Private equity's share of global M&A deals featuring an earnout provision rose last year to its highest level since 2020 as fund managers leaned on deferred payments to close transactions in a challenging dealmaking environment.

The value of all announced M&A deals with earnouts totaled $73.11 billion globally in 2023, falling 34.2% from $111.06 billion in 2022 as overall M&A activity slowed in 2023, according to S&P Global Market Intelligence data. Private equity- and venture capital-backed deals accounted for 26.5% of the 2023 total, up from 17.3% in 2022.

Earnouts link a portion of a company's sale price to its future performance, and they are typically used to bridge the gap between what a seller thinks the business is worth and what a buyer is willing to pay — the valuation gap. Earnouts have become the "go-to tool" to get deals done when the macroeconomic outlook is clouded with uncertainty, said Liam Timoney, a partner at law firm Goodwin and member of its private equity practice.

Timoney added that earnouts are "heavily negotiated and it's significant chunks of the potential consideration."

General Partners 'caught in the middle'

Kip Wallen, senior director at M&A advisory SRS Acquiom Inc., said earnouts factored into roughly one out of every three private market deals the firm saw in 2023, well above the typical one-out-of-five ratio it has observed in the past. That estimate does not include transactions in the life sciences sector, where earnouts are much more common, Wallen added.

The value and volume of private equity-linked deals with earnout provisions peaked in 2023 in the third quarter, with 19 deals totaling an announced value of $7.18 billion. When Dechert LLC surveyed 100 private equity executives around the start of the third quarter, 92% said their firms were using earnouts to push deals across the finish line.

Wallen said the prominence of earnouts in recent private equity deals signals that private equity fund managers, known as general partners (GPs), are seeking creative solutions to exit portfolio companies and return profits to limited partners (LPs). Private equity's typical hold period for portfolio companies lengthened to 7.1 years in 2023 as of mid-November, up from an average of 5.7 years in 2022, according to S&P Global Market Intelligence data.

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"GPs are caught in the middle of LPs who are encouraging them to make exits, but also wanting to maximize the value of those investments," Wallen said. "That makes them, perhaps, a little bit more amendable to using an earnout, because now you can make the exit on the timeline that LPs are asking you, but you're not leaving potential value on the table that buyers wouldn't be willing to provide or pay up front at closing."

Private equity exits with earnout provisions accounted for 5.8% of private equity exit deal value in 2023, the highest percentage since 2020, according to S&P Global Market Intelligence data.

Companies in the healthcare sector were the target in five of the 10 largest private equity-linked M&A deals to feature earnout provisions in 2023.

Earnouts are more common in the healthcare sector, particularly the life sciences subsector, because they may involve medicines or therapies still under development or awaiting approvals. That was the case with the top 2023 deal, the $1.93 billion acquisition in July of Versanis Bio Inc. by Eli Lilly and Co. from an investor group that included Atlas Venture LP, Medicxi Ventures (UK) LLP and Aditum Bio Management Co. LLC

Lilly could owe the trio of venture capital investors additional payments "upon achievement of certain development and sales milestones" for Versanis' obesity drug, according to a press release.

Outlook

The prevalence of earnout provisions in private equity deals is likely to remain elevated in 2024, Timoney predicted. While there are early signs that M&A activity will pick up, and earnouts could be expected to fade in a more competitive deal environment, there is still a healthy dose of uncertainty in the outlook, not least because of an upcoming US presidential election, he said.

"Private equity sponsors value stuff based on multiples of earnings, typically, and that's based on the assumption that those earnings will continue into the future. And with economic climate, with the uncertainty, the confidence is not always there that those metrics will continue," Timoney said.