Current Trends and Market Standards for M&A Transactions in the Life Sciences Sector

1. Introduction: Despite the corona crisis, a high level of M&A activity is still expected in the Life Sciences¹ Sector

1.1 M&A Market 2019

The year 2019 was notably busy in terms of transactions, continuing the trend over the last almost ten years of an increasing level of M&A activity each year.² Even though the global value of deals at USD 3.3 trillion with almost 20,000 deals last year was slightly down by 6.9% on 2018 and there was a drop of almost 22% in Europe to USD 770 billion, the market continues to be buoyed up by many really big transactions.³ There were 38 megadeals (over USD 10 billion) in 2019 with a trend towards ever larger M&A deals. The average value for transactions with reported figures of USD 389 million represents the highest level since 2015.

The life sciences sector was not affected by this slight decline in global M&A activity. To the contrary: In Europe, life sciences accounted for a 15% increase in deal value of around USD 145 billion for the year, although the number of deals was down by 11% at 560.⁴  In the USA, the value even increased over the same period to USD 234 billion, almost twice as much as in 2018. Worldwide there was an increase of 49% in the value of life science deals to around USD 477 billion, which is the highest level ever seen in this sector.⁵ This rise reflects in part the fact that some of the year’s biggest deals were in the life sciences sector. Examples here include the takeover of the cancer drug company Celgene by the American pharmaceutical Bristol-Myers Squibb for USD 87.8 billion⁶, the merger of AbbVie, a bio-pharmaceutical company, and its competitor Allergan, one of the leading producers of botox,⁷ as well as the spin-off of the Alcon eye care business from its Swiss parent Novartis.⁸ Although the average purchase price was based on a lower EBITDA multiple of 14.1, instead of 15.3, this was still above average compared to other sectors.⁹

1.2 Effect of the Corona Pandemic

The initially positive outlook for the year 2020 has for now suffered a harsh setback triggered by the outbreak of the corona pandemic (COVID-19). The value of global mergers and acquisitions has already fallen by 28% in the first quarter of 2020 to USD 698 billion, its lowest level since 2016. Although the value in the USA has halved to USD 252 billion, the deal value in Europe doubled to USD 232 billion,¹⁰ thanks to a few megadeals. Other megadeals, such as the attempted hostile takeover of the PC and printer company Hewlett Packard by Xerox, which was valued at USD 35.5 billion, have however been abandoned due to the COVID-19 pandemic.¹¹ The future will show how quickly the general M&A market recovers.

Notwithstanding the difficult situation, the life sciences sector should continue to attract a great deal of interest because of its strong market position and innovation. The corona crisis may even increase this trend further.¹² Private equity, which was involved in almost 28% of all deals in 2019, is likely to contribute to a lot of new transactions, as these firms are generally now in a better financial position than they were during the financial crisis in 2008.¹³ For these reasons, and because of the particularities of M&A transactions often encountered in the life sciences sector, this article will examine current trends and standards in M&A practice.

Another effect of corona has been to postpone reforms. The three-year transition period before the Medical Device Regulation¹⁴ (“MDR”) comes into force was due to end on 26 May 2020. The changes implemented by this directly applicable regulation would have been a further reason to address the not insignificant consequences for M&A practice, particularly in the life sciences sector. However the EU commission has recently decided to postpone the commencement date of the MDR for one year until 26 May 2021. As a result this article does not address the possible effects of the MDR on M&A transactions any further.¹⁵

This article focuses instead on the current M&A trends and looks first at the deal drivers in the past year (Section 2), before analysing specific contractual aspects of life sciences deals in more detail (Section 3).

2. Deal Drivers

The sharp rise in deal values and the level of M&A activity in the life sciences sector can be attributed to several factors. Alongside the aim of generating synergies and economies of scale through mergers, the rapidly advancing digitalisation in the innovation-driven life sciences sector as well as the increasing number of start-ups in this field also play an important role. In general, the deal drivers cited most often for transactions in the life sciences sector were an entry into new markets and/or the acquisition of a supplier, even though according to press reports the previously steady increase in investments by Chinese investors in the German and European market has been declining since 2016.¹⁶

