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April 2020

The effect of COVID-19 on M&A transactions

COVID-19 and its effects arrived very quickly meaning there was very little time for those planning or currently engaged in M&A transactions to plan for the likely consequences of the virus.

In this article we look at some of the implications of COVID-19 on M&A transactions (whether currently in the planning stage, being executed, or completed).

Planning an M&A transaction

If you are currently planning an M&A transaction it is likely you may now experience some delay for a number of reasons;

  • Reduced or changing funding opportunities. Mainstream banks may reduce or stop new lending for M&A transactions. Funding may continue to be available from non-traditional sources such as HNW’s who are not attracted to keeping their funds in the bank at vey low interest rates.
  • Reduced buyer appetite. Many businesses may be in a cash preservation mode and not looking to spend on acquisitions. That said, larger corporate buyers who have large cash reserves may look to acquire if they think they can secure an important strategic target, out-manoeuvre a competitor or achieve a purchase beneath market price.
  • Reduced seller appetite. Many SME’s are in cash-preservation mode and together with an uncertain outlook, may prefer to “batten down the hatches” and wait for the market to return.

Any delay can be put to good use. Spend the time going through sample buyer due-diligence questionnaires and perform as much “house-keeping” as possible, review and update statutory books and registers, employment contracts, review and check insurance arrangements as well as business continuity and disaster recovery plans.

The detail will become clearer over time but it is likely that the M&A data (Experian MarketIQ, Bureau Van Dijk, ONS and others) will show materially reduced transaction volumes for Q1 and Q2 2020 and possibly stretching into Q3 2020. Whilst the outlook for a recovery is difficult to forecast, it is likely that when it does return, there will be a considerable uptick due to the large cash reserves (“dry powder”) within both PE and corporate buyers.

Live M&A transactions

There is likely to be an increased focus by Buyers on certain areas of due diligence;

  • Employment law – have employees been placed on furlough or made redundant correctly? Are there HMRC liabilities / claims looming?
  • Contracts – are there unremedied breaches? Is the target in breach? Review force majeure clauses.
  • Tax – has VAT (and/or other taxes) been deferred? What does the company cash flow look like going forward, can those deferred liabilities be met?
  • Insurance matters – have there been business interruption claims? Should there have been?
  • Debtors – have customers been paying on time? How does the aged debtor book look? What is the probability of recovery?
  • Banking – have any covenants been breached?
  • Debt – has there been adoption of new Government-backed “COVID-19” loans? If so, how are those secured? Has the extra gearing affected long-term viability? How does this affect the seller on a cash-free debt-free basis? Does this materially affect the equity bridge such that it potentially threatens a deal?
  • Business continuity / disaster recovery – we may see an increased focus on this following COVID-19.
  • Conditions precedent – has the COVID-19 crisis affected seller’s obligations to perform any agreed within heads of terms?

Traditional “on site” due diligence and financial due diligence is also going to become harder if not impossible in the next few months as social distancing continues. Consider if much of this work can be completed remotely, i.e. providing access to key systems (subject to non disclosure and confidentiality agreements).

From a Seller’s perspective, potential areas to review:

  • EBITDA – has there been a diminution of adjusted EBITDA in the financial period under offer?
  • Working capital – any agreement to adjust Enterprise Value with normalised working capital needs to be scrutinised whether abnormal shifts in e.g. debtor book have materially impacted the calculation.
  • Earn-out & deferred consideration – have the conditions agreed within heads of terms shifted due to COVID-19?
  • Locked Box – has there been excess leakage due to COVID-19 and is this permitted leakage?
  • Deferred consideration – has the financial condition of the Buyer changed such that any guarantees / securities are now insufficient?

Ultimately a Seller’s ability to renege on an agreed deal may be limited. Review the heads of terms and speak with advisors if in doubt.

Existing M&A transactions which have finished the due diligence stage but have not yet completed may continue through to completion or exchange, may be aborted by the buyer or seller or could be renegotiated. There will often be little a seller can do if a buyer simply walks away from a transaction but refer back to the heads of terms to see if this scenario is addressed.

Transactions in certain sectors, e.g. hospitality, restaurants, bars, retail etc could well be aborted or renegotiated as consumer demand falls to almost zero in those sectors.

For those transactions which are structured with a split exchange completion where exchange has taken place both the buyer and the seller will be checking the share sale and purchase agreement to see what post exchange termination rights there are. This should be defined tightly but may include the material adverse change (often known as a MAC clause) clause allowing a buyer to walk away in certain circumstances. This can be a technical process so if in doubt on this point seek advice from the advisor who advised you on your transaction.

Completed M&A transactions

Transactions which have completed may still feel the effect of Covid-19, especially those transactions which have any element of deferred, contingent or earn-out consideration. If work levels in the target business reduce as a result of Covid-19 it could be that earn-out levels cannot be met. Sellers who have agreed to unconditional but deferred consideration should be asking for financial updates from their buyer, how is their cash flow, are they within their banking covenants etc. Deferred consideration clauses should allow a seller access to this sort of financial information.

There may also be an increase in post completion warranty or indemnity claims. Those claims could result from a target company’s disaster recovery plan or business continuity plan failing, or perhaps even IT issues. There could also be claims for insurance related matters if the sellers have warranted that the business would be covered by business interruption insurance which fails to pay out.

If you have any questions on any of the above please don’t hesitate to contact;

Article co-authored by Nick Davies of Steele Raymond LLP and Justin Levine of TheNonExec.

*The information set out in this article is correct at the date of publication (06 April, 2020). The effect of coronavirus on businesses is a fast-changing area and so it is important to obtain current legal advice to ensure you are properly protected.

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