The outbreak of the novel coronavirus disease 2019 (COVID-19) and the measures being taken at every level to contain the spread thereof is a rapidly evolving public health and humanitarian issue. Naturally, COVID-19 and its social and market impacts have also found their way into M&A processes in various ways. This article summarizes the principal issues that M&A practitioners are likely to confront as they push forward with transactional activity in the COVID-19 pandemic environment.
Deal Dynamics and Timing
While the situation remains fluid and subject to daily changes, existing M&A processes generally appear to be continuing forward (on both the buy side and the sell side). That being said, in certain jurisdictions and in industries particularly affected by the COVID-19 outbreak, some deals are on pause as the parties evaluate the effects of the outbreak. This is likely to lead to price renegotiations and, in some cases, termination of negotiations if buyers are unsure whether they are overpaying for an asset under current circumstances. As the pandemic continues to expand and the related market volatility persists, buyers and sellers that are party to pending M&A processes should increasingly expect sudden halts to their deals and a tendency toward re-evaluating and potentially renegotiating material terms (including pricing). One tool to bridge such newly erupting valuation gaps might be the greater use of earn-outs to prove out the impact of COVID-19 on the business over time.
An increasing number of sellers may also be reconsidering if and when to launch new auction processes. Setting aside economic and market realities, there are also practical concerns with commencing a process at this juncture (e.g., due to the logistical challenges of conducting in-person management meetings and on-site diligence).
When negotiating acquisition agreements, parties should also consider providing for extensions of drop-dead dates and otherwise adjust deadlines to take into account the anticipated extension of regulatory review periods, particularly competition review in the U.S. (where early termination of the HSR waiting period will be unavailable) and in Europe.
COVID-19 and its overall economic impact on the target businesses has become a focal point of recent buy-side due diligence processes, and buyers may expand their typical due diligence efforts to cover, among other things, the following areas:
- Related contract terminations, renegotiations, triggering of force majeure clauses and ability to perform under existing contracts
- Revenue risk related to impact of travel restrictions, quarantine measures and other government-mandated initiatives
- General impact on target’s operations (e.g., supply chain, inventory, payroll and invoicing)
- Impact on the target’s acquisition pipeline
- Insurance coverage
- General emergency preparedness (e.g., IT capabilities for remote working, etc.)
Parties will likely face logistical challenges in addressing typical and/or enhanced due diligence needs of buyers (especially on-site visits), which may result in a delay of the overall transaction. Furthermore, buyers may feel compelled to recommission in full or partially supplement previously completed due diligence reports (e.g., relating to market assessment or the integrity of revenues and earnings of the target) to reflect the post COVID-19 reality.
Focus on Certain Deal Terms
- Purchase Price. As noted above, parties should be prepared for pauses in transactions and potential price renegotiations or restructurings in light of the perceived risks. The traditional adjustments to purchase price (e.g., working capital, cash and indebtedness) are also likely to be impacted to a certain extent. In particular, the working capital adjustment will have some unique challenges (e.g., how to develop the net working capital target, which is often based on some historical average or analysis of working capital that may no longer be relevant). Parties may need to perform additional work to account for the COVID-19-related adjustments to net working capital (e.g., slower accounts receivable collections or accounts payable payments, nonrecurring penalty payments, etc.). Parties may also be more reluctant to use locked-box pricing mechanisms, which generally assume continuity of profitability (particularly in European deals where such construct is more common).
- Material Adverse Effect. While many customary acquisition agreement terms will be subject to greater scrutiny and negotiation in light of the COVID-19 crisis, the definition of “Material Adverse Effect” (MAE) will likely be of particular interest and focus. At this time, because it is difficult to predict the lasting impact of the COVID-19 outbreak for any particular company or industry, there is no standard analysis as to whether the effects of COVID-19 on a particular business would justify a party’s refusal to close on a deal under an MAE theory. However, MAE definitions are beginning to include specific exclusions focused on events such as the COVID-19 outbreak, or the worsening thereof, irrespective of whether the effects are disproportionate or materially disproportionate to the target’s business relative to other participants in the industry. For example, the recently signed merger agreement for Morgan Stanley’s acquisition of E*Trade (announced on Feb. 21, 2020) includes the following MAE carve-out: “…any acts of God, natural disasters, terrorism, armed hostilities, sabotage, war or any escalation or worsening of acts of war, epidemic, pandemic or disease outbreak (including the COVID-19 virus)…”. Such exclusions can be expected to become more customary going forward. Moreover, the risk-shifting between sellers and buyers as to which party will bear the risk of the COVID-19 outbreak (even if not disproportionately impacting the target business) will remain a negotiated and highly fact-specific point, and the parties’ leverage might shift as the situation develops.
