This article was written by Alex Elser.
The unprecedented uncertainty and volatility resulting from COVID-19 obviously has significant impacts for M&A transactions – both those currently under negotiation and those signed but yet to complete.
The resulting social and economic interruptions, including earnings impacts, supply chain disruption, consumer spending irregularity and the tightening of debt financing and capital markets, have combined to make traditional valuation and deal protection mechanisms potentially inadequate, at least temporarily. Moreover, one of the key challenges for M&A transactions in the face of COVID-19 is that whilst the fact of disruption is obvious, it is not yet possible to properly assess the magnitude or short, medium and long term effects of the situation at a macroeconomic level or on specific industries. There is no precedent crisis which affects us all both economically and socially and the issues raised are untested. The impacts are also highly industry specific. Some industries hit in the short-term may take longer to recover to their pre COVID-19 levels, while other industries currently experiencing a spike may see a decline in the medium term back to pre COVID-19 levels.
Parties will need to carefully consider risk allocations and be ready to work with the other side to find creative solutions to get the deal done. In this article, we highlight some key considerations for parties navigating M&A transactions in this environment.
Protecting a deal through a material adverse change clause
A material adverse change condition precedentor termination right (MAC) is a key component of the deal protection toolset in private M&A and will be a key focus of bidders and targets in deals. We have seen today the announcement by a Target, Abano Group, that it is assessing whether a MAC has occurred in relation to the proposed Scheme of Arrangement involving BGH and the announcement by Quadrant that it has ceased discussions in relation to its proposed acquisition of Total Tools.
Given that “qualitative” MACs which are not triggered by objective events are notoriously difficult to enforce (usually requiring a catastrophic adverse event which impacts the target over a sustained period - often of a couple of years), MAC clauses are usually carefully drafted by reference to the underlying basis of valuation (e.g. EBITDA).
Given that the impacts of COVID-19 are changing on a day-by-day basis, often in unforeseen ways, even an objective MAC which seems appropriate today may be inadequate to capture the effects on the business in both the short and medium term.
A MAC will need to be drafted and considered in light of all conceivable COVID-19 impacts on each particular business over different time periods. Even if a traditional financial metric (such as a diminution in EBITDA or asset value) is used as the foundation of the MAC, buyers should also consider including other relevant industry-specific triggers such as availability of suppliers and/or manufacturers and internal disruptions (especially the availability of the labour force). Key-man risk associated with specific personnel becoming unwell or unable to perform their roles because of social distancing measures or travel restrictions should also be addressed through the MAC where the role of specific people is important to the ongoing value of the target and its business.
It is common for MAC clauses to carve out an event which impacts the industry or economy as a whole, in some cases, so long as it does not disproportionately impact on the target. Given the global impact of COVID-19, we would expect to see such limitations strongly resisted by buyers as they may be triggered by the current COVID-19 related disruptions, which would make the MAC redundant.
For acquisition agreements that have already been signed but not yet completed, the parties will need to carefully consider whether any existing MAC provisions are triggered. This will require a close examination of the specific drafting.
Normalisation as a condition to completion?
A MAC protects a buyer by giving it the right to terminate a transaction if certain adverse events occur between the time of signing the acquisition agreement and completion of the sale. In short, it is something that is intended not to happen before the parties are otherwise ready to complete.
Given the level of disruption and extreme uncertainty caused by COVID-19, both socially and economically, and the entirely unpredictable timeline for the disruption to ease, we expect some buyers to look for a condition precedent which requires a level of normal financial performance and stability before they are willing to proceed with transactions. This could be because they cannot have confidence in their valuations and the underlying business before such stability returns. It could also be because of significant key man risk and the unavoidable issue of a key man becoming unwell. In the case of strategic buyers who are managing their own businesses in the face of the crisis, they may be unwilling to invest internal financial resources in M&A if those funds may be needed to maintain their own operations, service debt and ensure that existing debt covenants are not breached.
