We are currently living in exceptional and unprecedented times, to say the least. The COVID-19 pandemic has been keeping a tight grip on the world for months, leading to a virtual standstill in many areas of our normal lives.
Undeniably, this has also affected (or shall we say “infected”) the M&A market. A significant number of deals were cancelled or at least postponed. Potential strategic investors seem hesitant about spending their cash balances on inorganic growth. Private Equity funds might not be able to obtain the required approvals from their investment committees given this uncertainty. A tightening of debt markets takes an additional toll on deal financing. At the same time, sellers who are not forced to sell might be reluctant to enter an M&A market with anticipated lower valuations.
All in all, it appears as if market participants are practicing their own kind of safe distancing to curb the impact of COVID-19.
Quite a substantial amount of ink was spilled in the last few weeks on how COVID-19 might influence the legal M&A landscape. In this briefing we summarise the current trends and discussions and add our own thoughts and observations of the market. The goal is to provide a comprehensive overview that brings our readers up to speed. Before we begin, a word of caution: the current situation remains fluid and subject to continuous evolvement and changes.
We split this briefing into separate chapters for due diligence, transaction documents, consideration mechanisms, W&I insurance and other implications for transaction management consolidated at the end. Where applicable and required, we discuss how ongoing deals might be impacted by COVID-19 and how COVID-19 (or similar pandemics) might shape M&A deals in the future.
Wherever we refer to “COVID-19 measures”, we refer to any applicable laws or other recommendations and guidelines issued by governmental authorities in connection with or as a response to COVID-19, including quarantine, “shelter in place”, “stay at home”, social distancing, shut-down or closure measures.
We expect an increase in due diligence work on the following points, both for ongoing and future M&A deals:
We believe that a “COVID-19 stress test” will likely become part of any future due diligence exercise in the near term. In a post-COVID-19 world, such stress tests might also give interesting insights on the “anti-fragility” of the target business and, in particular, the capability of management to deal with extraordinary situations.
Last but not least, we must not overlook the most basic practical implications:
1. Material Adverse Change
Not surprisingly, this is currently the “hottest” topic: Material Adverse Change (“MAC”) clauses. NB: We use MAC interchangeably with Material Adverse Effect (“MAE”) and conceptually do not distinguish between them.
The predominant use of a MAC clause in transaction documents is the absence of a MAC as a condition precedent to Closing. This could be a standalone condition precedent or in combination with a breach of representations and warranties whereby such breach results, or is reasonably likely to result, in a MAC. The interpretation of a MAC clause, in particular if COVID-19 falls thereunder, lies first and foremost in its particular drafting. The devil is in the detail:
It will be interesting to see if there will be a change in risk-allocations of a MAC. Currently the risk of a pandemic such as COVID-19 emerging or escalating between Signing and Closing is rather borne by the purchaser. If the next months turn out to be a buyers’ market, then – maybe – the general risk of pandemics or other force majeure events will be shifted to seller by omitting the carve-outs to a MAC discussed above. It would also not surprise us that for as long as the COVID-19 pandemic is ongoing, a purchaser might push for a specific condition precedent besides a MAC clause, dealing with a worsening or escalation of COVID-19. Sellers will then need to decide whether to – reluctantly – accept such condition or face the alternative of calling-off the transaction. This will go hand-in-hand with the question on whether such risks are already priced in by the purchaser in the purchase price. If so, sellers will presumably refuse to additionally bear the burden of deal uncertainty.
We expect increasing usage of MAC clauses in jurisdictions where MAC as a condition precedent is not yet common.
2. Interim Covenants
An interim covenant customarily included in transaction documents where there is a gap between Signing and Closing is a “conduct of business” covenant. Conduct of business covenants oblige the seller to conduct the target business in the ordinary course consistent with past practice and to materially preserve and maintain the goodwill and relationship with customer and suppliers of the target group. Usually, there is also a catalogue added with specific prohibited activities and actions. The COVID-19 pandemic might necessitate adjustments in form of carve-outs thereto.
During the COVID-19 pandemic:
Following the COVID-19 pandemic:
Caveat: For any interaction of the parties between Signing and Closing ”gun jumping” prohibitions should be kept in mind. Such prohibitions interdict the premature implementation of mergers before anti-trust clearance is granted.
Two final points:
3. Representation and Warranties
Areas for potential breaches of representation and warranties (“R&Ws”) are myriad: Default under material contracts, loss of suppliers or customers, bad debt provisions for receivables, redundancies and other HR measures, write-down of assets and other impairments, just to name a few.
