Freeing Trapped Cash in Cross-Border Deals

John Olson is a founding partner of Gibson, Dunn & Crutcher’s Washington, D.C. office and a visiting professor at the Georgetown Law Center. This post is based on a Gibson Dunn alert.

In private company transactions, dealmakers often spend significant amounts of time talking about how to treat the cash held by an acquisition target. For example, if the buyer and the seller are negotiating price on the assumption that the target will be sold on a cash-free, debt-free basis, how does the purchase price get adjusted for cash that the target continues to hold at the time of closing? If the deal includes a working capital adjustment, how will cash and cash equivalents be taken into account? What are the procedures for measuring how much cash the target holds at closing?

In cross-border deals, the issues about how to deal with target cash often become significantly more complex. Businesses that operate around the world may have cash in several different countries. Regulatory and tax concerns may limit both the seller’s and the buyer’s ability to transfer cash held by the target from one country to another. Questions about how to deal with the target’s cash must be answered with these constraints in mind.

The balance of this post discusses some of the solutions that buyers and sellers use to resolve trapped cash issues in cross-border deals.

As a starting point, it is helpful to review the typical construct for a transaction involving a target business that is privately owned or that is operated by a larger public company. The buyer and the seller often determine the value of the target and negotiate the purchase price based on the assumption that the seller will deliver a business that has no cash and no debt. They assume that before the deal closes, the seller will sweep cash out of the target via dividends and pay off all indebtedness.

In a typical deal, the buyer and the seller often also agree that, to the extent any cash is left in the business at the time of closing, the purchase price will increase dollar-for-dollar by the amount of this cash. Similar clean-up mechanics may be developed to account for any debt owed by the business at the time of closing. The buyer and seller further agree on the terms of a working capital adjustment; they establish a target amount for closing date working capital, and then provide for an adjusting payment if actual working capital on the closing date is higher or lower than this target. Where the deal has been priced on a cash-free, debt-free basis, and provides for a separate cash adjustment and debt adjustment, cash and debt items will generally be excluded from the determination of working capital. The parties may also agree to exclude current liabilities that are associated with the cash (e.g., deferred revenue liabilities that were recorded when a customer prepaid cash for goods or services).

This basic construct may not work when dealmakers negotiate a transaction involving a business that generates significant amounts of cash in multiple countries. The parties may still want to value the target business on a cash-free, debt-free basis. But the seller’s freedom to sweep cash out of the business before closing may be limited by foreign currency and other regulations or U.S. and foreign tax laws. If the seller tries to solve this problem by leaving cash in the business and asking for a dollar-for-dollar price adjustment, the buyer may resist, particularly when its ability to sweep cash is also constrained by regulations or tax concerns.

This problem commonly arises in China. For example, a U.S. seller may decide to dispose of a subsidiary which generates earnings in China. The U.S. company has not been able to repatriate the entire amount of these earnings, however, because Chinese regulations limit the amount of cash that can be transferred out of China to after-tax profits. These regulations further provide that a specified percentage of after-tax profits must be retained by the Chinese company as reserve funds.

The seller facing Chinese regulatory restrictions may propose that the buyer keep the Chinese earnings and pay an increased purchase price. In some cases, this approach will be acceptable to the buyer. But in others, the buyer may respond by arguing that it does not have projects in China that will absorb the cash, and that its ability to repatriate cash will be similarly constrained.

Another example involves a seller that has chosen to leave cash generated by foreign subsidiaries in overseas bank accounts as part of its U.S. and foreign tax planning strategy. It may face negative tax consequences if it were to adopt the usual approach for a domestic transaction and repatriate the foreign cash before closing. Depending on the details of its tax planning strategy, it may conclude that it can solve this problem by leaving the cash in the target business’ foreign bank accounts and proposing that the purchase price be increased by a corresponding amount. The buyer may be willing to accept this proposal if it has uses for the cash and its own tax position will not be adversely affected. But if the buyer does not have immediate uses for the cash, or if its tax burden will increase, it will resist the seller’s suggestion and argue that a dollar-for-dollar price adjustment is inappropriate.

The issues become even more complex when the buyer and the seller are juggling currency regulations and tax regimes in many jurisdictions. For example, a target business might have cash that is trapped in a number of different countries, each of which has different rules regarding currency transfers. One country’s regulations may impose blanket prohibitions on the repatriation of cash; another country may permit repatriation but only over an extended period, or only if thresholds based on earnings or other similar requirements can be satisfied.

