The COVID-19 pandemic is expected to impact the process, timeline and documentation of M&A transactions in the turbulent times ahead of us. Below are some techniques for parties to protect themselves in the current crisis.
Impact on ongoing negotiations
Apart from the instinctive reaction to pause and reflect over the new developments, parties in the midst of negotiations will likely rethink some of the fundamental aspects of the deal, such as:
Valuation: Are the historical results of the target still a good benchmark for pricing and will the projections still hold the test of time? Can the expected post-closing synergies still be achieved?
Binding offer: How binding is an already signed binding offer and can one party discuss the terms or even walk away from the deal?
Timeline: What is now the realistic timeline for obtaining financing and closing the deal?
Transaction structure: Buying or selling a stake rather than the whole company? Investing in a different capital instrument (e.g. convertible bonds)? Reducing exposure by acting in partnership, joint venture or consortia?
Security: How to best secure indemnity and warranty claims against potentially insolvent sellers? How to secure, on the other hand, sellers' receivables for a retained part of the purchase price at a time when relying on purchasers' continued liquidity or locking cash in escrow may not be an option?
Impact on the due diligence process
Day-to-day business operations have been severely affected by travel bans, social distancing rules, quarantine measures, government-mandated closures and halted factory operations. As a result, on-site inspections and in-person management meetings will become more difficult or impossible. Extensive due diligence is even more important when facing the turbulence created by the COVID-19 pandemic, which has now become a due diligence focus of its own, underlying the more traditional topics.
Corporate: Is the target business organised in a way to enable the different corporate bodies (management board, supervisory board, shareholders' meeting) to function properly despite restrictions related to COVID-19 or even illness of members? Have recent crisis management decisions been taken in compliance with statutory procedures and director duties?
Finance: Is there a risk of covenant breaches being triggered in financing agreements and how much exposure does this create for the target (or any insolvency risk)?
Employment/Regulatory: Has the target complied with all COVID-19 related obligations as an employer (i.e. information and transparency, alternative working methods such as home office and virtual meetings, additional health and safety measures, GDPR-compliant handling of medical data of employees who have or may have contracted the virus, redundancies only as permitted by law, etc.)? What are the legal and operational consequences if it has not?
Material contracts: Is performance under contracts with customers and suppliers still possible in light of the restrictions imposed due to COVID-19? Are certain customers or suppliers entitled to terminate their contract? Could the target face damage claims as a result? Is price-adjustment / volume of orders adjustment regulated?
Insurance: Would the existing insurance policies cover any losses that have already occurred or may occur as a result of the COVID-19 pandemic (e.g. losses due to mandatory closures, problems in the supply chain or inability to fulfil own contractual obligations)?
Others: Have sufficient measures been taken with regards to cybersecurity and trade secrets protection in light of home office / virtual meetings? Has the target made use of or is it eligible to receive state emergency funding and if so under what conditions? Does the target have appropriate crisis management policies and contingency plans?
Impact on SPA terms
Purchase price: In split signing and closing, buyers are likely to push for a later valuation date, insisting on a closing accounts mechanism, so that interim negative impacts on the business can be captured in the price. Sellers will likely prefer the certainty of a historic pricing point and a locked-box mechanism. Hybrid mechanisms can also be used where the price is set by reference to locked-box accounts, but certain balance sheet elements are assessed at closing, e.g. cash (via net debt adjustment) and working capital. Adjustments could work either as a two-way euro-for-euro adjustment against an assumed/expected level, or an adjustment to only occur if the minimum assumed/expected level is not met. The closing accounts process provides protection as of closing (and so only until then). As a post-closing protection in case the pandemic has longer term repercussions, buyers could seek deferred consideration provisions, retention of part of the purchase price or an earn-out. Sellers will resist a mechanism that links price to performance post-closing, as they will have limited or no control over the target business after closing. Such structures will be more common in the sale of a majority or minority stake, as the seller retains some influence over the business. Earn-outs may introduce significant pricing uncertainty because of complex adjustments, including to mitigate any adverse impact of choices made by the buyer in crisis times post-closing.
Conditions precedent / Long-stop date: Clearances (e.g. merger control), consents or approvals from governmental authorities to be obtained between signing and closing will likely take longer and may delay the closing. Dealmakers should generally allow for extra time when setting deadlines for filings or formation of new SPVs, but also consider whether to add provisions for automatic extension of deadlines and/or the long-stop date where the delay is caused by the COVID-19 pandemic or measures for its containment.
