On January 30, 2020, the World Health Organization declared the 2019 Novel Coronavirus (COVID-19) a public health emergency of international concern. Since then, confirmed cases of the disease have continued to climb on a daily basis in countries across the globe, and local and state governments, businesses, and schools are instituting a wide array of measures to contain the virus and prevent its widespread transmission into a global pandemic. The steps taken across the globe in an effort to contain the outbreak have adversely impacted, and will continue to adversely impact, businesses, capital markets, supply chains, and workforces worldwide. Although the impact of COVID-19 on global private equity activity will take some time to be fully realized, buyers, sellers and borrowers can take certain steps to protect themselves against known and unknown risks associated with the current COVID-19 outbreak.
I. Considerations in Acquisition Documents
Clients should anticipate and prepare for potential interruptions and delays to transaction timelines.
- Clients may experience difficulties in scheduling in-person meetings and site visits due to travel restrictions and/or other containment protocols that alter ordinary course business operations of the target and third party consultants assisting in the transaction. Buyers, for example, should account for these potential delays in negotiating exclusivity provisions. More generally, all clients should be considering whether there are potential alternatives (e.g., videoconferences) that avoid the need for in-person meetings.
- Containment protocols that alter the ordinary course business operations of the target may also impact the target’s ability to respond in a timely manner to due diligence requests, particularly if a target does not have the technological infrastructure in place to allow its employees to effectively work from home. Clients on both the buy-side and sell-side should make sure they understand the extent of the target’s capabilities (and potential deficiencies) on that front early in the process.
- The implementation of containment protocols by government agencies in the United States and abroad could impact the timing for obtaining regulatory approvals required in connection with a potential transaction (e.g., HSR and other antitrust approvals). Clients should account for these potential delays in negotiating the outside date in the acquisition agreement, including the instances in which the outside date may be extended.
In addition to the timing implications discussed above, buyers should also expand the scope of their due diligence to address COVID-19-specific concerns.
- Buyers should ensure that their due diligence includes a review of any internal policies, procedures, and/or protocols the target currently has in place to address COVID-19, whether those policies, procedures, and/or protocols are sufficient and compliant with applicable employment and other law and, if there are deficiencies, the potential liability expense and cost, and general impact on operations, of addressing those deficiencies.
- Buyers should also consider specifically inquiring about the current and expected impact of COVID-19 on key business relationships of the target, including, for example, whether any communications have been made to or received from any material customers, suppliers, vendors, distributors, or other key business relationships regarding COVID-19.
- Buyers should also consider whether the target’s existing insurance covers any potential losses the target may experience as a result of COVID-19 and, if so, whether that coverage will remain in place post-closing.
Representations & Warranties
Clients should consider whether additional representations and warranties or disclosures are needed in the acquisition agreement to address the impact of COVID-19.
- Sellers should consider whether the target’s response to COVID-19 requires disclosure against any of the representations and warranties in the acquisition agreement, including, for example, those with respect to the absence of changes, suppliers, vendors, and/or undisclosed liabilities. In reviewing the representations and warranties, sellers should keep in mind that customary ordinary course of business qualifiers may be insufficient to address potential changes made or actions taken to address COVID-19.
- Buyers should consider whether any specific representations should be included that address the impact of COVID-19 on the target (including its business relationships), the policies, procedures, and protocols the target currently has in place, and the sufficiency of the target’s current infrastructure to support such policies, procedures, and protocols.
- Clients, whether on the buy-side or sell-side, should ensure they understand the allocation of responsibility in the acquisition agreement for, and the extent to which any rights against third parties (e.g., insurers) may offset, any losses the target may incur arising out of the spread of COVID-19.
Material Adverse Effect
- Buyers may seek protections through material adverse effect (MAE) provisions and/or a corresponding closing condition that would permit them to terminate an acquisition agreement without liability to seller in the event circumstances deteriorate further.
