Coronavirus (COVID-19) is likely to have a significant impact on M&A sentiment and deal negotiations. What should dealmakers in Australia be doing differently in this environment?
While it's too early to know the full impact of the COVID-19 on M&A volumes in 2020, it's clear that dealmakers will need to consider transactions through a lens which reflects the potential ramifications of the pandemic.
M&A deals will become more difficult at all stages of the transaction execution process. Parties involved in transactions at the early stages will need to consider how to address COVID-19 issues in their due diligence and documentation, while buyers on M&A transactions which signed before the COVID-19 outbreak will be carefully reviewing their agreements to see if there might be opportunities to terminate or reprice the deal.
Given that COVID-19 is likely to have a significant impact on M&A sentiment and deal negotiations, buyers and sellers of businesses should consider the following key questions as part of their approach to M&A transactions:
- Is the deal still viable and will it be repriced?
- What additional due diligence needs to be undertaken about risks relating to COVID-19?
- What additional sale agreement protections or risk mitigations are needed to address COVID-19?
- What's the impact of COVID-19 on the buyer's balance sheet and funding strategy?
We have considered each of these questions in more detail below.
Deal viability and pricing
As at the date of writing, the Australian sharemarket has fallen more than 20% from its high in February 2020. This has largely been driven by a contraction in trading multiples, rather than earnings downgrades, which means that bid pricing for M&A deals will fall where buyers use comparable trading multiples as a pricing methodology. As a result of this, and more generally as a result of the uncertainty associated with COVID-19, many deals will fall over or need to be repriced.
In the public market space, there are a number of announced deals where the target company's share price is trading below the bid price, implying that the market is factoring in a significant risk that these deals will fall over. Many public company boards will struggle to recommend transactions in circumstances where share prices are highly volatile and valuations can be difficult to determine.
Some businesses will be more exposed to COVID-19 than others, with a few companies actually seeing a short-term sales uplift from COVID-19. However, from a buy-side perspective we are now seeing examples of private capital sitting on the sidelines or withdrawing from deals, even where there are opportunities to buy businesses which are not adversely impacted by COVID-19. For bold buyers this will create opportunities, but many will instead prefer to wait until the picture becomes clearer.
For deals which don't fall over, in the private M&A space we expect to see an increase in deferred consideration structures, such as earn-outs, to bridge valuation gaps between buyers and sellers. In particular, deferred consideration mechanisms which minimise exposure to COVID-19-related volatility (for example, by linking deferred payments to the achievement of medium-long term earnings forecasts) could be attractive to sellers.
While a large part of the due diligence process is already conducted remotely through virtual data rooms, some logistical aspects of due diligence need to be reconsidered in light of COVID-19. In particular, travelling to conduct due diligence, including management presentations and site visits, will be more challenging, and some parts of the target company's operations may be shut down.
The focus areas for due diligence should now include understanding how the target company is exposed to COVID-19 and what risk mitigation has already been undertaken. This could include reviewing:
- whether the target company is exposed to supply chain disruption and, if so, whether there are flow on consequences for the target company's ability to meet its obligations to customers (and related to this, the impact on the target's business strategy, stakeholder relationships and financial implications);
- suspension and termination rights under material contracts, including whether the target company can rely on (or whether its counterparties can rely on) force majeure clauses;
- compliance with employment, health and safety laws as part of the target company's response plan for employees and other stakeholders;
- the risk of data privacy breaches where large numbers of the target company's employees are working remotely;
- coverage under the target company's insurance policies for any losses stemming from COVID-19;
- the target company's business continuity and crisis management procedures, and potential legal and reputational damage associated with any failure by the target company to take appropriate measures to mitigate the risks of COVID-19; and
- the potential impacts of COVID-19 on the target company's industry and competitors.
Target companies and their advisers should be prepared for these types of questions during the due diligence phase and, in most cases, these are issues that the target company should be considering even in the absence of the sale process.
Sale agreement protections
Many buyers will seek to include, and ultimately may seek to rely on, conditions in sale agreements which protect them against target company risks relating to COVID-19.
