As the world starts to navigate the ‘new normal’ and adapt to the widescale transformation in the way we live and work, we are seeing an uptick in M&A activity. In this note we look at what that new normal might mean for the future of M&A, including emerging themes and practical considerations for buyers, sellers and portfolio companies.
Expect a more cautious approach to due diligence from both buyers and W&I insurance providers following such a quick and unprecedented shift (of ‘once in a lifetime’ proportions) in the way almost all businesses are required to operate. They will want to understand how the target responded to this challenge, how it has adapted to its particular version of the new normal and how well placed it is to withstand future large-scale upheavals.
Key areas that may see heightened scrutiny in legal due diligence are likely to include:
Material contracts: how watertight are the business’ contracts with its customers and suppliers – are there any provisions that could allow counterparties to terminate by reason of the pandemic (e.g. an inability to fulfil the contract or force majeure)? Are any customers or suppliers facing a risk of insolvency or large-scale disruption?
Health and safety: how has the business managed employee safety in line with government guidelines? Does the business have a clear strategy around a full or partial return to work?
IT systems: is business continuity feasible through remote working? If so, how has the business’ IT infrastructure coped with new demands?
Financial support: has the business received any government support during the pandemic, such as the Coronavirus Large Business Interruption Loan Scheme, or through the furloughing of employees? How will the business transition away from such support? Has the business complied with the requirements of the relevant scheme?
Tax: has the business deferred any tax payments? Has the business considered the effect of remote working on which country it is tax resident in?
Mitigation: what steps has the business taken to preserve cash? Has it undertaken any restructuring or made any redundancies? What further steps could the business take should we face a second wave?
Buyers and insurers are increasingly likely to require a 360°, risk-based approach to due diligence to make sure that the impact of the pandemic, and how well the target has re-aligned itself for the future, is fully understood. On W&I backed deals, this will be essential if wide-scale exclusions are to be avoided. Providers of due diligence (e.g. financial, operational and legal) will need to collaborate to ensure key risks are assessed from all angles.
Most (if not all) businesses will have seen - in some cases extreme - fluctuations in their financial position during the pandemic. The direct impact of the pandemic as well as regular changes in restriction and government policy will mean that finding representative points to assess a business’ financial position, whether pre or during COVID-19, will be extremely challenging. Might the traditional equity ticker lose its place?
In what may become a buyer’s market, one consequence may be a shift to completion accounts; however this is not an attractive solution for selling investors, nor is it necessarily an adequate solution as the parties will still need to agree what ‘target’ working capital looks like. However, it does give buyers greater control to make post-completion assessments.
Market uncertainty is likely to result in mismatches between the pricing expectations of the existing stakeholders and what a buyer is prepared to pay.
Possible solutions are likely to include sellers being asked to roll-over some of their value alongside the incoming sponsor or strategic purchaser (in the form of vendor loan notes or institutional strip) or even accept an earn out contingent on the future financial performance of the business. Where this is needed, buyers should give early thought to structuring and key terms such as the sellers’ rights (if any) in the new structure and the tax effects of such arrangements.
COVID-19-specific warranties are already a prominent feature in transaction documents to cover actions taken in response to, and compliance with, COVID-19 related measures. Examples include new warranties relating to the furlough scheme, CLBLS, CBILS or other financial support and an expansion of existing warranties relating to the sufficiency of IT systems, counter-party termination rights in material contracts and employee health and safety.
Sellers should make sure that their disclosure processes provide as much detail as possible to give a clear picture of the target’s COVID-19 response and the impact of the pandemic on the business. Sellers should also remain mindful of the impact of COVID-19 in the round when disclosing against all warranties and ask themselves: “but how has COVID-19 changed this?”.
The resounding message from brokers has been that insurers have a sustained appetite for underwriting deals – particularly with the fewer processes that have come to market since COVID-19 began. In the short term, this has resulted in lower premiums and, in some instances, room for negotiation of blanket COVID-19 exclusions. In the medium term, however, the expectation is that there could be an increase in claims as buyers look to recoup value that has been lost during lockdown, which in turn may drive premiums back up beyond pre-COVID-19 levels.
Key due diligence topics are likely to be subject to closer scrutiny by insurers. Whereas warranties such as those in relation to health and safety or business since the accounts date may not have previously been a typical area of exclusion, buyers should expect a conservative approach from insurers in these areas – particularly if underwriters concede no general COVID-19 related exclusion.
