M&A opportunities in times of crisis
The truism that every crisis brings about opportunities also applies to mergers and acquisitions (M&A). Companies that encounter difficulties as a result of the COVID-19 pandemic, or even have to file for insolvency, will have to seek equity investors or joint venture partners, or otherwise sell parts or, in worst cases, all of their business operations. This provides ample opportunities for corporate buyers to enter a new market or expand their existing business or portfolio – for an attractively low price. However, bidders will need to be awake to numerous peculiarities of such deals made with a business in crisis, commonly called “distressed M&A”.
Choosing a target
The first step is to find potential targets. In many cases, the crisis of a company will be widely known, for example through press coverage, especially in the (restructuring) trade press, or through profit warnings and other stock exchange announcements, provided the company's shares or debt instruments are listed. Other sources of information include banks, which typically monitor their borrowers closely and identify crises at an early stage, as well as con-sultants whose networks are tightly woven in the restructuring industry.
Due diligence considerations
Once a company has been identified as a conceivable investment target, the next step is to identify all the causes of the target company's distress and ensure that the crisis was indeed only triggered by the consequences of the pandemic – the pandemic may only disguise the fact that the crisis was ultimately triggered by an unsustainable business model. This analysis is carried out as part of a due diligence review, which is indispensable even when purchasing in times of crisis (when there is urgency and some appetite for risk), although the process may need to be accelerated and more targeted. On the one hand, the directors of the purchasing company must obtain sufficient information to form a solid basis for their in-vestment decision and thereby mitigate personal liability risk. On the other hand, it should be noted that contractual protection, e.g. through warranties, will typically be very limited in distressed sales and, moreover, its enforceability may be questionable in view of the crisis of the selling entity. Warranty & indemnity (W&I) insurance can help to bridge the gap in contractual protection, but W&I insurers will only cover risks from areas that have been sufficiently examined in the due diligence review.
In the current crisis, an increasing focus of legal due diligence will be on whether the HR measures taken by the target (e.g., work from home arrangements, (government-supported) leave of absence, health tests, etc.) have been compliant with labour, data protection and other relevant laws. Another focus is to examine whether the pandemic has released the tar-get company or its most important trade and business partners from their contractual obligations, or significantly modified those obligations. Such issues can have significant implications for a company's profitability, in both a positive and negative sense. The availability of financial government support and legislative measures to protect businesses from the fallout of COVID-19 (e.g., the ability to defer rent payments) and compliance with their terms in all relevant jurisdictions will also need to reviewed and factored in. Special attention must be paid to compliance issues as companies in serious distress may take a haphazard approach to compliance in their rushed efforts to stay afloat.
The sales process for many distressed M&A deals must be completed quickly, because the seller and/or the target business is simply running out of money. This is a particularly virulent problem in 2020, where for many companies, revenue has not just collapsed but literally dissipated. Despite this, it is not uncommon for creditors to give time for a properly organized sales process in a distressed situation. Banks can defer their claims for payment of interest and principal in a so-called “standstill”, customers can make advance payments, and suppliers can grant longer payment terms. Of course, they will only do this if they believe in the success of the sales process and the business model of the target company. If the company has already filed for insolvency, the liquidity crisis often eases even more profoundly: all creditors are now in principle prevented from individually enforcing their claims; and further, in some jurisdictions, additional government support may be available to cover the in-solvent company's salary payments or other obligations.
Dealing with the right people
One aspect not to be underestimated is identifying the right contact person for the negotiation of the transaction. Even outside of an insolvency, the main creditors are often the drivers of the sales process. In doing so, they often press for the appointment of a new member of the management board who exclusively handles the restructuring of the company and, therefore, also any possible sales process. In case of doubt, negotiations will need to be con-ducted with this so-called chief restructuring officer (CRO). If the company is in insolvency or similar proceedings, the insolvency administrator or other court-appointed representative will most likely lead the sales process, depending on the applicable legal system and the type of proceedings. He or she typically answers to the creditors of the insolvent company, who may be represented by a creditors' committee. Many company acquisitions that were believed to be definitive have failed due to the creditors' veto. In addition, a company can only be successfully acquired out of a crisis if its key customers are on board. For example, the purchase of an automotive supplier is a no go without the goodwill of the relevant car manufacturers.
In the current climate, it will be particularly difficult to agree on the purchase price, even in non-distressed situations. Sellers will take the stance that the pandemic will only temporarily affect the company's profitability and hence its enterprise value. Buyers will naturally meet this with scepticism. Customary market adjustments of the purchase price as at the date of completion under the purchase agreement usually do not help in this regard. This is because they only record changes in net debt and working capital up to closing, but not long-term reductions in the profitability of the target company. Earn-outs or similar tools, which pro-vide for an adjustment of the purchase price at one or more points in the future, can help if the right metrics / calculation method for these can be agreed.
In the current phase of uncertainty, the buyer will also demand the possibility of being able to terminate the transaction right up until completion under the purchase agreement if certain material adverse events occur, such as a further significant deterioration in the financial situation of the target company. However, such a termination right will be difficult to enforce since transaction security is of paramount importance for the seller, especially if the seller is an administrator.
In addition to satisfactory due diligence and successful negotiations with the right people, transaction structuring is of immense importance in distressed M&A. Buyers will be keen to leave behind undesirable parts of the target business and, above all, liabilities. There are various ways to achieve this in most jurisdictions, including asset deals (where assets and liabilities are transferred individually) and demergers (where the desired part of the business is transferred to a new entity by way of universal succession). Every solution has disadvantages that must be weighed against each other. Many deals will involve the separation of the target business from the remaining business of the seller. Such carve-outs involve various complexities, including operational interdependencies of the two businesses that will need to be covered by transitional or long-term contractual arrangements.
Similarly, when structuring a transaction outside of insolvency, it is paramount to ensure that the acquisition is not open to clawback, meaning that it cannot be contested or other-wise reversed in the event of a subsequent insolvency of the seller. In the worst case, the acquired business is required to be returned, while the buyer can only demand repayment of the purchase price in return, which will only be an insolvency claim, meaning the buyer receives a (commonly small) quota on its claim like all other unsecured creditors. This devastating scenario can be prevented by means of fairness opinions, a properly devised transaction structure and other features depending on the jurisdiction of the target business.
Please click on the PDF document below for a slide deck summarizing the key features of distressed M&A, including information on distressed M&A transactions in select jurisdictions.
Author: Jochen Ellrott