An obvious starting point for buyers is to include a material adverse change (MAC) or material adverse effect (MAE) condition, so that the buyer can walk if the target business deteriorates between signing and completion of the transaction. Unlike the usual US approach to MAC conditions, Australian sale agreements typically include a specific definition of the MAC which includes quantitative thresholds (e.g. a specific percentage impact on earnings and/or net assets). Depending on how the clause is drafted, events which cause a short-term impact on earnings, but which may not have a material impact on long-term value, could still trigger the MAC.
It's also common to see carve outs to the MAC for economy-wide or industry-wide events, and target companies may push for MAC carve-outs which specifically refer to COVID-19 impacts being excluded (there may be negotiation around the specific wording for these carve-outs but they could, for example, be linked to the target company not being more adversely impacted by such events than others in its industry).
Given that one of the biggest risks of COVID-19 is the impact on a company's relationships with stakeholders such as suppliers and customers, conditions relating to change of control provisions in material contracts may now take on a different dynamic. Stakeholder relationships are more likely to be strained in this environment and some contractual counterparties could use the change of control as an excuse for early termination of their contract with the target company. This may, in turn, reduce the value of the target's business and could lead to the buyer walking or seeking to renegotiate the price.
We also expect to see increased attention on longstop dates (that is, sunset, drop-dead or outside dates), given many deals will now take longer to complete. In particular, there could be delays relating to conditions on regulatory approvals, third-party consents and financing.
Conduct of business rules
Conduct of business clauses typically require the target's board and management team to run the target business in the ordinary course between signing and completion. However, the emergence of COVID-19 means that we are not living in ordinary times. Target companies may push for carve outs to these rules so that they can take emergency action to respond to time-sensitive issues caused by COVID-19, including taking steps to protect the target company's workforce, entering into alternative supply arrangements and complying with recommendations from governments and public health authorities. One approach could be to allow the target company to take any steps contemplated in its business continuity and crisis management procedures, which the buyer could review prior to signing the sale agreement.
Price adjustment mechanisms
Most Australian private M&A deals include a working capital adjustment mechanism, with a post-completion payment benchmarked against an agreed target working capital level. In many cases, COVID-19 will drive volatility in working capital levels and parties may therefore continue to prefer a working capital adjustment mechanism rather than a locked box approach. However, there is likely to be debate around the appropriate target working capital level, in particular whether adjustments need to be made to historical average working capital levels to reflect short-term COVID-19 impacts.
Warranties and indemnities
A number of typical warranties in private M&A deals will already cover issues stemming from COVID-19, such as compliance with law warranties, but buyers may also seek specific warranties and indemnities relating to COVID-19. In particular, buyers may seek warranties relating to the due diligence items highlighted above, such as the status of material supplier and customer contracts, and in particular that no counterparty is seeking to terminate a contract due to force majeure.
We estimate that about 30% of Australian private M&A deals now involve W&I insurance policies. We have already advised on transactions where insurers have excluded losses related to COVID-19 from their policies, although this position may change as buyers focus more on COVID-19 issues during their due diligence. In circumstances where COVID-19 issues are excluded from the policy, buyers will need to consider whether they are agreeable to the W&I policy being their sole recourse, or whether they push for additional warranties and indemnities from the sellers for COVID-19 related issues (and sellers will need to consider whether they give up a 'clean exit' by agreeing to such warranties and indemnities).
Balance sheet and funding implications
The GFC showed that companies with high leverage and vulnerable balance sheets are often the most exposed in a crisis. In the current environment, companies may be more focused on protecting their existing earnings base, and potentially raising equity to boost their balance sheet and to ensure they have a sufficient cash runway, rather than pursuing growth through M&A. Directors of bidding entities also need to ensure that their company remains solvent, particularly given they can be personally liable to pay any debts incurred by the company when it is insolvent.
Funding deals in this environment is likely to become more challenging. Lower trading multiples for buyers translates to reduced firepower for scrip consideration, although recent rate cuts in Australia and other countries should make debt funding cheaper. Financiers may impose more stringent covenants in new facilities, and for existing facilities there will be increased attention on financial covenants that have earnings inputs (for example debt-to-income ratio and interest coverage ratio) given they are likely to be adversely impacted by the outbreak of COVID-19. This might force some buyers to delay substantial acquisitions to ensure their financial covenants are not breached.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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