Pre-closing covenants: Pre-closing covenants are essentially about ensuring that the target companies continue their "ordinary course of business" until the time of their handover to the buyer. A question will arise as to what is ordinary in our current times, and how quickly the target company should react to imminent challenges. Obligations to refrain from taking certain actions without the buyer's approval may conflict with the target's need to respond to the COVID-19 pandemic and limit exposure. Sellers will need an exemption from these covenants to be able to take emergency measures to preserve the business. Buyers will seek an increased involvement in the pre-closing conduct of the business, with the risk of pushing the boundaries of competition law restrictions. Given restrictions on travel and meetings, boilerplate access provisions will need to allow for virtual access rights and other online solutions.
Warranties and disclosures: While there is no one-size-fits-all solution in M&A deals, it is fairly common for buyers to insist on repetition of seller's warranties at closing. If repetition will be a default or rather an exception, if there will be specific exclusions related to COVID-19 risks, what will be the value of pre-closing disclosures? These will be strong negotiation points in forthcoming M&A deals, in conjunction with all other limitations of seller's warranties typically found in transactions of this type. Buyers may insist on specific representations regarding the COVID-19 pandemic. Sellers may seek a general COVID-19 related exclusion of liability. Ring-fencing (i.e. if COVID-19 related claims can only be made under specific warranties and not under general warranties such as the accounts warranties), the buyer's knowledge, changes in the law and other limitations will also be relevant.
With regards to warranty and indemnity insurance, the expectation is that the underwriting process will include detailed questions on the potential impact of COVID-19 on the target and the target's crisis recovery policies and compliance with them. Where satisfactory answers to questions from the underwriters are not provided, or where certain impacts of the COVID-19 crisis are already known risks, there may be exclusions from the insurance coverage. It is possible to see a rise in the key man insurance policies.
MAC/MAE: Material Adverse Change ("MAC") clauses have already been in the spotlight after the economic crisis, as many market players understood the significance of sudden changes in the economic circumstances of a deal. Since the COVID-19 outbreak in China, SPAs have cautiously shifted towards more specific MAC clauses, some of them pinpointing the pandemic as a MAC if coupled with a significant disruption of the business or an actual (as opposed to anticipated future) financial impact or linked to a specific risk (like termination of essential contracts). While still a negotiation point, we will likely soon witness increased pressure from buyers to negotiate broader MAC clauses. On the other hand, once it becomes an established reality, sellers will want to expressly carve-out COVID-19/epidemic/pandemic related risks, unless coupled with extraordinary consequences or to the extent the target business is affected disproportionately to its industry.
Obviously, in an agreement signed today, a situation caused by COVID-19 may no longer qualify as a "change" but rather as an "effect", which may prompt a shift towards Material Adverse Effect ("MAE") clauses. Is the MAE measured on the target business as a whole or by reference to a specific financial metric (e.g. EBITDA reduction) or by reference to another KPI? Is there enough time between signing and closing for the impact to materialise and be measured? Would it suffice if an event or change has occurred which is "reasonably likely to have" an MAE rather than only where such an event or change has had such an effect before closing? Are indirect impacts and effects captured if they can be attributed to COVID-19? The answers to these questions will be very deal specific.
Severability: This standard boilerplate clause could become critical if new legislation seeking to restrict the outbreak results in SPA provisions becoming illegal or unenforceable.
Can a party walk away now on account of the COVID-19 outbreak?
There is no straightforward answer to this question. Once a transaction is closed and money is wired, the intricacies of unwinding the deal are often too complex to even attempt. Hence, we should not expect a high rate of termination claims where the parties have already performed their obligations.
For transactions pending closing, or for those where at least part of the payment was deferred, buyers may be more inclined to explore their options. In those circumstances, parties will carefully review clauses dealing with:
- Material adverse change/effect: Is it purely based on company results or can it relate to the market/industry? Is it conditioned by long-term effects? Is it linked to a materiality threshold and can the adverse financial impact be measured at this point? Are force majeure, natural disasters, epidemics or changes in general economic conditions expressly excluded?
- Force majeure: Is it expressly (and exhaustively) defined or do parties rely on applicable law and practice? Are there special conditions to claim force majeure, such as a time limit or a certain documentation procedure?
- Hardship: Was it expressly excluded to preserve deal certainty or can the general principles of law be relied upon? Can it lead to termination or just allow the parties to adapt the contract to the new realities?
- Termination: Is it still possible or was it expressly excluded?
The COVID-19 pandemic is already causing volatility and uncertainty in global and national markets, making it more challenging to agree to pricing and achieve deal certainty in M&A transactions. Like other crises, this too will bring new opportunities and allow room for market consolidation.
By Madalina Neagu, Partner, and Stela Pavlova, Associate, Schoenherr