While M&A escrows have typically been a backburner issue in the midst of a transaction, in the wake of recent regulatory reform, dealmakers are increasingly taking active control of these investments. Historically, many dealmakers placed escrows in money market funds instead of bank accounts to diversify counterparty risk. However, new regulations make many of those products significantly less suitable for M&A escrows. Dealmakers that do not want the money placed in a bank account must now seek out new investment alternatives for transactions.
M&A escrows are formed to hold a portion of the agreed upon acquisition price to provide protection against certain potential losses. For example, if the selling company misrepresented a fact about its business or failed to perform a required task prior to closing, the buyer can make a claim against the escrow account rather than having to file a lawsuit against the former shareholders to be made whole. A typical M&A escrow duration is 12–24 months, with possible extensions if indemnification claims are made under the merger agreement. When it comes to M&A escrows, dealmakers have focused on investment vehicles that ensure liquidity, protect principal and gain some level of return. These objectives have guided most escrow dollars into money market deposit accounts and money market funds because they generally satisfied the first two objectives. Yield in money markets has been virtually nonexistent in recent history, but merger parties have accepted it, given a lack of alternatives. As noted above, many merger parties purposefully chose funds over deposits to diversify counterparty risk and, in their assessment, maximize protection against loss.
That analysis changed on October 14, when the SEC implemented rules that effectively disqualify prime money market funds as an escrow investment option on most deals. The new rules are largely due to a web of regulations enacted in response to the 2008 financial crisis, developed by regulators attempting to ensure the stability of large banks and the overall financial system. Of all the changes to prime money market funds, the most concerning to merger parties are floating net asset values and the possibility of liquidity fees. One dollar in is no longer necessarily one dollar out, meaning return of principal is no longer guaranteed. Merger parties should carefully consider their investment options and consider new approaches.
Government money market funds are not subject to many of the regulations applicable to prime funds but are challenged on their economic offering to the merger parties. Media outlets reported that over the last two weeks of September alone, government institutional money market funds took in $194 billion dollars, bringing their total assets to over $1.5 trillion. As money continues pouring into government money market funds, demand could soon outpace supply, driving exceedingly low yield to the merger parties. Additionally, because banks do not earn as much on these types of escrow investment vehicles, they will often charge fees to hold the money, which can be tantamount to negative interest.
As the landscape for suitable escrow investment alternatives to a bank deposit becomes increasingly scarce, financial companies have pioneered new options designed specifically for dealmakers who desire an escrow solution with diversified counterparty risk. These established investment options frequently fly under the radar but are becoming increasingly popular. With products like insurance-backed escrow vehicles coming to market, merger parties have real alternatives to bank deposits and money market funds. These products provide diversified protection against loss, comparable liquidity and attractive yields compared to most money market funds.
Like all market-based products, M&A escrows require innovation that keeps pace with regulation and other changes. As the impact of recent regulations begins to surface, merger parties can look to emerging products as a way to counteract risk, while maintaining yields they’ve grown accustomed to. Balancing inventive solutions in M&A – be it escrow, account administration, payments, etc. – require awareness, understanding and implementation, with a streamlined process as the ultimate goal. Ultimately, the challenge for dealmakers is to take active control of their escrow investments to utilize the most innovative and beneficial products available. This will ensure a clean post-closing process that doesn’t subject parties to unacceptable risk or leave money on the table. In today’s changing environment, it’s more important than ever to review all the facets of a transaction – including escrow investment alternatives and other administrative processes – to be sure the deal goes according to plan.
Paul Koenig is a co-founder of SRS Acquiom, an M&A advisory firm that provides closing and post-closing services, including escrow, transactional risk, payments administration and shareholder representation.