Insurers have increased their focus on specialist products, a trend that has been accelerated by recent events. Both synthetic warranty coverage for alternative opportunities such as distressed sales and public to private (P2P) deals (where a conventional warranty package may not be obtainable) and COVID-19-specific contingent risk policies may now be available. Contingent risk policies seek to cover specific known exposures, and thereby provide a route to unlock value. In the current climate, contingent risk policies may remove barriers to completion such as tax or debt related risks, or even exposures related to the legitimacy of government subsidies or loans.
The COVID-19 pandemic is likely to result in longer gap periods to accommodate the time needed to obtain approvals (particularly with the rise of state interventions and some widespread administrative backlogs created by the pandemic) and transaction conditions that give buyers flexibility to walk away from a deal. While long-stop dates and extension periods can be drafted to cater for this in part, the split deal brings with it uncertainty that both parties will seek to mitigate.
Buyers should be prepared for increased state scrutiny, particularly in acquiring strategic assets at a discount price in the wake of the pandemic. Although protectionism has been an existing trend for some time, in March 2020 the European Commission urged Member States to introduce or use existing foreign direct investment (FDI) regimes to screen foreign takeover of assets relevant to security and public order during the pandemic. The UK government is also planning a new and distinct FDI regime in the coming weeks to review a broad range of transactions on national security grounds. It is already amending existing merger control rules to allow for state intervention in respect of transactions related to public health infrastructure and certain advanced technologies.
Buyers should be mindful that minority deals can also be affected – for example in Spain, the acquisition of a mere 10% of share capital of an assets in certain sectors could trigger the requirement for government approval.
Buyers and lenders may seek the inclusion of walk-away rights to cover specific circumstances that may arise as a result of a second wave and further lockdowns. Normally more common in the US than on European deals, material adverse change clauses (MACs) that trigger walk-away rights may be seen as a mechanism to mitigate ongoing uncertainty. Although a typical MAC wouldn’t capture a pandemic itself (they normally exclude matters that the buyer is aware of), MACs could cover situations such as the reclosure of the relevant business for a certain period of time, non-extension of support measures, inability to secure debt finance or the insolvency of a key customer or supplier. Such provisions are likely to be contentious and buyers should expect sellers to resist strongly. Anecdotally, we have seen an uptick in questions relating to walk-away rights, but many deals remain competitive so we have not yet seen an uptick in their presence in sale and purchase documentation.
Delays may arise from regulatory bodies dealing with backlogs owing to periods of closure/reduced working during lockdown. Financing and refinancing processes may also be extended if lenders take longer to provide credit approval - well-scoped and thorough diligence will be important to facilitate this.
The unpredictability of the markets has created a real challenge for businesses to forecast their own growth, which has affected both sponsors’ and managements’ equity investments. Management incentive plans based on performance hurdles may be difficult to agree in the absence of a clear business plan. Similarly, recent years have seen HMRC increasingly focussed on the valuations that sit behind the price paid by managers for their equity, and it is important that businesses get this right despite the challenges of the current climate. As the UK government’s focus in the coming months changes from supporting the economy to raising taxes, there is likely to be an increased focus on changes to capital gains tax rates (possibly as part of the October statement). This may push management to try and open discussions with sponsors regarding the possibility of realising gains prior to any increase.
A reduction in the availability or feasibility of debt funding may lead to sponsors considering more creative funding, including more minority/co-investment arrangements in order to bridge this funding gap.
Despite the recent disruption, the leveraged market remains active with good levels of liquidity and favourable financing terms achievable for good credits. However, buyers may find pricing is higher than pre-COVID-19 levels and, given the potential for further uncertainty, particular attention should be paid to the deliverability and conditionality of a lender’s commitment.
Any steps taken by the target group to mitigate the impact of the pandemic, particularly the use of government funding schemes, should be factored into a buyer’s financing. Whilst it remains challenging to achieve broad COVID-19 related carve outs, features such as a PIK toggle can help to preserve a company’s cash reserves and buyers should look to maximise flexibility around financial covenants to protect against future fluctuations in the target’s financial position.
Many businesses have increasingly been placing environmental, social and governance (ESG) matters at the forefront of decision making and recognising both the benefits and, increasingly, imperatives in doing so. Will the impact and aftermath of the COVID-19 pandemic amplify and hasten the trend towards this ESG focus? While businesses seek a return to normality, the challenge remains: how can we create a better normal?
