While it is too early to know the full impact of COVID-19 on the economy, we are seeing that lockdown restrictions in South Africa are starting to have a significant impact on the bottom line of a number of companies.
In the coming months, we expect to see more distressed mergers and acquisitions (“M&A”) resulting from companies being pressured by creditors to divest assets to pay down debt and avoid going into business rescue (or liquidation) or to fund ongoing operations.
How is distressed M&A different?
Except for the abbreviated timetable, distressed M&A is not too different from traditional M&A. However, distressed M&A comes with certain legal and commercial challenges for both the buyer and the seller. Some of these challenges include preparing the asset for sale in a short period of time, giving the buyer a reasonable opportunity to do a due diligence, bridging the inevitable valuation gap and quickly obtaining regulatory approvals.
In a distressed M&A, the seller must balance the need for speed against an inherently complex divestment process that usually takes longer than expected to complete. The buyer must mobilise resources to be able to execute quickly because the best returns are often made by acquiring good assets in an existing portfolio forced into a sale.
To overcome some of the challenges, the seller and the buyer should:
Have a strategy
The seller should take a disciplined approach to the divestment process. This involves developing a divestment strategy and mobilising a dedicated deal team to execute the divestment.
A divestment strategy should include:
- Preparing a business valuation. The business valuation should take into account COVID-19 related impacts to revenue (e.g. due to business interruption), expenses (eg, reduced compensation, additional costs to support remote working, increased sanitation and safety costs) and liquidity (e,. government incentives, customer and supply payment arrangements).
- Analysing optimal deal structures and, to the extent required, a managed separation. Tax structuring will play a key role. There may a need to enter into a transitional services agreement with the buyer for a fixed period post-implementation.
- Assessing the pros and cons of a compressed auction sale process versus a single buyer process. An auction sale process will take more time but is likely to result in a higher deal value due to its competitive nature.
- Understanding key legal issues that underpin the asset being disposed of (eg, change of control provisions, B-BBEE requirements etc.) and key regulatory approvals required to implement the divestment. Understanding these issues will enable the seller to be forthright about any problems associated with the asset. This will help accelerate the due diligence and enable the buyer to price these problems instead of trying to regulate for these problems in the acquisition agreement.
- Identifying the buyer. A trade buyer (a buyer that operates in the same or similar market) may be willing to pay more for the synergies that can be realised from the deal but may give rise to greater deal complexity/uncertainty arising from the competition approval process. Financial buyers (such as private equity (“PE”) firms) may pay less but there is a higher degree of deal certainty. Some PE firms are keen acquirers of distressed assets.
- Using technology to undertake or complete parts of the divestment process in a post COVID-19 world. Face-to-face management Q&A sessions, all-night boardroom negotiations and travelling to conduct due diligences may no longer be possible. A large part of the due diligence process will need to be conducted remotely through virtual data rooms.
Be an early mover
Buying a distressed asset out of business rescue as part of a “pre-packaged buy-out” does not necessarily mean that the buyer is getting the best deal or buying at the best price. It may be more beneficial to acquire an asset from a company that is on the brink of financial distress rather than from one that has already entered the business rescue process.
The business rescue process takes time and the 3-month statutory period within which to “wrap-up” the business rescue proceedings is often extended. Even though business rescue practitioners are using the business rescue process to put together these “pre-packaged buy-outs”, the courts have expressed reservation as to whether, as the primary objective, it is competent to use the process to divest of distressed assets as part of a managed wind-down. Any legal challenge to the basis for pursuing the “pre-packaged buy-out” will delay the divestment process further.
Other risks include limited contractual protections. For example, the business rescue practitioner will not give any warranties and indemnities to the buyer. The buyer will not be able to insure itself (in the form of W&I insurance) against the risks associated with the asset. Because the protection offered by warranties and indemnities is curtailed, the buyer will need to undertake a comprehensive due diligence which is both time consuming and costly.
Therefore, while a buyer may be able to acquire a good asset at a significantly discounted price through the business rescue process, a buyer would need to consider whether it is better to acquire the asset inside or outside of the business rescue process.
A buyer and a seller should both make use of an experienced legal M&A restructuring team to help them navigate this complex aspect of the distressed M&A process.
