M&A in an uncertain world – wear gloves!

Apr 2020

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Like every aspect of business, deal-making is rapidly evolving its own COVID-related tests, and antibodies.

Business closures and limitations, spending deferrals, supply chain issues, tightening of capital markets and debt financing all affect earnings and the ability to get deals across the line.

These effects, combined with the inability to pick the trajectory of social and economic recovery, mean that traditional M&A valuation and deal protection mechanisms may be ineffective for both buyers and sellers.

We are yet to see how these unique factors play out for longer-term trends in deal structuring, financing and M&A activity once the COVID-19 situation stabilises. Those working on deals in this market need to be thinking about the specific COVID-19 impacts on valuations and deal structures and how they can take the strategic opportunities that will inevitably arise, while still managing risk.

Valuation and adjustments

Common pricing mechanisms aren’t suited to detecting the impacts of COVID-19 on market dislocation and resulting volatility of earnings and working capital. Working capital is a big unknown right now.

Clarity on collectability of receivables and the timing of revenue normalisation is extremely challenging. The result is that traditional post-completion adjustment mechanisms may lead to odd results due to unusual movements in the working capital reference point. For transactions under negotiation, these areas are getting a lot of attention.

A material adverse change clause (MAC) is a buyer protection often seen in M&A and will be a key focus in current negotiations. A MAC typically gives the buyer a right to terminate a transaction if certain events occur between signing and completion. While MAC clauses are usually drafted by reference to the underlying basis of valuation (eg EBITDA), given the unpredictability of the impacts of COVID-19, even an objective MAC may not be enough to capture the impacts on the business in the short and medium term.

The duration and severity of COVID-19 and its impacts will also be highly industry specific. Some will benefit in the immediate term; many are already suffering. MACs should be considered in light of COVID-19 impacts on the relevant business. We expect to see tailored triggers covering issues such as supply disruption being built into MACs. The usual carve-outs for economy-wide events are likely to be revisited.

Another common buyer protection is a requirement for the target business to be conducted “in the ordinary course”, coupled with specific restrictions on material transactions pre-completion. What is “ordinary” in this uncertain period? Targets may need to respond to events quickly and flexibly. Restricting a target’s ability to deal with the social and economic interruptions caused by COVID-19 may affect the target’s value – and therefore the buyer. Parties dealing now will need to consult much more closely over the pre-completion period.

Warranty & indemnity insurance has been increasingly popular in private M&A transactions. Not unexpectedly, insurers are looking to have exclusions in all policies for losses which are attributable to COVID-19 and government actions to stop its spread.

“Common pricing mechanisms aren’t suited to detecting the impacts of COVID-19 on market dislocation and resulting volatility of earnings and working capital. Working capital is a big unknown right now.”

Where to from here?

Buyers and sellers will seek ways to bridge gaps in valuation and to address uncertainty in the interests of a transaction. We will see more earn outs and components of deferred (and potentially flexible) payments. That is what we saw in 2009. Sellers will view COVID-19 as an interruption rather than a fundamental shift in value, whereas buyers will be wanting to manage their exposure in what looks like a risky environment.

Buyers will press for access to “more” – both in terms of extent and frequency of information so they can monitor the target’s businesses and the impacts of COVID-19. This information will feed back into MAC clauses. Buyers will be seeking protection on revenue, opex and capex and see targets maintain more normal levels across these measures in the medium term.

Opportunity will emerge, as it has after each major market shock, and those who are brave, decisive and pick well will come out of COVID-19 bigger and stronger.

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