A novel structure of scheme consideration
9 min read
The recent acquisition of an unlisted public company, Crestone Holdings Limited, has established a new market precedent involving the use of earn-out consideration under a scheme of arrangement.
In this Insight, we examine the relatively novel structure of the scheme consideration, which was carefully considered by ASIC, as highlighted in Issue 9 of ASIC’s Corporate Finance Update.
- The transaction involved the acquisition of Australian wealth management group Crestone Wealth Management by the world’s largest family-owned private banking and asset management group, LGT Group.
- The acquisition was implemented by way of a scheme, with eligible shareholders entitled to upfront cash consideration, along with the right to receive a potential future earn-out payment, calculated upon the financial performance of the business in the financial years 2024 to 2026.
- The use of earn-out consideration in public company transactions will continue to be scrutinised by ASIC and the courts.
- In any such future transactions, scheme parties should carefully consider what measures may be required to adequately mitigate any performance risk associated with the future provision of contingent or deferred consideration.
What was the scheme consideration payable in the Crestone scheme?
The target, Crestone Holdings Limited, was an unlisted public company with approximately 100 shareholders, the vast majority of which comprised current and former employees and officers. The commercial design of the scheme consideration in this transaction reflected the shareholder base of Crestone, given the importance of ensuring that former shareholders were incentivised to continue to contribute to the financial performance of the Crestone business.
Under the scheme, all fully paid ordinary shares in Crestone were acquired by LGT in consideration for an upfront cash amount along with a potential future earn-out payment, calculated on the financial performance of the business in the financial years 2024 to 2026. Shareholders may be disqualified from receiving the earn-out consideration if they engage in certain competitive conduct during the earn-out period.
Other examples of contingent consideration in public M&A transactions
The use of earn-outs and other forms of contingent consideration in Australian public M&A transactions is not entirely novel, albeit uncommon. Both ASIC and the courts are typically reluctant to sanction a scheme of arrangement in circumstances where a material component of the scheme consideration is subject to a contingency to be determined over an extended period following completion of the scheme.
Examples of such transactions include:
- Mitre 10 scheme of arrangement (2010): Metcash acquired a 50.1% shareholding in the Mitre 10 group upfront under a scheme, with redeemable convertible preference shares representing 49.9% of voting power being issued to existing shareholders. Metcash could elect that the preference shares be redeemed for cash at a future point in time, and acquire outright ownership of the business following the exercise of this right. The redemption price payable was calculated by reference to certain EBITDA and net debt thresholds for the relevant periods.
- Centrebet scheme of arrangement (2011): In addition to upfront cash consideration, Centrebet shareholders were entitled to contingent consideration, through the issue of litigation claim units, which were payable if the target obtained a tax refund following implementation of the scheme.
- Dental Corporation scheme of arrangement (2013): Bupa Australia acquired 100% of the shares in unlisted public company Dental Corporation Holdings Ltd, under a scheme, with shareholders entitled to upfront consideration and the right to receive three potential annual earn-out payments over the subsequent three years. The amount of these payments was determined by reference to the adjusted EBITDA and the net debt of Dental Corporation for the relevant periods.
- BINGO Industries scheme of arrangement (2021): Bingo shareholders could elect to receive mixed consideration under the scheme (ie a cash and unlisted scrip alternative). The scrip alternative included a Class C Share, which entitled the holder to receive an earn-out dividend per share, subject to certain conditions being satisfied (including EBITDA thresholds).
In contrast to these previous transactions, the Crestone scheme involved a significantly longer period of time over which the earn-out scheme consideration would be calculated, as well as the possibility that former shareholders could be disqualified from receiving the earn-out consideration if they were to engage in certain competitive conduct.
These arrangements were only accepted by ASIC and the court on the basis that Crestone was a closely held unlisted public company, and having regard to the unique characteristics of the Crestone shareholder class.
What are ASIC’s key areas of focus in relation to earn-out consideration?
When considering earn-out or other form of contingent scheme consideration, ASIC will focus on the following key points:
- Conduct restrictions: whether, as a matter of public policy, it is appropriate that scheme consideration be offered to shareholders that is contingent on certain conduct restrictions or other conditions. Where consideration could be rescinded or reduced as a result of a shareholder’s future conduct, ASIC may consider this to be akin to a restraint of trade that would typically be negotiated directly between a company and its employees as part of an employment relationship.
