The merger market – impact of COVID-19 on the M&A sector
M&A transaction volumes have decreased rapidly in recent weeks. Deals that were close to completion have been pushed over the line or paused while buyers evaluate the ramifications of the current crisis. Deals at earlier stages have been less fortunate with many being aborted or placed on hold indefinitely.
Sellers, who increasingly have seen their company’s valuation challenged by buyers, have diverted their attention from M&A activity to focus on preserving value in the expectation of higher valuations when the crisis ends.
Where transactions are continuing, buyer due diligence is focusing on:
- The impact of the crisis on cash flows and financial forecasts.
- The target’s mitigation strategies, including its ability to access alternative suppliers and customers, suspend contractual obligations and claim under insurance policies or government backed schemes.
- The ability of the target and its counterparties to perform, terminate and/or claim force majeure under material contracts.
- Breaches of contract and the associated risks – including failures to repay loans and meet financial covenants under banking arrangements, failure to pay rent and other contractual payments on time, and failure to properly deal with employees including selection for furloughing.
- The impact to the target from travel restrictions, quarantine and government mandated business closures.
We have seen a slight increase in distressed deals, with some private equity and trade buyers looking to cheaply acquire companies hard hit by the crisis. However, more prevalent is the increase in companies seeking to restructure their debt obligations to manage cash flows. These may be the same companies we advise on the sell side in coming months.
Short Term Advice
In the next three months, we expect M&A deal volumes to remain low. Company valuations will prove difficult to assess as financial forecasting, supply, demand and contractual positions remain uncertain. Deals will be hampered by physical restrictions, such as the inability of lenders to value assets to be used as collateral in financing the transaction. Also, let’s not forget about the human element. M&A deals are heavily dependent on relationship building between buyers, sellers and management teams – something that is best done face-to-face rather than online.
So, where does that leave us?
On the sell side, we are advising prospective sellers to focus on maintaining value through re-negotiating payment obligations and financial covenants with lenders, negotiating reduced rental payments, dealing with redundancies, wage reductions and furloughing and navigating breaches of contract and force majeure type scenarios. For those pushing ahead with sales, we are advising them to make diligent disclosures against warranties, to seek carve outs and/or caps for COVID-19 related warranty claims and to limit conditions to completion to reduce completion risks.
On the buy side, we are advising clients to:
- Be vigilant with due diligence.
- Obtain appropriate warranty and indemnity cover.
- Consider warranty and indemnity insurance.
- Include provisions to allow termination if there is a material adverse change to the target’s business caused by a pandemic.
- Consider the purchase price of the target, the payment structure and payment deferrals. Where there is uncertainty over the target’s future performance, part of the purchase price can be structured so it only becomes payable if the target achieves certain pre-agreed revenue or EBIT/EBITDA targets in future years. Similarly, buyers should consider making certain payments conditional on matters such as key customers or suppliers not amending existing contractual arrangements.
Medium/Long term View
Beyond the uncertainty of the current economic shock and the possibility of a deep recession lies the concern that there will be a second outbreak of COVID-19 (or similar) next winter. This poses several risks that require careful management:
- Companies should carry out COVID-19 audits of their commercial and insurance arrangements and put contingency plans in place (incorporating insurance cover over major contracts and key members of staff).
- Sellers need to exclude or ring-fence liability for pandemics, and focus carefully on the warranties and indemnities they give, as well as related disclosures.
- Buyer’s need to consider their valuation and pricing structure and how and when the purchase price is to be paid to sellers. They will also need to carry out a more rigorous due diligence process, with a focus on pandemic risks– which we expect will form a regular feature in due diligence questionnaires and warranties in share purchase agreements.
This article was also published in The WIZE.