Carl Powlson : Mergers and Acquisitions in the “New Normal”

We are now operating in a completely different and swiftly evolving M&A environment, but one in which certain trends are starting to appear. In this article, I will provide a high-level summary of some of these emerging trends and issues.

Heightened Due Diligence

More extensive due diligence is being conducted by buyers to deal with specific issues arising out of COVID-19, for example:

• Material contracts – can key customers or suppliers of the target terminate their contracts as a result of COVID-19? Can the parties still comply with their contractual obligations? Is there a force majeure regime, and is this broad enough to cover COVID-19? What are the related risks of litigation?
• Solvency – what is the ability of the target to withstand liquidity issues arising out of the crisis? Is the target eligible to apply for emergency funding from the government and, if so, has it done so and on what terms?
• COVID-19 legislation – review of compliance by the target with COVID-19 laws and regulations, for example relating to employee safety and the furlough regime.
• Corporate governance and residency – can the target’s various decision-making bodies function effectively in the current climate? Will there be any challenges to where a company is deemed to be tax resident because of COVID-19?
• Insurance – does the target have insurance policies in place that cover current and potential future losses arising out of the crisis?
• Supply chains – where are they located and what is the impact of COVID-19 on the ability of suppliers to continue supplying the target?

Additionally, given that financial information about a target might not be comprehensive and with audit reports likely to be caveated heavily, sellers are having to become more proactive in assisting buyers through their due diligence process – although both sellers and buyers are also having to accept that “the perfect deal” might not be achievable in the current climate.

Purchase Agreements – increased buyer power

COVID-19 has resulted in more of a buyers’ market, especially for those with readily available funds, after a number of years in which sellers held the upper hand.

Key issues we are seeing in relation to purchase agreements, often arising out of a more aggressive stance taken by buyers as a result of it being more of a buyers’ market, include:

• Purchase price adjustments – can the parties agree a purchase price mechanism that gives adequate protection and certainty for both sides? Buyers will seek protection against negative developments in the target business by means of completion accounts mechanics (rather than locked box accounts), and also by means of post-completion protection provisions relating to, for example,  deferred consideration, purchase price retention and earn-out mechanics.
• Deal conditionality and termination rights – buyers are highly likely to look for additional conditionality and/or termination rights. For example, will a material adverse change (MAC) clause become more prevalent in the UK market? Any such clause is likely to be resisted at first by sellers and, if accepted, is likely to be tailored to the material risks and issues for the target arising out of COVID-19. Third party approval conditions and related long stop dates will need to take into account the potential for delays arising from the current situation.
• Interim operating restrictions and covenants – sellers need to take particular care in relation to interim operating restrictions and covenants covering any gap period between signing and closing, whereas buyers will be more focused on this issue. For example, very few businesses are operating currently in “the ordinary course”, so how can a seller agree to continue to operate the target business in “the ordinary course” pending closing? Any provisions relating to buyer access to the business between signing and closing will also need to be considered carefully – can they actually work in the current situation?
• Non-COVID-19 issues – buyers are very likely to take a firm stance in relation to any material issues not related to COVID-19 that are identified during due diligence and will look for the seller to bear the cost of these (for example, through a purchase price reduction or an indemnity).
• Warranties – sellers need to take particular care in relation to any repetition of warranties at closing. Further, specific warranties relating to COVID-19 may become standard practice and sellers will need to prepare disclosure bundles carefully to ensure that issues arising out of the crisis are addressed adequately.
• Warranty and indemnity (W&I) insurance – although “traditional” W&I insurance policies might not be a solution for COVID-19 risks, other insurance products, such as cash release insurance or, for distressed and insolvent transactions, synthetic warranty protection, can help to facilitate transactions in the current climate.
• Boilerplate clauses – even boilerplate clauses in purchase agreements need to be reviewed to check they are fit for purpose given the present circumstances. For example, notice provisions should allow for service by email.

Déjà vu all over again?

Predicting anything more than the short-term impact of COVID-19 on M&A strategy is a bit of a guessing game. However, it is perhaps not unreasonable to assume that COVID-19 could have a similar impact on M&A strategy to that of the global financial crisis. If so, then we may see some or all of the following approaches become more prevalent:

• Focus by companies on increasing liquidity – companies considering recapitalisation proposals and, potentially, the sale of non-core assets or even high-value assets to increase overall liquidity.
• Buyer strategic partnerships or joint ventures – to reduce the overall exposure for individual buyers.
• Sales of a stake in, rather than 100% of, a company – as a way of sharing valuation risk between the seller and the buyer, potentially coupled with a route for the seller to seek a complete exit at a later date by way of further sale undertakings in certain circumstances.
• Use of preference and/or convertible shares – to reach an agreement on valuation, at least in the context of a sale of a minority stake in a business.

Additionally, COVID-19 has already increased barriers to foreign direct investment, and this is likely to continue and even possibly increase; potential buyers will need to factor in how regulators will view their “nationality”. Governments are also re-evaluating which assets are vital for national security and, in order to protect their own economies, could choose to adopt a very broad interpretation of what those assets are.

Towards a more fundamental change?

There is some evidence emerging that COVID-19 might provoke more fundamental economic and social change. A recent letter, which was co-ordinated by the UK Stakeholders for Sustainable Development and the United Nations Global Compact Network UK and signed by more than 100 leading companies, charities, universities and trade associations, called on the UK Government to ensure that the UN’s sustainable development goals are at the heart of the United Kingdom’s COVID-19 recovery plans. Of course, whether COVID-19 will have such an impact remains to be seen, but if it does then the effect on deal-making could be considerable.

Carl Powlson is a partner in Shepherd and Wedderburn’s corporate team. For more information, contact Carl on 020 7429 4963 or at carl.powlson@shepwedd.com.