During the COVID-19 pandemic:
4. Specific Indemnities?
Although currently discussed in the market, we deem it to be rather unlikely that a seller will be willing to give specific indemnities to compensate a purchaser for any COVID-19 related losses. Much will depend on the respective bargaining power. Since there are reasonable grounds to expect that the next few months will be a buyers’ market, we would not entirely rule out such possibility.
5. Force Majeure Clauses
Force majeure clauses (as encountered in commercial contracts) are so far hardly seen in transaction documents. And rightly so: Such specific force majeure clauses do not fit into the spectrum of M&A deals and their “strict” nature. It runs counter their structure as currently facilitated via the conditions precedent and would open a side-door jeopardizing deal security. Rather, the battles will be fought elsewhere, in particular on the definition of MACs and potentially the inclusion of new conditions precedent.
Judging from discussions in the market, it appears that “lockedbox” mechanisms are in serious peril following the COVID-19 pandemic. Most market participants expect a decisive shift to closing accounts with financial debt and working capital adjustment at Closing as one way to – at least partially – safeguard against pandemic risks.
However, this is not a panacea. Since the calculations of enterprise values on a cash-free / debt-free basis is usually based on EBITDA or other earning multipliers, the better question is whether these are still achievable going forward. So the “go-to” solution appears to be either (i) pricing in COVID-19 or other pandemic risks from the outset (and risking the attractiveness of the offer) or (ii) implementing earn-out mechanisms to somewhat share the risk between seller and purchaser.
On the latter, earn-outs also come along with their own intricacies:
It will be interesting to see whether any hybrid models emerge: Lowering of a certain portion of the consideration (possibly plus an earn-out kicking in) in case of the occurrence of a pandemic or other force majeure events during a certain period post-Closing. This again comes along with its own complications.
As debt markets are substantially tightened, we anticipate that purchasers might approach sellers to partly finance an M&A deal via the use of seller notes. Alternatively, the purchaser might offer share-for-share consideration for at least a portion of the purchase price whereby the consideration shares are valued by applying the same valuation as applied to the target shares. Question here is on whether there will be a fixed exchange ratio or a true-up at Closing to take care of any fluctuations in the value of the consideration shares.
In a nutshell: A cover for COVID-19 related losses under a W&I (Warranty & Indemnity) insurance is very unlikely. In fact, we expect such losses to be fully excluded under W&I policies.
1. Longer Timelines
Deal parties should expect longer time frames between Signing and Closing due to the extended timelines for regulatory approvals as well as existing travel restrictions. All such considerations should be reflected in an appropriate timing for long-stop dates.
Whether more due diligence time will have to be scheduled in deal planning to cover additional COVID-19 items during the due diligence exercise is yet to be seen.
2. Remote Signing and Closing
In most common law jurisdictions, Signing and Closing can be handled remotely with circulation of originals afterwards if required for filing purposes. Civil law countries might need the involvement of a notary and personal presence of representatives. Additional pre-cautions need to be taken in light of COVID-19 measures.
A practical point worth noting: Although a lot can be done remotely, face-to-face negotiations have proven in the past to be an extremely efficient way to hammer out material points amongst principals. It will be interesting to see how this evolves.
We need to stress that we are in unchartered waters and, to lean on a famous quote, it is difficult to predict, especially the future.
That said, we do expect M&A activity to pick up again once the first dust has settled and there is more certainty in the planning process. European countries are taking the first cautious steps towards easing the strict lockdown measures with the expectation that most economies will gradually reopen from the beginning of May. Here in Southeast Asia we observe similar trends. However, much will depend on the availability of an effectual treatment for or vaccine against COVID-19.
Various factors could reignite M&A activity: Vertical integration to secure supply chains or sales, buying out of joint venture partners, distressed sales and special opportunities or simply low valuations due to the COVID-19 pandemic. Evidence suggests that those that acted quickly in 2008 when all the other market participants were fearful benefited after the market recovery.
On the flipside, at least in Europe and most recently also in India, voices are gathering for stricter foreign take-over rules to shield vulnerable companies from potential hostile takeovers from abroad. This might significantly dampen foreign direct investment flow from purchasers with a substantial cash war-chest.
Whatever lies ahead, it is paramount to be in the best possible shape for a time post-COVID-19 – and there will be such time. We will be ready to guide and support you!