To what extent the corona pandemic will affect this trend, either positively or negatively, remains to be seen. At the forefront of recent transactions was a desire to focus more strongly on profitable areas while at the same time divesting assets that are not in core fields.¹⁷ For example, the expiry of patent protection for high-revenue generics has been often reason enough, especially for larger pharmaceutical groups, to try to compensate for the associated increase of pressure on costs by acquiring new technologies or smaller, specialised companies. Similarly, the healthcare reforms in the USA pose a challenge for many life sciences companies.¹⁸ The goal of transactions is not always primarily to optimise the company’s own business through consolidation or to develop the business in another direction, but may often be driven by tax reasons which also pave the way for a deal.¹⁹ In addition, the prospects for many companies in the life sciences sector are currently looking good due to the often high order levels created by the COVID-19 pandemic, which should also have a positive impact on the M&A business. On the other hand, falling share prices, a slump in business and stagnating production are leading to increased activity on the part of governments to rescue individual companies and by speculative investors who are hoping to acquire businesses that are currently under-priced. ²⁰ This could also increase the level of M&A deals.

Source: CMS Legal Services EEIG

3. Specific Contractual Aspects in Detail

The contract terms or dealpoints are the subject of sometimes intense negotiations as part of any transaction, since they seek to allocate particular risks to one or other of the parties. The CMS European M&A Study 2020, now in its 12th edition, analyses selected dealpoints in the legal agreements for 466 European transactions, as well as making comparisons between various business sectors and highlighting the regional differences. The Study provides insight into current market standards and the allocation of risk in M&A transactions and identifies the latest market trends. This allows the parties’ expectations, particularly in a competitive bidding process, to be measured against contemporary market practice.

3.1 Purchase Price Adjustment and Locked Box

(1) Higher Proportion of Purchase Price Adjustments

The purchase price provision in the agreement is always going to be one of the key terms. The deal can be structured with a purchase price either fixed in advance or to be revised using one of several mechanisms based on the position at completion (purchase price adjustment). The purchase price adjustment is then calculated subsequently depending on the actual financial position of the target.²¹ Particularly in the USA, the vast majority of deals will include some form of purchase price adjustment. The most recent figures suggest that 95% of US deals include such a clause compared with 45% of the CMS European deals. Although the use of purchase price adjustments in the life sciences sector fell slightly last year from 54% to 52%, this is still however significantly higher than the average in Europe. There has been a notable increase of purchase price adjustments, with a more widespread use in Benelux and the southern European countries, where a fixed purchase price no longer appears to be top priority. A further reason could be that the business prospects of companies with drugs currently under development can be volatile, so a purchase price adjustment may be more appropriate, particularly when a drug is still in an early phase of development.

(2) Increased Number of Locked Box Clauses

At the same time in around three quarters of deals in the life sciences sector, a locked box mechanism was used so no post-completion price adjustment was needed. In this sort of contract the seller warrants the accuracy of a fixed pre-closing balance sheet (the “box”), which is “locked” by a seller’s covenant that there are no leakage payments by the target to the seller, such as dividends and management charges. This mechanism has the advantage for the seller that there is less risk of a significant subsequent, and often difficult to estimate, purchase price adjustment. Although a locked box clause is less complicated than a purchase price adjustment and can therefore appear attractive, it may leave the buyer exposed to the risk of negative developments in the target company between the balance sheet date and closing. For this reason the seller is generally obliged to continue the business operations of the target normally and not to make any unusual payments. In order to reliably bridge the time between signing and closing, a locked box clause therefore presupposes that the target has a solid financial basis, which should be carefully analysed by the buyer as part of its financial due diligence. Whereas such clauses were agreed in 56% of purchase agreements in the life sciences sector in 2018, this increased to 76% in the last year and is thus significantly higher than the overall European average of 56%. This shows that it has been increasingly important to the parties to have as much certainty as possible regarding the purchase price in recent deals.

3.2 Earn-Out Clauses are popular

Since a fixed price is often agreed in the life sciences sector, with no purchase price adjustment depending on the closing cash, debt and working capital levels, this increases the attractiveness of earn-out clauses.²² This mechanism provides for an additional consideration to be paid to the seller after completion, depending on the performance of the target during an agreed earn-out period. However, since the future development of the business, by definition, relates to the post-acquisition period, an earn-out always has the disadvantage for the sellers that they will only have a limited influence over the target and are open to the risk of the figures being “tweaked” by the buyer. A downside also for the buyer is that in order to track the financial performance of the target on a stand-alone basis even several years later, a restructuring or integration of the target into its own group is often contractually prohibited.

