In Part I of this article, we discussed the possibility of PE investors, their portfolio companies, or their respective counterparties invoking material adverse change (MAC) or force majeure (FM) clauses to be relieved of existing obligations due to the COVID-19 outbreak. In Part II of this article, we will examine:

• How PE investors should work with their existing portfolio companies to respond to the immediate and long-term impact of the COVID-19 outbreak; and
• How the lessons learned from this outbreak may change the manner in which PE investment and M&A deals are concluded and executed in China and elsewhere in Asia.

Potential Action Points for Portfolio Companies

The COVID-19 outbreak is having a significant impact on companies worldwide. PE investors should coordinate closely with their portfolio companies to ensure that everything possible is being done to mitigate the negative impact of the COVID-19 outbreak on such companies. Some of the mitigation strategies listed below provide additional investment opportunities for PE investors or at the very least, if handled well, will allow portfolio companies to weather the COVID-19 outbreak better than their competitors.

• Increased demand for refinancing and emergency funding. Business in sectors that have been directly affected by the outbreak (such as manufacturing, consumer, retail, entertainment, tourism, and airlines) and other vulnerable businesses (such as cyclical businesses, unprofitable businesses, or those with low cash reserves or unstable cash flows) may soon require emergency funding. We have also observed a recent uptick in the number of debt restructurings involving repayment rescheduling, resetting of covenants, and extensions of maturity that have closed within very short timeframes. As interest rates continue to stay low, PE investors may push their portfolio companies to quickly evaluate the need to seek refinancing. Where permitted under the investment agreements, PE investors may need to step in to provide bridge financing to enable the survival of their portfolio companies.
• Alternative financing. Thinly capitalized and over leveraged companies and small and medium‑sized enterprises (SMEs) may find it difficult to obtain bank loans due to their higher risk profiles and lack of bankable collateral. Such borrowers may need to look to other debt and equity financing offered by alternative financiers. This may be an area of opportunity for credit funds of PE houses.
• Potential lay-off and exit terms. To the extent the lay-off of key management and employees becomes unavoidable, it will be critical for PE investors to understand how the existing incentive schemes of their portfolio companies work (e.g., whether the relevant individuals will benefit from exit packages associated with “good leavers”) and the severance benefits that the relevant individuals would be entitled to under the relevant employment laws (which may apply regardless of what the terms of the employment contract).
• Buyback and call option trigger. If the COVID-19 outbreak causes an adverse impact on a portfolio company’s financial performance or valuation, the right to buyback shares from founders or controlling shareholder(s) or acquire further stakes from them may be triggered. PE investors should familiarize themselves with the relevant processes under the governing documents and applicable company laws, and should be prepared to drive the negotiations if existing terms under the shareholders’ agreement need to be modified. Even where there are no existing call option provisions, controlling shareholders of companies that are strapped for cash may agree to sell additional stakes to PE investors at a lower valuation or provide significant equity incentives to ensure that PE investors achieve a specified IRR in exchange for PE investors injecting further funding into such companies.
• Review existing insurance policies. For existing portfolio companies that are unable to agree on an amicable solution to enable the continued performance of the existing contracts by their Chinese counterparties or portfolio companies based in China that have been or are likely to be severely affected by the current COVID-19 outbreak, the assessment of coverage under existing business insurance policies is imperative. Business interruption insurance, which is designed to cover income losses arising from operational interruptions or financial losses resulting from disruptions to a business’s customers or suppliers, is most likely to offer potential recourse and relief to an affected business. The breadth of coverage can vary significantly between policy and sector – for example, policies in the hospitality industry may have specific coverage for losses arising from communicable or infectious diseases; however, other policies may require there to have been direct physical loss by the insured. It should be noted that following the massive insurance losses arising from SARS, many insurers began to include specific exclusions for losses arising from epidemics and pandemics in these types of policies – the ability to claim COVID-19-related losses under such exclusions is likely to be extremely limited. Ultimately, unless there are clear provisions that entitle the insured to recover, given the massive volume of potential claims, we expect to see insurers taking time to process and assess particularly mid‑to‑large-scale claims and claims initiated solely on the grounds of FM. Therefore, PE portfolio companies should take a pragmatic approach to recovery against any existing insurance policies – instead of assuming that the insurance payouts will be received in time to cover near-term liabilities, they should assess coverage early with the involvement of their insurance brokers and make claim notifications as early as possible while making contingency plans (including arranging for alternative sources of funding) where necessary to allow time for claims to be processed.
• Monitor delay in achieving qualified exit. A delay in the IPO process for a portfolio company is likely unavoidable as quarantine measures hinder due diligence and marketing efforts and the market’s appetite to inject a significant amount in the equity capital market remains low. If the delay triggers a redemption right or other transfer or exit rights under the portfolio company’s investment agreements (e.g., due to a failure to achieve a “qualified IPO” by a specified date), PE investors should take note of any timelines within which they need to exercise those rights, as well as assess the likelihood of recovering their investment or achieving the desired returns under those mechanisms, while continuing to monitor the impact of the situation of the outbreak.

Post-Crisis Deals and Deal Execution

Once the situation has stabilized a bit and PE funds begin moving forward with investments and acquisitions, it is likely that the experience gained during the COVID-19 outbreak will impact the way PE investments and M&A are concluded and executed in China and elsewhere in Asia.

