issue. Indeed, most shocking was how the high-stake deal between LVMH and Tiffany & Co. was almost relinquished because of the sanitary crisis. It is reasonable to assume that other companies are poised to be subject to significant changes in value as the pandemic and, most importantly, how economic consequences unfold. This calls for a review of each of these methods and, when possible, an assessment of their adequation to the current situation.
First and foremost, the LBM is about bringing certainty at an early stage of the transaction. However, this system is often perceived as seller-friendly because the downside risk is transferred to the buyer. While this might have been palatable in the pre-COVID era, it might seem hard to fathom why buyers in Europe would still accept to bear the cost of unpredictable epidemic spikes, government-mandated cessation of activity or even of the macroeconomic conditions in general. In this regard, it would seem that the current events call for Europe to align with the U.S. The CAM indeed allows for more flexibility and mitigates the risk for the buyer of paying a price disproportionate to the current value of the company.
Another point to consider is the cost of negotiations, whether it be in terms of money or time. Under the assumptions of the Coase theorem, negotiations between the parties should yield a Pareto efficient outcome, in which no party can be made better off without making one worse off. At first, it would seem that the CAM allows the parties to “negotiate” the price for a longer time, albeit within the framework of the SPA, and is therefore more likely to lead to Pareto optimality than the LBM which locks the price at an earlier stage. However, before drawing this hasty conclusion, one should at least consider the two following caveats.
The basic one is that the assumption of zero transaction cost bars the Coase theorem from applying to this situation. Since it waives the post-closing adjustments, the LBM is much faster to negotiate and simpler to devise than the CAM. In times of liquidity strain such as this crisis, firms on both sides of the deal might want to spare themselves the cost of negotiating post-closing adjustments, unless they anticipate a potential benefit probable enough to outweigh them. No general rule should be inferred; this is to be determined on an ad-hoc basis. The second caveat is that the concept of Pareto efficiency offers no information about the distribution of the welfare between the stakeholders. Yet it would be unreasonable to argue that the parties care more about the total welfare than their personal welfare. While there is some truth to the Chicago school’s idea that leaving the will of the parties unconstrained would help yield a fairer and more balanced outcome, there is little logical evidence that this applies to the choice between CAM and LBM.
As far as the timing of the transaction is concerned, there is no clear-cut advantage for one mechanism over another. While the CAM may pave the way to protracted and bitter post-closing disputes on post-closing adjustments, making the pricing drag on over a longer period, Paul Hastings rightly emphasizes the fact that LBM is also challenging in terms of the extensive due diligence the historic balance sheet requires. The simplicity of LBM discussed above is therefore not necessarily the logical solution for stakeholders who might want to rapidly complete the deal to avoid the occurrence of external events during the negotiation process. In conjunction with the analysis of the potential negotiation costs of CAM, dealmakers in times of COVID might find the certainty and simplicity of LBM appealing. Post-closing adjustments, while leading to a more accurate valuation, might be a deterrence because of their potential complexity in such uncertain market conditions. This is particularly important for private equity funds exiting an investment and trying to redistribute the returns to Limited Partners right after closing. This compounds the idea that the management during such a crisis is already a delicate exercise, and CAM makes managers devote a significant amount of time to the completion accounts.
This does not mean that COVID has ushered in a new era where LBM will dominate because of its simplicity. CAM has, indeed, more arguments in its favor than merely offering the opportunity to do post-closing adjustments.
In a 2015 publication, Adam Tsao pointed out that CAM dominated U.S. transactions partly because LBM is not adequate when the balance sheet of the acquired company is not easily available. This includes startups and carve-outs. The COVID crisis has interacted with both these cases.
First, in spite of, or perhaps thanks to, the context, 2020 was a strong year for venture capital. Pitchbook even reports that the third quarter of 2020 was one of the strongest on records. In such deals, relying on historic balance sheet for valuation makes little sense as start-ups are acquired for their growth potential, which shows the limit of LBM.
Second, the Boston Consulting Group anticipates a sharp rise in distressed M&A activity for 2021 in light of historical data. They indeed observe that the 2001 recession led to a wave of carves-out which peaked only in 2002 and, similarly, the 2007-2008 crisis’ full impact in this regard was in full force only in 2010. It would not come as a surprise to see this pattern repeat itself in this crisis. Carve-outs are complex operations for which the LBM tends to be less suitable insofar as the financial statements of one business unit are difficult to isolate from the others’.
Thus, one can see how different factors in this crisis play in favor of one pricing mechanism or the other. It would be of little value to try to predict which one will be prominent in the aggregate numbers. The stakeholders in each deal might have different preferences or be under different constraints which will be decisive for their specific case. It is noteworthy that Weil, Gotshal & Manges observed that the exposure of Private Equity firms to European deals had led, prior to the pandemic, to more U.S. deals adopting the LBM. The jury is still out as to whether this crisis will contribute to an alignment of practices between the U.S. and Europe. Nonetheless, it should be mentioned that, since CAM is more complex to set up than LBM, European lawyers might have to go through a learning curve before being able to use CAM in an optimal way. Alternatively, or concurrently, the current circumstances could make European lawyers reconsider the restrictiveness of MAC clauses and allow them to encompass a wider array of unforeseen events such as the COVID crisis.
 McGonigle, Samantha and Weisser, Michael “Global Private Equity Update Q2: Unlocking “Locked Box” Deals” Weil, Gotshal & Manges (2014) : 1 (emphasis added).
 Tsao, Adam. “Pricing Mechanisms in Mergers and Acquisitions: Thinking Inside the Box.” U. Pa. J. Bus. L. 18 (2015): 1236.
 Ibid. Op. Cit.
 Daout, Caroline et al. , “Does COVID-19 qualify as “material adverse change” from an M&A perspective?”, DLA Piper, June, 4th 2020.
 McGonigle, Samantha and Weisser, Michael, Op. Cit.: 1 (emphasis added).
 Latham & Watkins “Mergers and Acquisitions Report 2017” International Financial Law Review (2017) : 1.
 CMS European M&A Study 2014, CMS Hasche Sigle 1, 5 (2014) cited in Tsao, Adam. Op. Cit.: 1234.
 Coase, Ronald H. “The problem of social cost.” Classic papers in natural resource economics. Palgrave Macmillan, London (1960): 87-137.
See Winston & Strawn LLP “Purchase Price Adjustment Mechanisms in M&A Transactions – The Locked Box Mechanism” (2014) ; Tsao, Adam. Op. Cit.: 1239.
O’Sullivan, Ronan and McNaughton, Ross “Pricing mechanisms: Locked box vs. completion accounts” Paul Hastings, Practical Law Publishing Limited (2012).
 Tsao, Adam. Op. Cit.: 1241.
 The Harvard Business Review has dedicated a whole section of its website to “Managing through crisis” in reference to the COVID-induced turbulences.
 See O’Sullivan, Ronan and McNaughton, Ross, Op. Cit.: 6.
 Tsao, Adam. Op. Cit.: 1239.
 Gillet, Kit “VC deals in Europe had one of the strongest quarters on record in Q3 2020” Stifted, October 29th 2020.
Wolf, Rüdiger; Georg Keienburg, and Tobias Söllner “Taking the Stress Out of Distressed Carve-Outs”, September, 3rd 2020.
 Tsao, Adam. Op. Cit.: 1239.
 McGonigle, Samantha and Weisser, Michael Op. Cit. : 2.