Despite the decline in the mining sector, Mergers and Acquisition (M&A) activity in the Engineering and Construction (E&C) sector continues to accelerate, driven by increased Government commitment in infrastructure, consolidation of smaller players and spin-offs of non-core businesses.
The level of activity is likely to continue following;
- The G20’s endorsement in Brisbane in November 2014 of a plan to improve public and private infrastructure development (as part of the global infrastructure initiative), which is expected to unlock an additional AU$2 trillion in global infrastructure capacity to 2030; and
- Australia’s Free Trade Agreements with China, Japan and Korea, which is already resulting in a greater interest by North Asian E&C companies exploring acquisition opportunities in Australia.
M&A in the E&C sector raises unique issues and challenges which will need to be managed as part of the due diligence process and in dealing with the allocation of risk between buyers and sellers.
These unique issues and challenges include:
Assessing Debtors and Work-in-Progress
As part of the due diligence process, a buyer will need to carefully assess the value of debtors, work-in-progress and other accrued income balances (such as underclaims) recorded on a target’s balance sheet relating to E&C projects. A seller will normally view these account balances positively, as they add considerable value to the sale price. However, buyers need to tread carefully. Risk areas include:
- where revenue is recognised, but cannot be claimed under a contract until certain milestones or dates are reached; or
- where revenue is recognised in relation to variations to the scope of program of works, but the variations and/or value of the variations have not been agreed by the client.
Assessing Contract Risks
A buyer will also need to understand the risks arising under contracts typically seen in the sector, such as Design & Construct (D&C), Operation & Maintenance (O&M) and Public-Private Partnership (PPP) related contracts. The areas that have historically given rise to disputes or reduced returns include:
- Onerous provisions: Contracts will need to be reviewed for onerous provisions, including where contracts do not contain overall liability caps or exclusions for consequential loss or contain provisions that allow a principal to terminate for convenience.
- Post-construction claims: The defects liability period and the tail of liability in major projects will need to be considered (including understanding the target’s track record with respect to the level of post-construction claims).
- Likelihood of project delivery: It will be important to review contracts to determine whether current projects are likely to be delivered by the relevant sunset date, and if not, the consequences for the target (eg. through “look ahead tests” which are often included in Project Agreements and which often flow through to underlying D&C contracts). Determining extension events (and whether they are compensable) and whether there are any other project relief/ entitlements will also be important.
Obtaining Third Party Consents
Ensuring the consent of counterparties to D&C and O&M contracts and related project agreements and joint venture agreements are obtained (where required under those contracts) will be another key issue to ensure the continuity of the business post-closing. Consent may be required if there is a restriction on upstream changes of control in the target (which is likely in relation to PPP related contracts).
For example, Australian State and Territory Governments normally have an absolute discretion under PPP related contracts with respect to whether they consent to changes of control. It is also not uncommon for Governments to use the consent process as an opportunity to renegotiate the terms of the relevant contract.
Foreign investment approvals
As foreign buyers seek opportunities in the sector, foreign investment approvals may be required. Broadly, this may be the case if the value of the shares or assets being acquired exceeds AU$248 million. As part of the China, Japan and Korea-Australia Free Trade Agreements, this threshold will move for investors from those countries to approximately AU$1 billion.
However, foreign investment approvals may be required irrespective of the value of the shares or assets being acquired in the following cases:
- Foreign government investors – This is the case where the buyer is a foreign government investor. This will include entities in which governments, their agencies or related entities from a single foreign country have an aggregate interest (direct or indirect) of 15 per cent or more; and
- Sensitive areas – Investments in sensitive industries, such as defence and transport (including airports, port facilities and rail infrastructure), may require foreign investment approval irrespective of value. This is particularly significant to the E&C sector, where many of the key contractors and consultants are involved in Defence infrastructure projects.
The expected increase in M&A activity in the E&C sector means presents an exciting opportunity. However, buyers and sellers will need to be alive to the unique features of the sector to avoid negotiations becoming frustrating and protracted or the deal falling over.