Mergers and acquisitions (M&A) are an established part of the CEO playbook and we can fully expect to see an increase in deal activity as the year progresses and we learn to live with the impact of COVID-19.
There are many reasons why companies and investors will consider the opportunities that transactions provide. History has shown that amongst the big winners from the post-financial crisis following the 2008 downturn were those companies that acquired quality assets.
The impact of COVID-19
When M&A activity picks-up again, the impact of COVID-19 will drive and shape those deals. It is impossible to predict with absolute certainty, but we expect to see a number of themes emerge.
- Buyers will become more assertive. Companies and investors that emerge strongly from the crisis will look to take advantage of opportunistic acquisitions.
- Other companies will emerge weaker, leading to forced sales in order to realise cash or allow for an exit. In common with previous recessions, we may see owner managers decide that this is one downturn too many and seek to exit. The volume of opportunistic, stressed or distressed M&A opportunities will increase.
- Private equity (PE) has money to invest. Protecting portfolio companies has been their immediate focus, so initial PE backed deals are likely to be for bolt-on acquisitions. The increased time it will take to complete diligence on management, and banks’ willingness to deploy acquisition finance will impact investments in new companies in the short term. Notwithstanding these challenges, the record levels of capital held by PE houses still needs to be deployed. This mandate will lead to sponsors adjusting their expectations on debt leverage, return ratios and indeed the types of investment they target, accordingly.
- The number of take private transactions seems likely to increase. Smaller listed companies may want release from their regulatory burden, and depressed share prices dictated by wider market conditions may take the choice out of their hands.
- Certain sectors, notably life sciences, healthcare and technology will be most active as they are less impacted by the COVID-19 challenges than, for example, automotive.
The uncertainty of valuations is a stumbling block to all deals, especially in the hardest hit sectors like leisure and retail. Buyers who can show most flexibility to bridge the valuation gap will have a greater chance of success.
The underlying rationale behind transactions conducted in the shadow of COVID-19 means we expect to see new (or at least different) structural trends and norms emerge.
We have highlighted below examples of these likely trends, and how they might impact on buyers, sellers and investors.
- Longer deal timetables. All parties must be realistic as to timeframe. An inability to meet face-to-face will slow diligence, especially of management, and in the short term the challenge of COVID-19 itself will put constraints on the time that management and investment committees can give to new deals.
- Diligence issues. Collating documents for data rooms, site visits and meetings with management will become more challenging. In considering a target, expect buyers to have particular focus on issues raised by COVID-19, including furlough and redundancy programmes, contract resilience, government support (and State Aid), as well as increased IT and security risks posed by home working.
- Split exchange and completion. Typical covenants restricting business operation between exchange and completion may need to flex to allow sellers and target to act quickly in an ever changing world. They will perhaps be permitted to act “prudently” rather than necessarily requiring buyer consent if their conduct is not consistent with past practice. Warranty coverage between exchange and completion, and the implications of a warranty breach might become a source of increased negotiation, as buyer’s and investors seek certainty and sellers try to avoid losing control of a deal.
- MAC clauses. Material adverse change clauses often enjoy a resurgence at times of crisis, as they enable buyers to terminate agreements if certain events occur between exchange and completion. This time is unlikely to be any different and, whilst it is unclear whether COVID-19 will satisfy a generic MAC clause, buyers will propose wording that covers as many scenarios as possible while sellers will want to narrow the scope.
- Warranties and indemnities. Reliance on warranties and indemnities will come into sharper relief if diligence is compromised in any way, and COVID-19 impacted issues will come under increased scrutiny. With such an increased focus on warranties and indemnities, the use of warranty and indemnity insurance is likely to increase.
This could well result in sellers putting forward W&I cover at the start of a process to help address buyer concerns about diligence information and a more specific focus on allocation of W&I premiums as part of deal pricing. We may also, of course, see push back from insurers attempting to exclude the COVID-19 risk and/or an upward trend in the cost of W&I premiums.
- Consideration. For buyers and investors, being able to bridge the valuation gap will become the most important factor in deal success.
- Earnouts, and other contingent provisions are likely to increase in popularity. They are a means of (a) addressing downside risk for, and providing comfort to, buyers that there is some degree of risk sharing in an uncertain market and, at the same time, (b) allowing sellers to achieve some liquidity immediately (for example, by the sale of a non-core asset to assist cash flow for the primary business) when prices have dropped, whilst getting a second bite of the cherry in 1 -3 years in a more “normal” world (better reflecting the true underlying value of the asset). Counter-intuitively, sellers may prefer longer earn-out periods to allow time for market conditions to stabilise.
- With a likely buyer’s market, completion accounts may once again become the purchase price adjustment mechanism of choice; being considered more buyer friendly than the locked-box. However, post-completion adjustments usually compensate for any deviation of certain financial measures (typically the target’s working capital) from a “normal” level at completion. Buyers and sellers will need to agree how to “smooth” the impact of COVID-19 when setting that target level.
- Share consideration, particularly for public company buyer’s, may appear more attractive as it helps them to protect their cash reserves. Guarding against the risk of a fluctuating share price between exchange and completion may act as a disincentive, together with the usual complicating factors and considerations.
- Remote completions. In the era of COVID-19, completions will need greater planning. Expect to see greater reliance on the use of electronic signature platforms and, with the demise of physical meetings, perhaps the beginning of the end of the post-deal glass of champagne.
Anything else on the horizon?
As corporates and investors get to grips with changes caused by COVID-19, did we mention that there is also the impact of a US presidential election and the ongoing Brexit saga to consider!
More than ever, flexibility, planning and good advice will remain key to a successful transaction.