- Sellers would be well advised to resist such buyer protections on account of the fact that the COVID-19 outbreak is a well-known risk affecting businesses generally. Accordingly, sellers should seek carve-outs in the MAE provisions for any epidemic, pandemic, or disease outbreak (including the COVID-19 virus) in addition to the litany of other exigent circumstances typically carved out from MAE provision.
Interim Operating Covenant
- Interim operating covenants often include a blanket covenant requiring sellers to operate the target business in the ordinary course during the period from signing to closing of the transaction; however, questions may arise when businesses need to take swift action in response to a disease outbreak or other similar local, national, or global exigent event.
- Although buyers will be focused on preserving the value of the target business they intend to purchase, in light of the COVID-19 outbreak and the associated risk to human health and safety with this outbreak, sellers should preserve their ability to respond and react to these events without needing to obtain buyers’ consent or risk breaching the covenant.
- Accordingly, sellers’ obligation to operate the target business in the ordinary course should still allow sellers to take reasonable action to (i) comply with requirements under applicable law and (ii) protect human health and safety.
To the extent clients have any questions regarding COVID-19 and compliance with their transaction documents, clients are encouraged to contact their transaction deal team to discuss.
II. Considerations in Financing Documents
Availability of Financing
Capital markets have tightened in response to the unstable stock market. Clients contemplating new committed or other debt financing should be aware of the evolving impact of COVID-19 on the negotiation, documentation, and syndication of debt financing.
Both buy- and sell-side clients will want to ensure that COVID-19 has as little impact on the availability of committed acquisition financing as possible.
- Outside Date Buy-side clients should negotiate automatic extensions to the “outside date” in any commitment papers, when arising from COVID-19-related delays. For example, if there are delays in the HSR process, the financing sources automatically agree to extend the outside date of the financing commitment.
- Material Adverse Effect Buy-side clients and their financing sources should anticipate that sellers will push for buyers and their financing sources to bear the risk of any adverse consequences caused by COVID-19 by expressly excluding “pandemic” (and similar terms) in the definition of “Material Adverse Effect” (or like term) in acquisition agreements, as described above in further detail.
- “Due Diligence” Condition Both sell- and buy-side clients should be aware that financing sources will likely request diligence regarding the impact of COVID-19 on any target, notwithstanding any logistical or other constraints on the availability of such information.
- Flex Terms Clients must be aware that commitment parties may introduce higher pricing and new flex terms (and exercise any flex terms) in order to achieve successful syndication. Clients should ensure that they have appropriate flexibility to reset financial covenants to account for the imposition of any market flex terms.
Refinancings or Incremental Financing
In the case of “best efforts” or other uncommitted financings, clients should consider the practical impact of tighter debt markets, including the likelihood of a successful syndication. Clients may ultimately turn to direct lenders and club-style transactions to preserve the availability of refinancings and incremental financing.
Unlike in the case of committed financing, agents and lenders will have more flexibility to decline to fund in the event of a company’s material decline in performance. Clients should discuss risks with making any “Material Adverse Effect” representation at closing and in connection with the bringing down of such representations after closing.
- ABL Borrowing Base Eligibility Criteria In light of COVID-19, Borrowers must be aware that ABL agents and lenders will carefully evaluate eligibility criteria in connection with calculating the borrowing base. Borrowers should give due consideration to the following:
- granting extended payment terms to any customers;
- inclusion of receivables generated by non-U.S. customers;
- increased concentration of receivables among all customers;
- availability of credit insurance to mitigate non-payment/write-offs;
- solvency of any customers;
- slow-moving inventory; and
- in-transit inventory.
- Bring Down of Representations and Warranties Borrowers will bring down their representations and warranties when they incur additional revolving loans. Borrowers should review their representations and warranties to ensure that there are no concerns regarding breaches. In addition, if a borrower anticipates breaching in the future, borrowers should discuss mitigation strategies as soon as possible with their debt finance deal team.
