In preparation for a post COVID-19 world, Chinese outbound investors have begun to source for bargain deals in other countries, with markets characterised by corporate restructurings, low prices, depressed valuations, distressed assets, and fire sales. In this article, we briefly set out some suggestions for Chinese outbound investors when entering into bargain M&A deals in this unprecedented M&A landscape. 1
Choosing what you want to buy
A post COVID-19 world is likely to be a buyer's market, and buyers could consider purchasing assets over shares. In an asset purchase, the buyer can cherry-pick what it wants to buy, and leave out unnecessarily acquiring unwanted or unattractive assets that would come with a share purchase. In addition, the buyer will not take on the target company's risks and liabilities that come with a share purchase. Such risks and liabilities are likely to be aggravated, more contingent, and less foreseeable in a distressed market.
The downside with an asset purchase, however, is that it can be more complicated and time-consuming to complete. This is due to varying tax implications, individual transfers and assignments being needed, and possibly more third party and regulatory consents being required. Even in a distressed market, a valuable asset at bargain prices is likely to attract several interested buyers, and sellers are likely to be put off by a lengthy and cumbersome sale process.
Hybrid or alternative structures may be available. For example:
- After the buyer selects the desired assets, the seller could incorporate a new special purpose vehicle company, transfer such assets to such company, and then sell such company to the buyer. This is likely to simplify and streamline the eventual sale process, although the initial restructuring process could take time. Time is always of the essence in securing a bargain deal, as sellers in distressed sales value speed and deal certainty.
- A buyer could consider subscribing for convertible debt instruments to be issued by the target company, with an option to convert them into equity at a later stage. Whilst this approach may elevate the protection given to the buyer in the event of insolvency proceedings (i.e. where it would take the position of creditor instead of shareholder), it may not fit in with traditional Chinese outbound acquisition strategies where full or majority equity control is sought at the outset.
Re-strategizing your due diligence
Due diligence, of course, is an important part of the M&A process. It helps buyers ascertain price, identify risks, resolve problems, allocate responsibility, and protect against liability.
In a distressed sale, due diligence will also focus on the particular issues which caused the business to flounder, and on the extent of consequent liability or litigation (both actual and potential). In a distressed sale in a COVID-19 context, liability and litigation risks are still important. However, examining the particular issues that caused the business to struggle may be less pertinent, given that almost all businesses and industries have been affected by the pandemic.
If a buyer chooses to purchase assets instead of shares, this issue would be less important. This is because due diligence will be targeted at and limited to the asset in question, as opposed to an overall check on the target company's business and operations that would be needed in a share purchase. If a buyer chooses to purchase a target company's shares, a more pertinent due diligence focus may be to investigate how COVID-19 had affected the business and is likely to continue affecting the business moving forward. For example:
- A failure of existing supply chains may mean an over-dependence on certain sources in certain countries. If the target is unable to restructure or diversify its supply chains, or if the buyer is unable to inject alternative supply sources, this could reduce the attractiveness or valuation of the target company.
- Key customer contracts should be examined to assess which ones have been, or are likely to be, suspended or terminated, whether as a result of force majeure/material adverse changes clauses or otherwise. The continued viability of such contracts directly ensures the continued sustainability of the target company moving forward.
- The target company's health and safety costs, labour redundancy and compensation plans, and other cost-cutting measures should be reviewed. The target company's costs structure must be carefully managed to ensure its continued viability through this crisis.
Setting the price
As a default position, a buyer should consider a purchase price adjustment structure, allowing the consideration to be adjusted on completion if there are any changes to cash, debt, working capital or other financial metric. Given the ongoing COVID-19 pandemic and prevailing market volatility, the probability of any such adjustments is very real, and the likelihood is that such adjustments will be downward in nature favouring the buyer. If the gap between signing and closing is very short, and strict anti-leakage provisions are agreed to, a locked-box price mechanism can be considered.
Buyers, particularly cash-rich ones, may be tempted to adopt an aggressive price strategy when negotiating transactions in the current economic climate, believing that desperate sellers will cave in to a low "take it or leave it" price bid eventually. However, with governments around the world announcing relief budgets and stimulus programmes in record figures, troubled companies may not be under immediate pressure to offload their prized assets. Buyers may wish to analyse how such budgets and programmes specifically benefit their identified target companies, and take a calculated approach regarding the manner and timing of their bid.
Purchase price deposits, break fees/reverse break fees, and other related consideration arrangements (e.g. deferred consideration, payments in escrows, earn-outs) will continue to be negotiated and agreed based on the relative bargaining strength between parties. A buyer will be minded to temper an aggressive negotiating approach against the seller's receptiveness. In joint venture arrangements, a buyer should not lose sight of longer-term considerations, and should maintain structures that incentivise management to continue to perform once COVID-19 abates.