Adopt a fair and flexible pricing mechanism
A key issue when negotiating an M&A deal is the agreed pricing mechanism and related adjustments. There is almost always a gap in expectations on price and even more so in a distressed M&A scenario. Think how best to use the pricing mechanisms such as the locked box (fixed price plus an interest component), working capital, capex and net debt adjustments and earn-out (upfront payment plus a performance related component) to bridge this valuation gap.
Buyers are not willing to overpay for a distressed asset and will see the distressed sale as an opportunity to acquire the asset cheaply. No one likes the idea of selling cheap and sellers are going to want to attempt to maximise value.
An earn-out mechanism can provide some protection on both sides because the buyer can receive downside protection if the asset acquired does not maintain the same level of performance pre COVID-19 and the seller has a chance to receive a purchase price similar to the one it would have received pre COVID-19 if performance improves.
A working capital, capex and/or net debt adjustment mechanism post-implementation may also provide some downside and upside protection if there is a negative or positive change to the financial position at closing compared to the financial position when the initial acquisition valuation is done.
Both these pricing mechanisms tend to speed up the negotiations because of their inherent upside and downside protections.
Avoid making a meal of a MAC
Just as buyers will want to preserve “walk-away” protections by including a material adverse change (“MAC”) condition, sellers are going to resist these “free options”. Backward-and-forward negotiations on a MAC clause is time consuming.
A MAC should be used to protect a buyer for a significant deterioration of the target asset between signing a completion – it should be used for this purpose only, and not as an opportunity to walk away because of “buyer's remorse”. Less significant deteriorations in the target asset can be catered for in a well-crafted price mechanism.
Be nimble: do a targeted due diligence and take out W&I insurance
The buyer should do a targeted due diligence on the main issues and then use warranties and indemnities more extensively.
W&I insurance cover should be taken out to allocate risk. The premium payable can be factored into the price.
Beware that W&I insurance policies will include standard exclusions relating to the impact of COVID-19 as well as mandatory and/or advisory restrictions issued by government authorities. Buyers will want to shift the exclusion risk to the seller and the seller will need to understand the consequence of taking on this risk as an uninsured warranty.
Co-ordinated competition regulatory approval
If required, the submission of a merger notification to the competition authorities is a joint obligation. A notifiable transaction cannot be implemented until approval has been obtained. This could delay implementation of the transaction, as well as receipt of much needed funds by a distressed seller.
The buyer and the seller will need to work together to submit the merger notification as soon as possible. It is useful to engage an experienced competition law team to assist in navigating this complex regulatory requirement. In practice, it is possible to submit the merger notification before the acquisition agreement is signed, provided that the elements of the transaction giving rise to the change of control are clear. For example, the merger notification can be submitted on the basis of a comprehensive signed term sheet. When the acquisition agreement is signed, it can be submitted to the competition authorities as confirmation that the change of control structure has not changed.
Merging parties can seek to expedite the investigation process on the basis that a failure to speedily implement the transaction will result in the demise of the target firm (with knock-on impact for competition and the public interest, in the form of job losses). One of the factors that is considered in assessing whether or not a merger transaction is likely to substantially prevent or lessen competition is whether the business or part of the business of a party to the merger has failed or is likely to fail (the so-called “failing-firm defence”). Importantly, the triggering of the failing firm defence does not mean that the transaction will automatically receive approval.
Mergers that substantially lessen competition will generally be prohibited. Conversely, when a firm is likely to fail and exit the market, this may actually lead to a less competitive environment relative to the implementation of a merger (where the failing firm is absorbed and sustained by an acquiring firm). A merger between an acquiring firm and a failing firm could thus potentially neutralise or lessen the competitive harm caused by the failing firm’s exit.
The Competition Commission, in its recent presentation to parliament, stated that it is improving its procedures to better manage the expected surge in merger notifications expected to arise from the COVID-19 crisis. While the Competition Commission will still investigate the transactions submitted to it, this is a clear indication that the regulator is willing to assist in supporting distressed M&A.
The parties to a distressed M&A will need to move quickly and be able to navigate the complexities and challenges in executing the transaction. By leveraging outside expertise (such as M&A legal counsel with M&A restructuring experience) the buyer and the seller can make informed M&A decisions that are likely to result in a successful transaction with fewer setbacks along the way.