Many clients are reporting to their respective debt finance deal teams that they anticipate incurring some COVID-19-related charges in the coming year. Clients should give due consideration whether such additional expenses create stress on testing financial covenants.
In connection with negotiating new financial covenant levels, clients should ensure that any projected COVID-19 impact is built into their models. Clients can then consider appropriate cushions to the model when proposing financial covenant levels.
In addition, clients may be able to utilize EBITDA addbacks to help mitigate the financial covenant impact of COVID-19. Clients may be able to use, or negotiate for, certain addbacks, including:
- non-recurring, one-time or unusual charges addbacks;
- lost profits/revenues/earnings;
- write-offs; or
- proceeds of business interruption insurance.
- Equity Cures
- Many credit agreements permit sponsors to contribute equity into a portfolio company in order to cure a financial covenant default. If there is a risk of a financial covenant default, sponsors should discuss as soon as possible whether to exercise any such rights, given the likelihood such rights expire soon after delivery of financial statements.
Many clients are reporting that agents and lenders have affirmatively inquired about the potential impact of COVID-19 on their performance. Practically all credit agreements will obligate clients to provide responses to such inquiries. In addition, clients should review their credit agreements and other loan documents in the context of bring down of representations, material adverse changes, and other relevant provisions to avoid, among other things, a “foot fault”. As described below, clients may be obligated to provide information or request consent to take a COVID-19-related action.
- Notice Requirements Nearly every credit agreement obligates borrowers to notify promptly the agent and/or lender(s) in the event of certain events, including, without limitation, the occurrence of a Material Adverse Effect, material casualty events, material litigation, or loss/breach of material contracts. Examples of such actions may include:
- borrower receives a notice that a material customer is terminating its contract;
- borrower makes a claim on business interruption insurance;
- borrower proposes to waive a default by its supplier for failure to meet certain delivery requirements under a take or pay contract; or
- borrower receives service of process in connection with a lawsuit.
Note that lenders and agents are likely entitled to make follow-up requests when a borrower reports the occurrence of a material event and borrowers must respond to such follow-up requests.
- Material Contracts (including supply/vendor contracts) If considering replacing, terminating, or otherwise amending a “material” contract (whether a customer contract, supply/vendor contract, or otherwise), clients should evaluate any requirements in their credit agreement, including any special notice or consent requirements, before taking any such action. Some credit agreements require advance notice or consent in order to amend certain material contracts, including a waiver of material terms.
- Lender Meetings Many credit agreements require, or permit lenders to request that, portfolio companies hold annual or quarterly meetings with lenders shortly after the delivery of financial statements. Management should anticipate that lenders will use these meetings as an opportunity to understand various risks and mitigation strategies for their borrowers. Management should be adequately prepared to describe such risks and strategies.
Many clients are reviewing financial results for fiscal year ending December 31, 2019 and preparing and delivering to their agents, lenders, and other financing sources their financial statements, together with projections/budgets for fiscal year ending December 31, 2020. In connection therewith, clients should consider the following now and for this year:
- Audit Exceptions Most credit agreements limit the exceptions auditors may introduce into an audit. However, most credit agreements do not limit what information may be included in any “Subsequent Events.” To the extent clients have any concern regarding disclosures regarding COVID-19 in their audited financial statements, clients should consult with their debt finance deal team.
- MD&A Clients are likely required to provide MD&A in connection with delivering quarterly and annual financial statements. Clients may want, or may be obligated, to explain any impact of COVID-19 on prior performance or as against budget/projections.
- Projections Clients are likely required to provide MD&A in connection with delivering quarterly and annual financial statements. Clients may want, or may be obligated, to explain any impact of COVID-19 on prior performance or as against budget/projections.
- In addition, if clients anticipate delivering projections that forecast a covenant default during the fiscal years covered by the projections, clients should promptly discuss strategy with their respective debt finance deal team.
To the extent clients have any questions regarding COVID-19 and compliance with their loan documents, clients are encouraged to contact their debt finance deal team to discuss.