While many healthcare-focused middle- and lower-middle market private equity firms and their portfolio companies continue to spend the bulk of their time addressing operational, cash flow and workforce issues related to COVID-19, we are still seeing a significant amount of M&A and growth equity activity in this market. Although concentrated in add-ons or strategic platform assets with good long-term theses where the private equity firm does not want to lose its toehold, progress continues to be made on numerous deals across healthcare services and IT. At the same time, others are simply slow-walking diligence and negotiations in a wait-and-see mode to be prepared to reengage at full speed once there is more clarity around the long-term impact of COVID-19.
We are optimistic there will be an increase in deal flow once there is more visibility around the duration and general industry impact of COVID-19. It is likely the CARES Act stimulus programs will help offset the hold of the recessionary environment if this can be mitigated in the near term and the compelling market dynamics propelling the pre-COVID-19 healthcare M&A market remain relevant. Add to this several months of backlogged deals, an inevitable quarry of distressed opportunities soon to emerge, billions of dollars in dry-powder needing to be put to work, and the need for portfolio companies to find ways to recapture and accelerate growth, and it is logical to anticipate a Q3 or Q4 booming rebound of healthcare M&A.
In the meantime, for those healthcare private equity funds that have recently closed M&A transactions or are still pressing forward on the deal front, we have consolidated several important issues for consideration.
Contingent Payments in Closed Deals
A number of closed deals have contingent purchase price payments with measurement periods that may overlap with the present crisis. If the earnout is payable in the near-term, many sponsors are also considering whether there is a way to negotiate with the seller to delay or stage payments. One consideration is whether your debt documents would even allow a payment. To the extent the earnout was subordinated, this could permit a delayed payment without a breach of the earnout agreement and similarly could help if a seller’s note is coming due soon. Consider satisfying payment of the earnout with equity as a possible option as well. Likewise, companies with a softness in the current business are looking at whether it is desirable or strategically beneficial to extend an ongoing earnout performance period and afford the seller the opportunity to earn that payment over time, at a future date or based upon revised performance metrics – especially where the earnout is payable to key providers or management. Buyers also should be sensitive to operational changes or budget, workforce or compensation reductions as it relates to any potential good faith or commercially reasonable efforts covenants agreed to in connection with any earnouts, as well as any express or implied working capital commitments that may be difficult to comply with currently.
Impact of MAEs, Bring-Downs and Disclosure Updates in Signed Deals
If you have recently signed a deal that has not closed, the first thing to evaluate is whether you can slow-walk or even terminate the deal as a result of a material adverse effect (MAE). That will depend on two things:
- How you defined MAE and the specific exceptions in the transaction documents.
- The significance and length of decline in the target’s business.
As we all know, an MAE is an extremely high bar, well beyond a materiality condition. It is such a substantial and long-term change that it is exceedingly rare for the courts to have found an MAE to have occurred. Therefore, if you have deals that are currently signed and awaiting closing, the potential ability to successfully utilize an MAE as an out should be carefully analyzed and discussed with your counsel. Conversely, if you are on the sell-side, among other things, you should assess the specific MAE carveouts arguably relating to pandemics and your ability to rely on those, as well as any disproportionate impact qualifier relative to your industry peers. Further, buyers also should consider that often the standard closing bring down of the representations and warranties may have lower materiality standards and provide an easier out – as would potential breaches of the interim operating covenants resulting from actions taken to address COVID-19. Buyers and sellers alike need to assess whether there is a need under the agreement to bring-down disclosure schedules, which could ironically impair the buyer’s ability to make claims for those matters post-closing under a representations and warranties insurance (RWI) policy. Buyers also have an obligation to bring down the no-claims declaration at closing under such RWI policies, again leading to policy exclusions often to the buyer’s detriment. Finding leverage for an out or renegotiated price may be the buyer’s only hope to avoid being stuck overpaying for damaged goods. This was a common dance in the last major recession in 2007.
Negotiating Deal Terms in the Current Market
Both buyers and sellers should consider fair risk allocation if they want to transact in the current environment. To that end, it may make sense to revisit typical deal terms that are often seller favorable in a hot market, including how to define MAE, interim operating covenants, and closing conditions. The parties might be well served to step back and consider what is equitable and appropriate to ensure a deal that is fair to both parties will be consummated at closing – or otherwise renegotiated or amicably separated in place of costly and emotional litigation.
Purchase Price Issues. Some buyers may feel pressure to proceed in the current environment to keep a lead or leash around a key asset. It may be possible to mitigate the buyer’s purchase price risks by utilizing creative earnouts. These earnouts could be structured around key performance metrics or milestones that indicate the renewed health of the business and supportive of the full purchase price. They may, however, need to reflect extended or delayed measurement periods. Further, the impact of the buyer’s contributions to working capital and other resources needed to achieve these earnouts should be carefully considered and modeled and often captured in any EBITDA targets. Be mindful of regulatory compliance when structuring earnouts in healthcare deals as well, particularly where referrals of government reimbursed healthcare services are provided by the earnout recipients.