In spite of these disadvantages, life sciences remains the most popular sector for earn-outs. Even though their use has dropped slightly by 2% to 41%, this is still almost double the average of 21% of the European transactions analysed. In the life sciences sector such clauses are more often based on turnover (67%), whereas overall in Europe the criteria EBITDA/EBIT and turnover are more equally balanced (around 40% each).

The high prevalence of earn-out clauses in the life sciences sector is due partly to the fact that there are a particularly large number of start-ups with still largely uncertain forecasts of future business development. In addition the performance of drug manufacturing companies is largely determined by their marketing authorizations, which are difficult to assess in advance. Also, research and development are generally a long-term process in the life sciences field, so that the prospect for future business development often have to take a period of several years into consideration. These sector-specific factors are also reflected in the earn-out time periods which are agreed. In medium-sized deals (between EUR 25 million and 100 million) periods of 24-36 months were agreed in every contract which contained an earn-out clause. In transactions over EUR 100 million, every second earn-out clause was based on a duration of over 36 months. In contrast, the earn-out periods in other sectors generally end earlier, usually with the next financial statements’ following completion.

Source: CMS Legal Services EEIG

3.3 De Minimis and Basket

(1) Increased Use of De Minimis Clauses

In order to protect the seller from potential liability for very small and trivial claims, many M&A agreements exclude individual warranty claims below an agreed minimum amount (i.e. the de minimis). This is intended to keep the legal peace between the parties where there are no major issues.²³

The use of de minimis clauses in the life sciences sector has increased by 10% in the last year to 61%, although this is still under the overall average of 73% of all deals. The likelihood of such clauses seems to be lower, the higher the threshold for the de minimis is, so that a de minimis of 0.5% of the purchase price was only included in 2% of deals. In southern European countries there were very few deals in the life sciences sector which included a de minimis clause (only 14%).

(2) Increase in use of Basket Clauses

De minimis clauses are often used in combination with a basket as a further protection for sellers. This means that the buyer can only raise warranty claims if or to the extent the total amount claimed in respect of all warranties exceeds an agreed amount (threshold). Here again, the aim is to avoid relatively minor claims being raised. The basket will be structured either so that only the amount of warranty claims which exceed the basket can be claimed (“excess only”) or that the total amount of the warranty claims can be recovered if the threshold is exceeded (“first dollar”).

Although there was a further slight decline in the application of baskets in European transactions at 66% for 2019, their use in the life sciences sector is significantly lower, even if this did increase from 44% to 51%. The excess-only type of basket was used twice as frequently and was to be found in 41% of the deals analysed. The most commonly agreed threshold was between EUR 1.00 and 0.5% of the purchase price (36%) and was agreed less often with a higher threshold.

3.4 Lower Liability Caps

Whereas de minimis and basket mark the lower limit on liability, it is also standard to agree on the maximum amount for which the seller may be liable (liability cap). Since even the buyer must concede that it would be disproportionate to impose a liability risk on the seller which exceeds the purchase price many times over, in practise the negotiations focus not on whether there should be a limit on liability but on the appropriate amount of the liability cap. The use of liability caps in the life sciences sector increased last year to 60%, but thereby only reached the general average percentage of previous years and is around the overall level of 58% of transactions.

The liability cap is often agreed by reference to a percentage of the purchase price. Whereas in the past high liability caps were often agreed in the life sciences sector, the trend is now in the other direction. In previous years a liability cap equal to the purchase price was agreed in one out of five transactions, but in 2019 this was only the case in 10% of transactions. Instead, in a quarter of cases now (instead of previously only 6% of deals) a cap of less than 10% was agreed.

3.5 Trend to shorter Limitation Periods

Overall in 2018 almost a quarter of all transactions had longer periods during which warranty claims can be raised (limitation periods of more than 24 months); in 2019 this was only agreed in 20% of deals. The use of such long limitation periods in the life sciences sector almost halved in line with this trend from 42% to 23%. Limitation periods of 18-24 months were also less frequent, reducing from 52% to 38%, whereas now in almost a quarter of cases a limitation period of 12-18 months is agreed. This shows a trend, irrespective of deal size, towards shorter limitation periods. The reason for this is probably the extremely seller-friendly market, which makes it more difficult for the buyer to insist on longer limitation periods.

