The Locked Box – Unlocked
By now, probably everyone that works in M&A or private equity has heard of the concept of a locked box as an alternative to completion accounts (or, in the U.S., “closing accounts”) on a deal.
The locked box structure replaces the traditional “completion accounts” mechanism, with its cumbersome process of preparing and agreeing accounts as at the actual completion date and making consideration adjustment payments to reflect any surplus or deficit in the chosen financial metrics, with one where the price is fixed by reference to a given set of historic accounts and is only subject to adjustment where there has been “leakage” of cash from the target to the sellers.
Locked box deals are now very common in the UK and across Europe, particularly on competitive auction processes and where private equity is involved. In recent years, we have also seen a shift towards more locked box mechanisms being utilised by trade sellers.
If we compare the two models, a locked box is not much different to completion accounts in terms of the underlying economics. The deal will still be done on a debt free/cash free basis and subject to a normalised level of working capital. The difference is that, instead of the purchase price being determined as of the date of completion (often referred to in the US as “closing”), it is instead determined as of an agreed date prior to completion by reference to a historic net debt and working capital position on that date. This is the date on which the “box is locked” and the so-called locked box accounts are made up to that date. The purchaser has an opportunity to investigate and test the locked box accounts in detail before committing to and signing the deal.
Key to the locked box model is the concept of “leakage”. Leakage is the extraction by the sellers of value (e.g. cash or assets stripped out by way of dividends, management charges, bonuses etc.) from the target in the period between the locked box date and the completion date. Sellers have to give a no-leakage undertaking in the sale agreement, which is subject only to certain items of permitted leakage (e.g. salaries in the ordinary course, expense reimbursements or pre-agreed dividends that have already been taken into account in the purchase price). If the sellers breach the no-leakage undertaking, the amount of the leakage is repayable on a pound-for-pound uncapped basis. A buyer usually has to bring a leakage claim within 6 to 12 months of completion.
During the early days of locked box deals, sellers would typically attempt to charge a rate of interest on the purchase price for the period between the locked box date and completion. The rationale was that, as the deal was priced as at the locked box date, the sellers should be treated as having sold at that point and interest on the proceeds should run from that date until the date of actual receipt by the sellers of the sale proceeds. When interest rates nose-dived following the global financial crisis, sellers changed tack on this and, instead of interest, started to demand compensation for profit or cash generated by the target group between the locked box date and completion. This concept is typically referred to as the “profit ticker” and is effectively an agreed daily charge payable by the buyer to the sellers (on top of the agreed purchase price) for each day that elapses between the locked box date and completion. As interest rates are now on an upward trend, it will be interesting to see whether there is a move back towards interest rates over profit tickers.
Whilst the locked box mechanism is generally perceived to be seller-friendly, as it provides certainty, simplicity and an ability to compare competing offers on a like-for-like basis for sellers, it also offers benefits to buyers. In particular, buyers may welcome its relative simplicity and certainty of pricing in contrast, completion accounts can result in very significant upward or downward price swings by reference to any surplus/deficit in cash or working capital. Additionally, buyers are typically able to argue for more robust warranty cover in respect of current trading as a quid-pro-quo for accepting the locked box structure – and valuable management time is not taken up with a potentially cumbersome and drawn out completion accounts process at a time when the focus should be on business integration.
We will follow with interest whether the trend towards locked boxes will continue as we head deeper into 2023 or whether there will be a retrenchment towards completion accounts with buyers taking a more conservative approach in response to economic uncertainty. Looking across the Atlantic, we note that the M&A market in the U.S. has, to date, stubbornly resisted wide-scale adoption of locked boxes on deals. However, over time, as the climate improves and we begin to return to a more normal level of M&A activity, we predict that there might be a slow shift towards more locked box deals in the U.S. too. If this is the case, then it will only be a matter of time before we start to encounter them in the context of U.S. acquirers who are widely predicted to be attracted to the UK by the favourable U.S. dollar to pounds sterling exchange rate.
