Beyond the pandemic: the future of M&A
Micro focus: how will deal processes change?
As well as its impact on macro deal-drivers, the COVID-19 crisis will affect M&A at a practical level, too. Lockdown restrictions have limited buyers’ ability to conduct robust due diligence and engage with management in person, while auditors have been prevented from visiting facilities to provide assurances around the seller’s financial statements. If this forms part of the ‘new normal’ for any meaningful period, then the way deals get done – particularly complex carveouts and financed transactions – will need to adapt.
From a buyer’s perspective one of the biggest challenges with carveouts is to understand which assets – from intellectual property to IT systems, contracts and real estate – are being transferred, which will be shared, and which will remain with the seller after closing.
Understanding the liability side of the deal perimeter is equally important. What will the buyer be taking on and what is left behind? How much of the risk be indemnified? And what about successor liabilities?
Limits to due diligence force change in tactics
All these things are typically tested through due diligence with the help of (often) audited financial statements. This process allows the buyer, its financing sources and the provider of its reps and warranties insurance (which will become vital to M&A where information is imperfect) to get comfortable that the business being purchased – and its associated risk profile - maps across to the acquisition agreements.
In a world where detailed checks in an ‘old school’ way may not be possible (and where audit reports may be heavily caveated) positioning a carved-out business for sale will become an exercise in creativity and pragmatism. For the seller that will mean crafting compelling narratives to help guide buyers through less-than-ideal financial information. It may also mean providing more information in diligence than might otherwise be the case – for example by highlighting issues that show up in the data room or offering detailed breakdowns of pre-closing reorganisations and any gaps in the assets being transferred. Alongside this, the use of clean teams may become even more common.
It will also mean keeping the transaction structure and documentation as clear as possible to help each party understand what’s being sold. It will mean offering tried-and-tested solutions to roadblocks in negotiations that minimise execution risk. It might even mean packaging up a broader combination of assets to compensate for buyers’ inability to conduct detailed analysis (although this will inevitably come with a price).
Smart M&A participants however will recognise that COVID-19 has changed the limits of what would usually be considered ‘deal perfection’ - and will adjust their methods accordingly.
Deal terms evolve as power flips to buyers
These are plenty of other deal-making elements that will evolve in response to the pandemic. Some, such as closing long-stop dates (ie terms that govern the duration of deals by setting a date following which either side can ‘walk’ without penalty), will need to change to cover the impact of lockdown restrictions on regulatory approvals processes. Expiration of external funding commitments will also need to move in step.
Others will reflect the fact that, after years of sellers being in the ascendancy in M&A, the pandemic has created more of a buyers’ market. Post-COVID, creditworthy purchasers will be in a stronger position to negotiate protections against downside risks in the form of walkaway rights, purchase price adjustment mechanisms and enhanced access to representations and warranties insurance – although we are seeing insurance providers more closely scrutinising deal documentation as they look to reduce their exposure to COVID-related risk.
Elsewhere, there has been a rise in material adverse event/material adverse change litigation emerging in the Delaware courts, which will be watched closely as the parties seek clarity on the allocation of business performance risks during the pandemic. And while the results will be widely publicised, dealmakers are well served to likewise focus on interim operating (pre-closing) covenants – including the very precise language around ‘lead in’ provisions and clauses allowing a buyer to withhold its consent. Indeed, interim operating covenants may be the most important elements of pending and future M&A agreements.
Re-evaluating financing orthodoxies
Just as we saw established orthodoxies challenged amid the uncertainties of the financial crisis (such as the wisdom of putting large sums in escrow with banks), so COVID-19 could have a similar effect.
In Europe we might see a shift away from ‘certain funds’ mechanisms towards more US-style ‘sponsor methods’ of allocating financing risks. US sponsor deals typically allow a buyer to terminate the transaction – subject to a reverse break fee – in defined financing failure circumstances. With all ‘market’ terms potentially upended, we could even see a return to true ‘financing condition’ deals from here on out.
‘Certain funds’ financings – by keeping conditions to drawdown to a minimum and, where possible, within the buyer’s control - assure both sides that the acquisition financing will be delivered at closing. They give the lender few ‘outs’ as long as conditions to closing are met. One of those conditions however is that it is not unlawful for the arranging bank to fund the deal. Under normal circumstances this is a given, but as banks take on significantly more risk in support of government recapitalisation programmes, who’s to say how legislation might change before the pandemic is over? With this in mind, it’s possible parties may want to reconsider their options in search of something more flexible.
COVID-19 has cut some companies off at the knees and entrenched the power of others. It has reshaped consumer behaviour, given fresh impetus to new forms of regulation and radically altered the role of government in corporate life. It could push society along a path towards greater sustainability, open a window for private capital, diminish activist investors and fundamentally change the process of doing deals. How long this change lasts – and how far it could go – is impossible to predict right now. But what’s clear is that M&A will play a pivotal role in shaping the businesses that thrive in a post-COVID world.
If you are interested in discussing any of the themes in this report, please reach out to your usual Freshfields contact. For more insights on the current and future impacts of COVID-19, visit our coronavirus hub