MAEs and Financing Conditions. MAE definitions should not be viewed as boilerplate. Sellers are understandably seeking specific COVID-19 pandemic, epidemic, or similar events as an exception to an MAE. Buyers are pushing back on that for obvious reasons and instead trying to include COVID-19 impacts as a specific MAE event. One way for buyers to address this is to negotiate instead for a financing contingency on terms favorable to the buyer and lender, which may be preferable to a seller than terminating discussions or delaying a transaction. This may be attractive in particular if the buyer is willing to maintain the original purchase price, upfront or through an earnout structure. In addition, as discussed below, a buyer may be better served trying to negotiate for specific COVID-19-based closing conditions on specific key operational or financial matters or metrics.
Net Working Capital Adjustments. The current crisis is likely to have a significant impact on the target’s net working capital. A key consideration is whether a customary adjustment is even feasible (i.e., can you even set a target), versus moving to a black box-type model or similar approach that forgoes any formal working capital adjustment and perhaps instead settles liabilities and reconciles cash at closing. This is a bigger concern if you have a longer period between signing and closing.
Interim Operating Covenants. Because of this unique situation, there has been more granularity on the operational items that require buyer consent between signing and closing of the transaction. It may be prudent for the parties to agree on a detailed COVID-19 action plan (as an exhibit to the transaction documents) between signing and closing. This could include actions that are pre-approved or that can be taken within limits without buyer approval. This plan also can specifically call out the coordination of contract breach matters, customer issues, litigation, breach notifications, and employee actions. It is a good idea to be lockstep in this environment, especially for buyers who will be left holding the bag after closing and want to ensure that they get what they are paying for. To the extent a buyer insists on more control than a seller is comfortable giving, a fair trade-off may be allowing the buyer a walk right if the seller desires or needs to press forward with key actions despite a buyer’s protest. A break-up fee is one way to compensate the buyer for its costs in this scenario.
Closing Conditions. Relying on an MAE or financing condition alone, however, still leaves uncertainty for a buyer. In this environment, buyers may be better served to negotiate for specific, unambiguous closing conditions to equitably address COVID-19 risk. Specific conditions may include:
- Issues around the seller’s defaults under specified key contracts.
- Commencement of certain types of material litigation.
- Default by certain key vendors, or supply chain or distribution disruptions.
- Loss of key employees or other employee unavailability issues (due to stay-at-home orders or otherwise).
- Satisfaction or lack of satisfaction of financial metrics related to key contracts, or termination of key contracts.
- Potential executive orders that could otherwise impair the business, especially if the company operates in “hot zones.”
At the end of the day, the goal of this additional conditionality is to bring parties back to the table to confirm the deal terms are still fair to the buyer at closing.
Representations and Warranties Insurance. Although we are seeing a decreased demand due to lower deal volume in the current environment, the RWI markets are still open for business. This is true for healthcare deals, albeit with more robust underwriting diligence and often broad exclusions based on COVID-19. The approaches that carriers are taking to COVID-19 risk are changing daily, but while some carriers are insisting on a broad COVID-19 exclusion in every deal, some are taking a case-by-case and more tailored approach to the exclusions. Buyers and sellers need to allocate the risk of these exclusions, and a seller might posit that this is the buyer’s risk for undertaking the deal with full awareness of the ongoing crisis. A buyer might be willing to accept that risk allocation subject to increased, specific conditionality as described above.
Due Diligence. Similar to RWI underwriters and lenders, all sponsors should be doing enhanced diligence focusing on the COVID-19 impact. This is similar to the process you should be employing at your existing portfolio companies as part of a full risk assessment and mitigation analysis. Issues include short- to longer-term operations impacts; rights and exposures under key contracts; whether employees or operations are located in “hot zones;” collectability of accounts receivable; industry demand dynamics; workforce management and morale; and key employee succession planning. It also is important to assess how the companies are treating their customers, vendors and employees as that may have a lasting impact on their reputation going forward. Employing a rigorous and documented COVID-19 diligence process also will make the lender and RWI underwriting process more efficient. We are working with our clients to prepare specific, detailed COVID-19 due diligence checklists.
For various reasons, many sponsors want and need to move deals forward in the current market. Now more than ever, dealmakers need to be thoughtful and sensitive to the key nuances of historically standard or boilerplate deal terms. Now is not the time to be simply reactive or rely on old playbooks. It is a time to be proactive and think creatively to implement transaction structures that work for all parties.