By Paul Exley, Nicole Perez, and James Marshall
Law360 (June 23, 2020, 6:19 PM EDT) --
The M&A market has been in virtual lockdown since the COVID-19 pandemic began. Potential transactions were abandoned as would-be buyers preserved their cash and/or turned their attention to shepherding their core businesses through the crisis.
Transactions already in the pipeline have been rapidly impacted in every respect, including in respect of valuation and financing, due diligence, deal terms, conduct of negotiations and timeline.
As the global lockdown begins to lift in places, it is clear that the M&A landscape has materially changed from the pre-COVID-19 market practices. Other articles already have amply covered the surges in distressed M&A, restructurings and protectionism.
Here, we'll discuss ways in which the crisis has changed M&A deals for the longer term and how buyers and sellers can adapt to the changing patterns in M&A to take full advantage of the opportunities that will undoubtedly arise.
Unlocking the Market by Bridging the Valuation Gap
One of the biggest obstacles to unlocking the M&A market as we emerge from lockdown is the valuation gap between buyers and sellers attributable to macro-level uncertainties.
Target prices usually are based on a multiple of future earnings. In the financially precarious post-COVID-19 world, however, historical financial information and the assumptions that commonly underpinned management projections no longer reflect reality.
Moreover, valuations of comparable transactions from before February also will no longer be helpful metrics. How do you accurately price a target that has no revenues and an uncertain future in a rapidly changing world facing a global recession, from which the shape and timescale of the recovery is anyone's guess?
One way to bridge the valuation gap is to use a contingent pricing mechanism, such as an earnout. Earnouts are typically based on the target's performance — measured in sales, earnings or some other benchmark — over a 2- to 5-year period.
By making all or part of the price dependent on the target's future performance, the seller can share in any outperformance of the target not reflected in the price the buyer would be willing to pay up front. Similarly, the earnout protects the buyer from overpaying for a target that does not perform to expectations.
During this time, where predicting future performance is even more difficult than normal, structuring earnouts to achieve the parties' objectives is challenging. The time periods for measuring performance are being vigorously negotiated — with sellers generally favouring a longer period and buyers a shorter one.
Covenants governing how the business should be run during the earnout period, particularly in the event that the business is affected by a COVID-19 second wave, also are being negotiated more heavily than in the pre-COVID-19 period. But, buyers and sellers that are able to negotiate a mutually beneficial earnout have a win-win way of bridging the price gap.
Another similar tool is linking all or part of the target price to an external benchmark or other relevant key indicator that drives the target's performance, such as, for energy companies, the oil price.
Through such linkage, buyers and sellers can limit their exposure to fluctuations in commodity prices or other key variables, which can be particularly volatile and hard to price in at times of great economic uncertainty.
Portfolio Optimization to Continue
Despite current market instability, large corporations are continuing with portfolio optimization programs (i.e., selective acquisitions and divestments) to achieve optimal asset allocation. This will create attractive buy-side opportunities for private equity and other investors.
Heightened price uncertainty increases the risk that sellers will get the pricing wrong, allowing canny buyers to make a quick profit by flipping the target in an early exit.
Accordingly, we expect to see more parties explore using so-called anti-embarrassment clauses, which require the buyer to make additional payments to the seller if the buyer sells the target for a big profit in a short time frame.
Vendor Financing on the Rise
Many M&A deals depend on debt financing. It is still not clear whether, in the post-COVID-19 market, such financing will be readily available and, if available, what terms will govern.
To the extent liquidity is available, we expect to see lending and financial covenants continue to tighten and lenders face additional challenges in trying to syndicate loans.
As a result, to lessen the need for third party financing and to participate in upside growth, we expect to see more vendor financing, including sellers taking equity stakes in the buyer as part of the consideration.
Risk Allocation in a Buyer's Market
Buyers unsurprisingly take a view that these uncertain times mean that this is a buyer's market. That said, sellers that successfully bridge the valuation gap or who are holding assets whose value has remained steady or increased during the crisis (e.g., virtual meeting technology) will be seeking certainty and deal protection.
They will want to close the deal as quickly as possible and most will worry more about the risk of execution than the risk of future warranty claims. This will lead sellers to put a premium on well-run sale processes and to favour buyers with a good understanding of the target's business.
Many sellers will be willing to provide robust warranty and indemnity protection so that buyers can be locked down as quickly as possible.
Sellers' desire for speed may not lead them to capitulate at the negotiating table. We expect sellers to press for stronger protections for the gap between signing and closing and fewer deal outs.
Sellers will seek to eliminate the material adverse effect, or MAE, closing condition — which would allow a buyer to walk away from the transaction if a materially adverse and durationally significant effect impacts the business between signing and closing — and/or expand the exceptions to the MAE definition, including specific exceptions for the effects of COVID-19.
By contrast, buyers will seek to include language providing that COVID-19 can be deemed an MAE if it has a disproportionate effect on the seller. Sellers will try to negotiate looser interim operating covenants.
Most purchase agreements require a seller, in the interim period from signing to closing, to operate its business in the ordinary course. However, such a requirement may not give the seller enough flexibility to react to the COVID-19 aftershocks or to appropriately respond in the event of a COVID-19 second wave.
After all, what does it mean to operate a business in the "ordinary course" — let alone "consistent with past practice" as some operating covenants may require — in the middle of a pandemic and an associated global economic downturn?
In addition to negotiating looser interim operating covenants, sellers also may try to eliminate buyers' right to walk away from the transaction if the covenants are breached and, instead, in that situation, limit buyers to a damages remedy.