The buyer and the seller may agree on a range of possible solutions:

  • No purchase price adjustment. The buyer and the seller may agree to forgo a purchase price adjustment relating to cash, or provide that any adjustment will apply only with respect to cash that is already in the US or that can be freely repatriated into the US.
  • Discounted purchase price adjustment. The buyer and the seller may agree to a straightforward purchase price adjustment, in which the buyer pays the seller for the trapped cash. But the adjustment would be paid on a discounted basis, to reflect tax or regulatory burdens on the buyer. This solution is most likely where the buyer has leverage and is able to persuade the seller to accept a haircut.
  • Delivery of cash on a delayed basis. The buyer and the seller may agree that the buyer will deliver the trapped cash to the seller over time, when applicable currency regulations or tax restrictions permit the cash to be repatriated. In effect, the buyer agrees to make a dollar-for-dollar adjustment, but is only obligated to deliver cash to the seller when and if the buyer can actually repatriate the cash. There are a number of possible variations on this theme. For example, the parties might agree that, regardless of what the regulations provide, the buyer will deliver to the seller an amount equal to the full amount of the trapped cash no later than a specified date. If $10 million of cash are trapped, and only $8 million have been delivered to the seller by the outside date, the buyer would be obligated to pay the $2 million balance to the seller, regardless of whether applicable currency regulations would permit it to repatriate this amount from the relevant foreign jurisdiction.
  • Details of delayed delivery arrangement. If the parties agree to a plan under which cash will be delivered on a delayed basis, they must work out a variety of issues. Should the obligation to deliver cash be memorialized in a promissory note? If the parties use a promissory note, the tenor of the note and the size of the installment payments might be matched to the parties’ best estimates of when trapped cash could be released pursuant to the applicable currency regulations. Should the buyer be required to pay interest, and if so at what rate? Will the buyer be permitted to use cash in the foreign bank accounts before it is repatriated without any restriction, or will the cash be held in trust or in an escrow account? Alternatively, will the buyer be subject to covenants that limit how it can use the cash? Will the buyer have an obligation to deliver U.S. dollars or local currency? Will changes in foreign exchange rates over time be taken into account?
  • Using the cash before closing. The seller may be able to find productive ways to use its trapped cash before closing that do not run afoul of currency restrictions or create tax problems. For example, it may be able to use the cash to fund transaction expenses, pay employee bonuses or make capital expenditures for the benefit of other entities. This approach makes most sense when the seller can use the cash for expenditures that the buyer would not be interested in making—if the buyer would be happy incurring the same expenditures, then the cash could simply be left in the business.

Since many trapped cash problems can be solved over time, the earlier the seller identifies these issues the better. If the seller starts to repatriate funds or looks for other ways to use the cash when the deal is still on the drawing board, it may be able to reduce meaningfully the impact of the trapped cash problems.

Buyers that plan to obtain debt financing to fund the purchase price should be aware of the impact of trapped cash on credit arrangements. First, the inability to upstream trapped cash to the credit parties will be an issue for almost any lender. The lender may exclude EBITDA attributable to operations subject to cash traps from the “underwritten” EBITDA, potentially reducing the amount of debt financing that can be raised for the acquisition. Likewise, financial calculations under the debt documents (such as leverage based baskets and financial covenants) will typically exclude “blocked” EBITDA unless the cash is in fact upstreamed to the borrower or guarantors of the debt. Second, the mandatory prepayment provisions of the debt documents should exclude cash generated at operations subject to cash traps. For example, an asset sale should not result in a requirement to prepay the debt if the cash needed to make the prepayment cannot be upstreamed to the borrower, or if upstreaming would result in a material adverse tax consequence (such as a material withholding tax).

If the parties decide not to structure the deal using the traditional private company target deal structure with closing adjustments, trapped cash issues may be much less meaningful. For example, in European deals that use the so-called “locked box” structure, the parties may not negotiate special trapped cash provisions. In these transactions, the company is valued on the basis of a balance sheet dated prior to the signing date. The seller makes “leakage” covenants that are designed to preserve the value of the target business through closing, and there are no purchase price adjustments at closing or thereafter. The presence of trapped cash may be taken into account when the deal is priced, and the leakage provisions may be designed in part to permit or restrict the repatriation of trapped cash, but the parties are much less likely than in a U.S. deal to develop trapped cash mechanics.

Trapped cash issues are less problematic in public company deals. Although the parties may consider the possibility that cash is trapped in foreign jurisdictions when they negotiate the purchase price, the acquisition agreement will almost never provide for purchase price adjustments or special trapped cash delivery mechanics. These mechanics simply are not practical in a public company deal.

Working out an appropriate solution to trapped cash problems requires a full understanding of the tax and regulatory requirements that place limits on repatriation by the buyer and the seller. This understanding can generally only be developed with the help of relevant tax and regulatory experts. Where the target business has cash in a number of different countries, the parties may need to develop a separate solution for each jurisdiction. Each party must also assess its relative bargaining power, and the credibility of assertions by the counterparty that its ability to use the cash is limited. Each party must also make judgments about the importance of the issues related to trapped cash, in juxtaposition with all of the other issues that may be addressed in the negotiation.

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