- Representations and Warranties. Buyers may consider additional situation-specific representations and warranties about the target’s business relating to the impact of COVID-19 (e.g., inventory on hand, absence of anticipated supply chain failures and other diligence items discussed above). Sellers will likely attempt to maximize inclusion in the disclosure schedules of references to the potential impacts of COVID-19 or otherwise ring-fence or qualify the representations and warranties, so as to minimize the possibility of the buyers claiming that the outbreak resulted in a breach of more general representations and warranties.
- Interim Operating Covenants. Parties are spending more time discussing key decisions and actions that may need to be taken (e.g., contingency plans such as moving to alternative suppliers, shutting down a facility temporarily, not paying certain vendors or accepting delayed collections on AR, etc.) between sign and close. Conversely, “ordinary course of business” qualifiers in, or disclosure schedule exceptions to, interim covenants are likely to be negotiated to take into account any extraordinary measures to be implemented in the target’s business or workplace as a result or in anticipation of the consequences or worsening of COVID-19.
- Indemnity. Special indemnities aimed at protecting buyers from COVID-19-related losses have yet to appear, but could be on the horizon. However, “sandbagging” clauses allowing a party to bring a claim regardless of such party’s knowledge or due diligence may begin to exclude claims related to the impact of COVID-19 because it is a known risk.
- Closing Conditions and Termination Rights. Parties do not seem to be introducing closing conditions or termination triggers specifically addressing the consequences of the COVID-19 outbreak (or the worsening of the severity thereof). Rather, the issue continues to be addressed through the definition of Material Adverse Effect, as discussed above.
Lenders appear to be honoring existing debt financing commitments. However, buyers may become increasingly concerned about the consequences under their acquisition agreements, and their rights under debt commitment papers, if the lenders do not lend into a committed deal. Given that the MAE clause might be difficult to invoke to address COVID-19 risks, some buyers may see this as an opportunity to request a “financing out” condition or at least a limited version thereof that is triggered by a COVID-19 related financing failure that would not require the buyer to pay a reverse breakup fee. Others may be considering extending the drop-dead date or tolling the triggering event for payment of a reverse breakup fee arising from COVID-19-related issues. Buyers whose deal documents do not have such provisions should consider the legal remedies under their commitment papers in the event of a lender funding default. Buyers should also be in close and continuing contact with their lenders, be alert to any indication that funding may not be forthcoming, and be prepared raise the lenders’ reputational or relationship risks should they threaten a failure to fund.
Representation & Warranty Insurance
COVID-19 is affecting both the process and the scope of representation and warranty insurance underwriting. In transactions that have already bound, carriers and the deal parties are scrutinizing representations most likely to be implicated by developments surrounding COVID-19, as well as policy language that likely did not fully contemplate the severity of recent developments. Underwriters are also using pre-closing “bring-down” calls to carefully assess and specifically document the known or anticipated impact of COVID-19.
Caveats in nonbinding indications of insurance are appearing to the effect that underwriting diligence will include an investigation into the potential impact of COVID-19 on the target’s business. Underwriters are beginning to require an exclusion for such impact, ranging from more tailored exclusions capturing the target’s anticipated business interruption to broader formulations of exclusions tied generally to losses arising out of or relating to COVID-19, and compliance with government directives, policies or actions in response thereto. MAE definitions and common “could/would reasonably” expected standards are falling under enhanced scrutiny, as are representations regarding customer and supplier relationships, absence of changes or MAE, undisclosed liabilities, compliance with laws, and adequacy of insurance, among others, particularly where they involve a forward-looking element. Underwriters, like buyers, can be expected to be keenly focused on MAE provisions in purchase agreements and force majeure language in the target’s commercial contracts.
Buyers relying on representation and warranty insurance should be prepared to address policy exclusions relating to COVID-19, both with respect to specific exclusions (e.g., supply-chain interruptions) or more broadly (e.g., all losses arising out of business interruption related to COVID-19).
The COVID-19 outbreak, its related containment measures and the current market turmoil are changing on a daily basis. The impact of COVID-19 on M&A transactions is also rapidly evolving as dealmakers adjust in real time to the changing circumstances. Transaction processes may be put on hold, economic deal terms may be subject to reconsideration and renegotiation, due diligence efforts may be redoubled and enhanced, and parties may press to reallocate deal and certainty of closing risks. Practitioners need to be alert and nimble as buyers, sellers, lenders and insurance underwriters scramble to navigate the transactional challenges presented by the unprecedented circumstances of the COVID-19 pandemic.