Watch out for insolvency law implications
In many foreign jurisdictions, insolvency law prohibits certain types of transactions to protect creditors of an insolvent company. If a buyer is dealing with an insolvent (or soon to be insolvent) company, it should be mindful of the legal minefields and guard against their possible impact. For example:
- Fraudulent trading: If, during the winding up of a company or any proceedings against a company, the company carries on business with intent to defraud creditors or for any fraudulent purpose, the persons who were knowingly parties to such act shall be personally responsible for the debts or liabilities of the company.2
- Wrongful trading: If a company is insolvent or a director knew (or ought to have concluded) that there was no reasonable prospect of the company avoiding insolvency, the director has a duty to take every step to minimise potential loss to the company's creditors.3 If, during the winding up of a company or any proceedings against a company, the company contracts into a debt, and an officer of the company who was knowingly a party to such act had no reasonable or probable expectation that the company could repay such debt, such officer shall be subject to a fine or imprisonment. If found guilty, such officer can also be made personally responsible for the payment of such debt.4
- Transactions at an undervalue: A transaction made at an undervalue in a certain period of time before the commencement of winding up of a company may be clawed back5 , if such transaction was made when the company was insolvent, or if the company became insolvent as a result of such transaction. A transaction is at an undervalue if it was entered into for no consideration or consideration of significantly less value in monetary terms was provided.6
- Unfair preference: A transaction which amounted to an unfair preference to certain parties (e.g. certain creditors or guarantors) in a certain period of time before the commencement of winding up of a company can be set aside7 , if such transaction was made when the company was insolvent, or if the company became insolvent as a result of such transaction8.
To mitigate these risks, a buyer should inspect all relevant board and shareholder resolutions of the target company to ensure that the transaction is properly approved and all relevant details and actions taken are properly recorded. Such resolutions should describe the rationale and benefits of the transaction to the target company, and state that the transaction was conducted on arm's length basis, in good faith, and in the best interests of the target company. Support in the form of an independent valuation report from a third party expert would also be helpful. In all cases, a buyer should ensure that the target company's representative that it is dealing with has been duly authorised. Unlike China, which has the concept of a legal representative, a single director or officer (regardless of his title) does not have automatic authority to represent and bind his company in common law jurisdictions.
If insolvency or other official proceedings have commenced, the acquisition process would be more structured, regulated, and certain, without being subject to the above risks. However, the liquidator or other official is far less likely to grant the buyer the usual contractual protections in a typical M&A transaction (e.g. representations and warranties, indemnities).
Note that in many jurisdictions, emergency legislation in view of the effects of COVID-19 is being passed to provide temporary relief from certain of the above requirements. The core principles highlighted above, however, remain.
Risks of politicization
Prior to the outbreak of COVID-19, the global political and economic landscape was affected by factors such as Chinese outbound investment controls, currency outflow controls, and the US-China trade war. With the expanding impact of COVID-19, negative public reactions in host countries could hinder or scuttle foreign investment or other regulatory approvals required for the transaction.
Given present sensitivities and circumstances, a Chinese buyer, in strategizing its outbound investment strategy, should tread with care. It should adopt a lower-key approach, focus on the commercial and economic benefits of the transaction, adopt an inclusive "win-win" and mutual benefit approach in negotiations, and moderate the political overtones of the investment.
Chinese outbound investment has had its ups and downs in recent years, along with the advancement of the Belt & Road Initiative and suffering a setback with COVID-19. In the aftermath of COVID-19, traditional playing fields will be levelled, new opportunities will arise, and valuable assets could become available at attractive prices. At the same time, Chinese buyers would need to be more flexible, be open to new acquisition approaches, and take on unfamiliar risks, all when navigating troubled markets marked by heightened political and cultural sensitivities.
1. The discussion in this article is in broad and general terms in order to assist readers to acquire a basic understanding of the subject matter in question, and should not be construed as legal advice. If you have any specific or further questions, please feel free to contact the author to discuss.
2. In the UK, see s213 Insolvency Act. In Singapore, see s340 Companies Act. In HK SAR, see s275 Companies (Winding Up and Miscellaneous Provisions) Ordinance.
3. In the UK, see s214 Insolvency Act.
4. In Singapore, see ss339(3) and 340(2) Companies Act. In HK SAR, there is presently no equivalent statutory provision.
5. In the UK, the period of time is 2 years (see s240 Insolvency Act). In Singapore and HK SAR, the period of time is 5 years (In Singapore, see s227T Companies Act, read with ss98 and 100 of the Bankruptcy Act; In HK SAR, see s266B Companies (Winding Up and Miscellaneous Provisions) Ordinance).
6. In the UK, see s238 Insolvency Act. In Singapore, see s227T Companies Act, read with ss98 and 100 of the Bankruptcy Act. In HK SAR, see ss265D and 265E Companies (Winding Up and Miscellaneous Provisions) Ordinance.
7. In the UK, Singapore and HK SAR, the period of time is 2 years where it involves a connected person/associate, and 6 months in other cases (In the UK, see s 240 Insolvency Act; In Singapore, see s227T Companies Act, read with ss99 and 100 of the Bankruptcy Act; In HK SAR, see s266B Companies (Winding Up and Miscellaneous Provisions) Ordinance).
8. In the UK, see s239 Insolvency Act. In Singapore, see s227T Companies Act, read with ss99 and 100 of the Bankruptcy Act). In HK SAR, see s266 and 266A Companies (Winding Up and Miscellaneous Provisions) Ordinance.
Originally Published 12 May 2020
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.