What constitutes a level of normality will by necessity be industry specific. Buyers will need to look not only at revenue and earnings but also the ability to maintain a normal level of earnings in the medium to long term. For example, if ongoing supplier and/or manufacturer closures mean that medium to long-term earnings will be impaired after any stored inventory has been exhausted.
Shifting sands in valuations
Traditional purchase price mechanisms may not be adequate to protect buyers, nor achieve the right valuations for sellers, in a COVID-19 environment.
Whilst we have seen a strong shift to locked box pricing mechanisms in recent years (especially in competitive auctions), basing the purchase price off a historical balance sheet may be resisted in a period of earnings volatility. More traditional post-completion adjustment mechanisms may also be sub-optimal both for a seller seeking to retain transaction value and a buyer seeking downside earnings protection. For example, supply chain impacts and other movements in working capital items which do not reflect historic patterns, will likely cause abnormal impacts in working capital which in turn cause historical working capital reference points to be inaccurate.
In the face of volatility and uncertainty which cannot be fully managed with the standard deal protection armoury, we expect to see parties negotiate alternative consideration mechanisms such as an earn out. In circumstances where acquisition financing is difficult to arrange, we also expect to see increases in vendor finance and other deferred consideration.
Buying extra time
M&A transactions will inevitably take longer to negotiate and complete than usual in the current environment. Consents from government agencies will take longer to obtain. Due diligence will need to be broader to cover the COVID-19 impacts in detail and will also be harder and more time-consuming to complete. Parties will need to carefully consider the long stop / sunset date in any proposed acquisition agreement and closely monitor existing dates in acquisition agreements that are yet to complete.
Given the inherent desire of parties for some degree of deal certainty, where the parties have invested significant resources in pursuing a transaction but the level of uncertainty proves unmanageable or debt financing is unachievable, we may see parties entering into options which give the buyer the option to proceed with the deal on the already agreed terms.
No such thing as ordinary?
Requirements for the target business to be conducted “in the ordinary course of business” pending completion and base line information requirements (such as monthly management accounts) are usually considered par for the course in acquisition agreements. However, in a period which cannot realistically be described as “ordinary” and where targets may well need (and want) to respond to events quickly and flexibly, parties will need to closely examine these otherwise usual provisions.
Buyers will need to very specifically consider the transactions and other actions which the target should not be allowed to take pre-completion, or alternatively must take to preserve the business. Restrictions on pre-completion conduct which typically contain ordinary course carve outs (i.e. where the seller is permitted to acquire or dispose of inventory in the ordinary course of business) may no longer be straight forward and will require specific consideration on a case by case basis. The common exception to the pre-completion covenants for emergency measures will need to be considered in more detail and in light of the COVID-19 responses the target may need to take.
We also expect to see buyers seeking significantly greater information rights so that they can monitor targets’ businesses and COVID-19’s impacts both at a greater level of detail and in real time.
It is usual practice for there to be disclosure against the business warranties of matters “fairly disclosed” in the data room and disclosure letter.
In our transactions, we have already seen several instances of sellers making broad disclosures against warranties for all matters which are, or may be, in any way attributable to COVID-19. Whilst there is a legal question about whether such unspecific disclosures are actually effective disclosures at the “fairly disclosed” standard, appropriate disclosures against the business warranties will be an issue for both sellers and buyers in the current situation.
Sellers will need to make sure that their disclosures are sufficiently specific to ensure that the relevant matters are “fairly disclosed” and ensure that they have access to the most current information available so that the disclosures are accurate.
Buyers on the other hand, will need to make sure that the disclosures are genuine specific disclosures of issues the target is encountering, and not just effective disclaimers of anything related to COVID-19.
W&I insurance may not protect against the impacts
We are seeing W&I insurers in the Australian market endeavouring to impose exclusions in all policies for any matters which can be traced to COVID-19 and avoid liability for any eventuality which can be tied back to a COVID-19 impact. The bounds of this exception, especially in relation to impacts which are not directly referrable to COVID-19, remains to be seen.