Sellers are also likely to ask for bigger deposits and reverse break fees to reduce execution risk or ease the pain of deals not closing. Moreover, sellers may insist on a specific performance remedy in the event buyers refuse to close.
Buyers will seek to exploit their relative advantage by maximizing their risk protection. In the past, many buyers achieved such protection by purchasing representation and warranty insurance.
However, such insurance typically is not available, or is not available at an acceptable price, for known risks, and it is difficult to predict the impact of such risks.
Therefore, we can expect buyers to seek, among other protections, enhanced due diligence to understand the impact of COVID-19 and the financial crisis on the target business, extensive representations and warranties about the target business, expansive indemnity protection, substantial escrows and possibly even nonstandard closing conditions relating to the performance or condition of the business.
From the seller's perspective this may be a price worth paying to get the deal done at a reasonable valuation, particularly if the seller knows the target well and can assess the risk and size of post deal claims.
How Will Representations and Warranties Change?
The nature and scope of representations and warranties will change in the post-COVID-19 world. Warranties relating to historic financial information will be less important because prior accounts may be less predictive of future results and based on a business model that no longer applies.
As more employees work from home, warranties relating to business continuity issues such as cyber security will be included in more purchase agreements and will be more heavily negotiated. Environmental, social and governance issues have become more prominent during the crisis and are increasingly appearing in warranty schedules.
We may start to see warranties that refer to future prospects and performance in purchase agreements as well as warranties referring to COVID-19 and other health issues.
Closing the Door on Locked Boxes
There are two methods for addressing shifts in a target's value between signing and closing which are usual in M&A deals: the locked-box method, favored in Europe, and the post-closing purchase price adjustment, favored in the U.S.
Locked-box deals calculate the final price for the target company based on a historical balance sheet at a presigning date. We expect to see fewer deals done on a locked-box basis given that historic financial information will no longer be trusted as a reliable starting point for valuation and due diligence purposes.
In deals that use a purchase price adjustment, the target price is determined by accounts prepared as at the closing date. Where a post-closing working capital adjustment is used, closing working capital is compared to an agreed target working capital that represents normalized working capital for the business.
In the post-COVID-19 world, settling on the appropriate working capital target will be challenging. Buyers may want higher target working capital amounts that reflect the impact of COVID-19 to protect against uncertainties and potentially increased expenses and decreased revenues.
Sellers may seek to limit such adjustments by putting floors and collars on the adjustment.
The New Way of Doing Deals
Perhaps the most interesting aspect of the new normal for post-COVID-19 M&A deals will be the way market participants interact and behave. During the global shutdown, critical meetings and presentations that usually were conducted in person, including management presentations, kickoff meetings, board and shareholder meetings, company due diligence site visits, and purchase agreement negotiations, were replaced with virtual solutions.
We have all been forced, with different degrees of enthusiasm, to use the full range of remote working technologies to hold virtual meetings and to use virtual data roomss and virtual deal rooms. Some deal teams even have employed drones and 3D video to complete site visit due diligence.
While it hasn't always gone smoothly, the technology is improving and evolving rapidly and generally worked well enough that everyone anticipates many of these virtual tools will become permanent, particularly as companies and firms seek to cut costs during economically uncertain times.
Virtual meetings are here to stay and can replace most face-to-face meetings involved in M&A deals, including due diligence, signing and closing meetings. Virtual meetings tend to be shorter and more collaborative and more cost effective than equivalent face-to-face meetings.
They work best for information sharing — for example, due diligence meetings — or to discuss issues where the parties interests may be broadly aligned such as process and timing issues. But they work less well when the meeting involves tough negotiations or "horse trading."
The physical proximity of a deal team to its members and to the other side changes the fundamental nature of the negotiation. The difficult points on most M&A deals are typically decided on the night of signing in a suite of breakout rooms surrounded by coffee cups and empty pizza cartons. It's not impossible to recreate this vibe on a virtual platform, but it is challenging.
In a virtual meeting, without physical proximity to other team members, sidebar conversations become more difficult and, by necessity, more information must be shared with the entire group — including the other side. For better and for worse, this makes the negotiation more collaborative and makes certain negotiations strategies that depend on real time signaling significantly less effective.
Also, there are some meetings in the M&A process, the primary purpose of which are to establish trust and goodwill between the parties, which cannot easily be conducted online. Examples include deal origination and management presentations/meetings.
However, as younger generations — who have grown up developing deep relationships with people they have met online through gaming, chat rooms, etc. — replace older generations, virtual meetings are less likely to be a barrier to establishing trust and goodwill.
Generally, going forward we expect that parties will continue to use virtual platforms for most deal processes and for the technology to continue to evolve to make this more effective. Face-to-face meetings will be the exception rather than the norm, and will be limited to those meetings where it is necessary or strongly preferable.
As a result, the deal cycle could get shorter as it is easier to schedule a virtual meeting than to coordinate multiple travel plans. Also, online meetings are more collaborative as there is less scope for grand standing and 'banging the table' and people tend to be more focused on getting through the agenda quickly. Point making rather than point scoring works best online.
Some of the changes referred to in this article will pass as we move beyond the crisis, and the relative bargaining strengths of buyers and sellers becomes more balanced. But, as with many other facets of our lives after the COVID-19 pandemic, it seems likely that much of the virtual technology we have been using the last few months will stick.
Paul Exley,Nicole PerezandJames Marshall are partners at Baker Botts LLP.