• Slowdown in PE activity. The immediate effect of COVID-19 on M&A appetite has been felt across Asia and on deals involving Chinese targets, buyers and/or investors. Although some transactions that commenced prior to the outbreak are continuing to progress (albeit at a slower pace for some), others have been temporarily suspended. Bidding deadlines are being extended for M&A transactions and IPO calendars are being pushed back amid a general slowdown in business activity. The travel restrictions, market volatility, and general uncertainty caused by the COVID-19 outbreak have had a chilling effect even on transactions without a direct China nexus, with some transactions in Southeast Asia visibly slowing down as stakeholders ponder the impact of the outbreak on valuations in industries ranging from consumer electronics to asset management. However, as we note in Part III of this article, the outbreak and the resulting change in consumer needs have created opportunities in certain sectors – we see transaction demand continuing in those sectors.
• Investment opportunities given expected impact on valuations. As businesses suffer from the immediate effect of COVID-19, some sellers may be prepared to accept a lower valuation, giving buyers with available funds the opportunity to buy low. Where a seller is unwilling to lower the valuation, ongoing price negotiation may be prolonged as both the seller and the buyer will seek to quantify the impact of the COVID-19 outbreak in some way, which may still be a challenge at this stage.
• Business continuity planning; impact on investment terms. In light of the experience from SARS and the current COVID-19 outbreak, when assessing a potential portfolio company, PE investors should intensify their focus on how the company plans to continue business through similar “black swan” events in the future, as well as how the investment terms should legislate for such events, and actively engage with the founders and management in formulating the terms so as to avoid any misunderstanding. Issues to note in this regard include the following:

  (1)Information and notification rights – whether the proposed portfolio company is prepared to share information with the PE investors to facilitate timely reaction and crisis management;

  (2) Succession plans – in the event a key person is unable to travel or continue work, whether the business has in place a system (including with respect to information sharing) that allows another employee to assume the role of such manager;

  (3) Key person provisions and insurance – in the event a key person is unable to continue work, whether the investment documents contain key person provisions with clear triggers and consequences (including with respect to such key person’s entitlement to shares of the company). PE investors should also consider if any key person insurance is required to protect the business from a key person event;

  (4)Failure to meet performance milestones – if a similar event prevents operational and/or financial milestones from being attained, whether the investment documents should provide for any “grace period” and what consequences should follow;

  (5)Control over business decisions – PE investors may wish to consider requesting strong veto rights or control over operational decisions (such as the duration and the extent of business suspension) triggered by such an event; and

  (6) Establishment of disaster coordination committees – in addition to the typical board committees, PE investors may wish to consider requesting that a disaster coordination committee, comprising members that include representatives appointed by such PE investors, be swiftly constituted following the occurrence of such an event.

• Downside Protection. PE investors should intensify their focus on downside protection mechanisms such as value adjustment mechanisms, puts to and guarantees from founders, call rights, investment by means of convertible instruments instead of equity, and other means of ensuring stronger downside protection. Redemption rights would not provide sufficient downside protection in such a scenario as the portfolio company is very unlikely to have sufficient legally available cash to satisfy its redemption obligations.
• More due diligence into contract terms before investment and more thorough negotiation of MAC and FM clauses. If widespread disease and a resulting quarantine would likely disrupt the supply chain of the potential portfolio company, PE investors should perform more diligent review of the FM terms of its existing contracts and its operational insurance policies. At the same time, PE investors should encourage, and to the extent possible require, their portfolio companies to devote considerably more resources and attention to negotiating specific and appropriate MAC and FM language to protect themselves against any future unforeseen risks.
• Impact on warranty and indemnity (W&I) insurance. If PE investors are in the process of using W&I insurance in connection with an M&A transaction (whether on the buyer side or on the seller side) with respect to a target group with significant operations/supply chain in China or other jurisdictions significantly affected by COVID-19, they should be aware that W&I insurers will be expecting to see that the deal parties have proactively considered and assessed losses that have arisen and those that are likely to arise. For example, with respect to affected businesses, the insurer will expect to see specific disclosure from the sellers on the impact that COVID-19 has had on the target business (including an assessment of matters such as financial losses suffered, disputes threatened, pending, or anticipated, provisions in material contracts that may give rise to termination rights for counterparties and/or tenants to claim rebates, and/or events triggered in lending arrangements). The insurer will also be likely to test the adequacy of the buyer’s and its advisers’ investigation (both legal and financial) into the impact of COVID-19 on the target business and is likely to want to hear how the parties are addressing the risk of the potential of the impact worsening between signing and closing of the transaction. Deal parties should be prepared with detailed assessment and analysis of these changes.
• Negotiation via video conferences. Given the impact that COVID-19 has had on travelling and face-to-face negotiations, a few signings have taken place via video conference. We expect to see increasing use of video conferences and other technology to execute and conclude deals remotely (which has the added benefit of reducing the parties’ carbon footprint). SARS had a significant impact on the conduct of in-person due diligence in China, hastening the development and uptake of virtual data room services.
• Bidding deadlines extended but deals may be expected to close more swiftly upon revival. With many not expecting to see much M&A activity in Q1 2020, some expect the auctions and sales that have been put on hold due to the outbreak to be revived quickly throughout the rest of 2020 to make up for lost time.