Whilst the full impact of the global COVID-19 pandemic on mid-market M&A transactions is yet to become clear, there is little doubt that COVID-19 has already impacted the matrix through which seller and buyer risks are viewed.
We explore below what potential buyers and sellers may expect when approaching mid-market M&A deals in the current environment.
Price, pricing structure and adjustments
Contraction of trading multiples and uncertainty regarding future maintainable earnings will no doubt adversely impact headline pricing.
Buyers will likely seek to mitigate their risk by utilising earn-outs, making payment of a portion of the purchase price contingent on future performance of the target. Certain key aspects of how the earn-out will operate will become critical in the context of COVID-19, such as treatment of exceptional, abnormal or one-off costs, restrictions on the conduct of the business during the earn-out period and “catch-up” payments where trading improves in subsequent earn-out periods.
Traditional purchase price adjustments, such as net asset or working capital adjustments, will also need careful consideration. Agreeing on normal working capital targets will become more difficult as parties grapple with what exactly is normal in a post COVID-19 world. Similarly, agreeing to specific accounting policies for preparation of the completion accounts (for example provision for doubtful debts) will also likely be more challenging.
Financing the transaction
Current market volatility may make it more difficult for buyers to obtain financing on acceptable terms. To minimise the risk of the deal not completing, sellers will want to verify, at an early stage in the deal process, how a buyer proposes to finance the transaction and how committed those funds are.
While a large part of the due diligence process is now conducted online with virtual data rooms, certain aspects of due diligence, such as site visits and management presentations, are likely to become more difficult.
We expect to see parties increasing focus on matters impacted by COVID-19 such as:
- trading and revenue;
- supply chain (and flow-on impact to customers);
- customer payment terms and outstanding debts;
- suspension/termination rights under key contracts and financing arrangements (e.g., force majeure rights);
- business continuity/crisis management policies (e.g., ability of employees to work remotely);
- potential redundancies and employee claims;
- insurance coverage for pandemic related issues; and
- compliance with and adaptability to regulatory changes resulting from the pandemic.
Conditions in the sale and purchase agreement
Negotiating conditions precedent to completion is likely to become more challenging as sellers seek to minimise risk of completion not occurring, while buyers seek to ensure they have an “out” if there is a change which adversely impacts the target business.
The time between executing the sale and purchase agreement and completion of the transaction is often due to required regulatory approvals (e.g., ACCC, FIRB, liquor licensing, etc.). Turn-around times for these approvals are likely to be slower meaning that deals will take longer to complete (which buyers and sellers should factor into any “long-stop” or “sunset” date by which conditions precedents must be satisfied).
In the case of FIRB, due to the threshold amount for determining whether particular foreign investments are subject to Australia’s foreign investment framework being reduced to $0 in response to COVID-19, we anticipate that more mid-market deals will now require FIRB approval which will then no doubt impact FIRB’s approval times.
We expect buyers to push for inclusion of a material adverse change (MAC) or material adverse effect (MAE) condition enabling them to terminate a signed sale and purchase agreement where the target is adversely impacted by COVID-19. Conversely, sellers will likely seek exclude from the MAC/MAE condition events that impact the whole of the market or economy, or a particular industry, including events resulting from COVID-19.
In any event, a MAC/MAE condition usually includes quantative thresholds (e.g., a percentage reduction in earnings and/or net assets). Parties will need to consider whether events with a short-term, as opposed to long-term impact, are sufficient to trigger the MAC/MAE condition enabling the buyer to terminate the sale and purchase agreement.
Change in control consents, novations and assignments
Parties may need to be more sensitive when approaching key contractual counter-parties of the target business when seeking consents to change in control, novations and assignments, particularly if such counterparties are looking for ways to terminate or vary their agreements with the target.
Conduct of business rules
Whilst buyers typically place certain restrictions on a target business during the period between signing and completion, sellers will now, more than ever, want to ensure that the target can effectively respond to emergency situations if and when they arise, particularly if there is a risk of a potentially lengthy period between signing and completion (for example, where regulatory approval is required).
Warranties and indemnities
The impact of the COVID-19 pandemic on warranties and indemnities will largely depend on buyers’ and sellers’ relative bargaining powers. At one end of the spectrum, buyers may seek specific indemnities for COVID-19 related risks, whereas at the other end, sellers may seek a general exclusion of liability for all COVID-19 related issues.
In preparing the disclosure letter, sellers will need to consider each warranty specifically in light of COVID-19. For example, if the financial records disclosed to date does not reflect downturns due to COVID-19, then this may require a specific disclosure. Similarly, if the warranties include a general information warranty that “all material information has been disclosed to the buyer” then sellers should, in most cases, expressly disclose the COVID-19 impact on the target’s business.
If the parties have obtained warranty and indemnity insurance, it is important to be aware that insurers may exclude COVID-19 related issues from coverage under the policy. If the W&I policy is the buyer’s sole recourse (i.e., the buyer cannot make a claim against the sellers except in certain limited circumstances such as fraud) then the buyer will assume the risk of any matters not covered by W&I insurance. Conversely, if the seller is liable where the W&I policy does not respond then the sellers will assume this risk.
Undeniably, the uncertainties caused by the COVID-19 pandemic will cause some buyers and sellers to re-consider whether now is the right time to be pursuing an acquisition or sale.
However for others, these times will represent a once in a generation opportunity. Whether they be sellers with a target business resilient against current market volatility or opportunistic buyers, we expect the current environment to present unique possibilities for mid-market dealmakers.