- Uncertainty of earn-out consideration payable: any uncertainty as to the calculation of the earn-out consideration that shareholders may ultimately receive, particularly if the total consideration payable may not be known for a number of years.
One of the key reasons why ASIC ultimately determined that the above concerns should not prevent the Crestone scheme from proceeding was that, unlike a typical listed company scheme where the scheme consideration would be received by a significant group of retail investors, the Crestone shareholder class was a closed class comprising primarily current and former employees, directors and their associates (a distinction that Justice Black of the NSW Supreme Court also highlighted). The views of ASIC and the court might ultimately have been different had the target company’s shareholder base included a significant number of retail investors.
How were ASIC’s key concerns addressed in the Crestone scheme?
The vast majority of the (now former) Crestone shareholders continue to work in the Crestone business following implementation and are collectively crucial to its ongoing performance. This can be contrasted with most schemes of arrangement, where shareholders are typically no longer associated with the business following the sale of their scheme shares.
This distinction was recognised by both ASIC and the court, where they acknowledged that the conduct restrictions applicable to scheme shareholders served a legitimate commercial purpose, as any breach of such restrictions may adversely affect the ability of the Crestone business to realise its full value, and thereby reduce the total consideration that might be paid to shareholders.
No new class created
The conduct restrictions here applied equally to all Crestone shareholders (as opposed to being applied on an unequal or inconsistent basis to particular shareholders who were also Crestone employees). The fact that some shareholders may, due to their personal circumstances (including retirement), be less likely to breach the conduct restrictions was not, in these circumstances, regarded as sufficient to constitute a separate class.
Uncertainty of earn-out consideration payable
In approving any scheme of arrangement, the courts will typically focus on the ‘performance risk’ issue, being the risk that the bidder will not perform its obligations under the scheme to provide the scheme consideration once the shares in the target have been vested in it. This issue was of particular significance in the Crestone scheme, given that a material component of the scheme consideration could potentially be in the form of an earn-out payment, the payment of which will not be due until more than five years after completion of the scheme.
To address the performance risk issue, various measures were adopted to mitigate the risk of non-payment of the earn-out by LGT as the purchaser. These measures included specific undertakings from LGT under the deed poll, a trustee structure under which the right to receive earn-out consideration is held (and enforceable) by a corporate trustee on behalf of all Crestone shareholders and a bank guarantee provided by a related company of the purchaser.
Justice Black observed during the first court hearing that:
- the nature and conditionality of the earn-out consideration, and the extent of the performance risk with respect to its future payment, was sufficiently disclosed in the Crestone scheme booklet; and
- Crestone shareholders would be able to commercially evaluate the future performance of the business and the level of associated performance risk, given their expertise as current and former financial advisers.
Independent expert valuation
In considering the Crestone scheme, the independent expert concluded that the upfront cash consideration was within the assessed valuation range for the Crestone shares on a controlling interest basis, and was accordingly fair, reasonable and in the best interests of shareholders. As a result, in arriving at its opinion, the independent expert did not need to take into account the value of the earn-out, as the earn-out merely enhanced the total consideration, and represented further value that could be realised by shareholders under the scheme.
A further protection afforded to Crestone shareholders under the scheme was a mechanism under which shareholders could dispute:
- the preparation and calculation of the earn-out payment by LGT; and
- whether or not that shareholder may have breached any earn-out conduct restrictions that could disqualify them from receiving earn-out consideration.
ASIC has indicated that it will continue to monitor the use of earn-out consideration in public company transactions and intervene where appropriate. It is clear that both ASIC and the courts will closely scrutinise any scheme of arrangement undertaken by a widely held or publicly listed company involving contingent or deferred consideration, where the entitlement to such consideration is subject to certain conduct restrictions or other eligibility conditions.
ASIC recently reiterated that it only accepted arrangements of this type in the Crestone scheme on the basis that Crestone was a closely held unlisted public company, and the independent expert had concluded that the initial scheme consideration was within the assessed valuation range for the Crestone shares (ie it did not need to consider the value of the earn-out to reach that result). In future transactions of this type, scheme parties should carefully consider the measures that may be required to adequately mitigate any performance risk associated with the future provision of contingent or deferred consideration.