3.6 Security for Warranty Claims less common

Along with the strongly seller-friendly M&A market, the increase in W&I insurance²⁴ is likely to be a factor why sellers increasingly are able to avoid having to provide security for warranty claims. Such security is intended to protect the buyer if there are concerns about the covenant strength of a seller to stand behind the warranties given in the purchase agreement. Even though the overall use of such clauses increased slightly to 33% of transactions, in the life sciences sector this decreased to 43%; in previous years almost every second transaction required the seller to give security for any warranty claims. The most common type of security, in almost half of transactions, is now no longer a bank guarantee but an escrow account.

3.7 Significant Decrease in MAC clauses

Material Adverse Change clauses (MAC clauses) allocate the risk of detrimental changes occurring between signing and closing, by allowing the buyer to terminate the agreement if a specific event happens, often such as war or natural catastrophes. The events covered by such a clause are expressly defined in the agreement and are often subject to extensive negotiation. There are often carve-outs from the MAC clause for overall economic developments or unforeseeable events which only affect the target sector. Whether the COVID-19 pandemic can be seen as a MAC-triggering event depends on the wording of the clause. The interpretation is still unclear, but it could possibly be included under the category of “natural disaster”. In order to be on the safe side, it should therefore be clearly defined in the purchase agreement which events are covered and whether this includes also an international pandemic.²⁵

While MAC clauses are standard in the USA and are to be found in 97% of deals, they are still relatively seldom in Europe (16%). The use of MAC clauses in 2019 almost halved in the life sciences sector to 14%. The continuing high success rate of European sellers in resisting MAC clauses generally demonstrates their strong commercial position, especially in a competitive bidding process.

3.8 More international Arbitration Clauses

Last year 34% of all purchase agreements that were analysed contained an arbitration clause. The trend since 2016 towards an increased popularity of arbitration clauses is also seen in the life sciences sector, where their use has almost doubled to 25% of deals. There may be various reasons for agreeing on arbitration. On the one hand any disputes are not public. In addition there is often an expectation that arbitration will reduce the length of any proceedings and that an arbitration award will be easier to enforce. Also the possibility of choosing the arbitration rules of a “neutral” country can be a factor where the parties come from different jurisdictions. There are however perceived downsides, such as the relatively high cost of arbitration compared to ordinary court proceedings. Throughout Europe the use of international arbitration clauses appears more popular on larger deals, which are seen in half of all deals with a value of over EUR 100 million. In the life sciences sector the use of international arbitration clauses has more than tripled and was agreed in 64% of transactions in 2019. Indeed, every large life science transaction over EUR 100 million contained an international arbitration clause. The reason for this is likely to be the number of international groups involved in such large transactions.

3.9 Higher Prevalence of W&I Insurance

The use of warranty & indemnity insurance (W&I Insurance) continues to rise every year and 2019 was no different, with almost one fifth of CMS transactions involving a W&I Insurance policy. Such insurance is used to supplement or replace the warranties given by the seller, for example where a seller is not willing to give certain warranties or is not in a position to stand behind the warranties (e.g. private equity sellers).²⁶ In life science deals the use of W&I Insurance increased from 3% to 8% and the premiums were paid by the buyer in two thirds of these deals. This reflects once again the seller-friendly terms of transactions which allow the buyer’s protection under the warranties to be shifted from the seller to an insurance company.

3.10 Increased Use of Legal Tech and Artificial Intelligence

The trend towards digitalisation has also affected M&A transactions. There has been a noticeable increase in the use of legal tech tools and systems based on artificial intelligence²⁷, reflecting the increasing availability of suitable tools and increased pressure on costs and time. Using legal tech, documents can be analysed for example as part of a due diligence in a much shorter time than would be possible by hand. With the rapid development of technology in this field, it seems likely that the trend to using such tools will continue to grow in future.²⁸

4. Conclusion and Outlook

Whether the positive outlook for M&A transactions that existed generally at the start of the year ²⁹ can be maintained in view of the corona pandemic is uncertain, to say the least. In any case the life sciences sector is well positioned compared to other industries. In particular the high demand for drugs and personal protective equipment, medial devices (especially ventilators) and the massive amount of work dedicated to developing a vaccine, are all leading to a sales boom for many life science companies. This is likely to have an impact on M&A transactions and lead to an increased demand for mergers and acquisitions, so that this sector may look forward to the rest of 2020 with a certain degree of optimism.