By Richard D. Harroch, David A. Lipkin, and Richard V. Smith
The coronavirus (COVID-19) crisis is having and will continue to have a material global impact on mergers and acquisitions (“M&A”). On a massive scale and in a very short period of time, hundreds of thousands of businesses have shuttered or cut back their operations significantly, millions of workers have been laid off or furloughed, consumer spending has been drastically reduced, supply chains have been disrupted, and demand for oil and other energy sources has plummeted.
The M&A world has endured and recovered from past economic crises, including the burst of the dot-com bubble in 2000-2002 and the Great Recession of 2007-2009. As in past financial and economic crises, uncertainties in the business and capital markets have already contributed to buyers delaying or cutting back on their acquisition plans. But this time things are different—the impact of the pandemic is not just on the financial system generally, the valuation of sellers, and the appetite of buyers to get deals done in the short term, but on a multitude of other factors affecting M&A deals.
These include deal terms themselves, new due diligence issues that have arisen, the manner in which due diligence is conducted, the availability, pricing and other terms of deal financing, and the time it will take to obtain necessary regulatory and other third-party approvals for transactions
Moreover, unlike in past crises that have affected M&A deals and activity, this time there has also been a sea change in the manner in which M&A transactions are developed and negotiated. With all of the principal players working remotely, the effective use of new and creative collaborative tools, technologies and techniques have become more critical as buyers, sellers, providers of M&A financing, and all of their respective legal and financial advisors adjust to the changing environment.
In this article, we will discuss how the foregoing factors and others have already impacted M&A dealmaking and will likely continue to impact the M&A world for some time to come, including how buyers and sellers can each adjust to the changed circumstances to help minimize their exposure to the business risks resulting from the pandemic.
1. M&A Deal Activity
Global mergers and acquisitions have already plummeted as result of the coronavirus crisis, and by the end of March 2020 had reached a near standstill. M&A levels in the United States fell by more than 50% in the first quarter to $253 billion compared to 2019, but most of those transactions were entered into or closed earlier in the quarter before the crisis spread worldwide.
Among other things, executives of companies that would typically have been strategic buyers have been forced to redirect the focus and energy of their teams toward the immediate health of their own companies and away from longer term goals that include pursuing growth through acquisition strategies. Similarly, private equity sponsors have spent an increasing amount of time on efforts to strengthen or save their existing portfolio companies, at the expense of new deal activity.
Parties to pending M&A transactions are also abandoning significant deals that were pending, such as Xerox recently dropping its $34 billion offer for HP, after having postponed meetings with HP shareholders to focus on coping with the coronavirus pandemic. SoftBank has terminated its $3 billion tender offer for WeWork shares, citing the coronavirus impact together with the failure of a number of closing conditions. Bed Bath & Beyond has initiated litigation in Delaware with respect to delays in the pending sale of one of its divisions to 1-800-Flowers for $250 million. Boeing suppliers Hexcel and Woodward have called off their pending $6.4 billion merger of equals transaction noting the “unprecedented challenges” caused by the pandemic. Investment bankers report that most new sell-side assignments are being put on hold until things stabilize.
Of course, certain industries that have been disproportionately affected by the pandemic, such as travel and leisure, transportation, and oil and gas, may see upticks in M&A activity in 2020 as buyers see opportunities for bargains in these sectors. The existing M&A pipeline is thin, and the percentage of transactions involving rescue deals, restructurings, and distressed sellers will likely increase, both in dollar terms and as a percentage of overall M&A activity.
2. Timing and Delay in M&A Deals
For both existing M&A deals that survive the pandemic and new deals entered into during the pandemic, it is expected that deal timelines will be significantly extended. Each stage of a typical transaction, including preliminary discussions between the parties, the negotiation of letter of intent or term sheet, the negotiation of a definitive acquisition agreement, and the pre-closing period, will likely take longer to accomplish. These delays will result from a number of pandemic-related factors, including the following:
Negotiations will take longer: the overused adage of “getting everyone in the room” to get a deal agreed is not currently possible.
Due diligence will take longer, and new M&A due diligence issues will need to be addressed.
Third-party consents (such as from landlords, customers, and intellectual property licensors) will take longer to obtain.
There will be delays in obtaining any necessary antitrust or other regulatory approvals. The Department of Justice has asked firms involved in mergers and acquisitions to add 30 days to their deal timing agreements, and European competition regulators have suspended investigations of a number of proposed deals.
Buyers and their boards of directors are going to be much more cautious, and internal justifications for dealmaking in this environment will need to be more compelling.
M&A agreement terms will take longer to negotiate as buyers will want to shift more closing risk and (where applicable) indemnity risk to sellers, and sellers will seek comfort that the persistence of the pandemic will not permit buyers to walk away from deals based on “buyer’s remorse.”
Buyers will have concerns about their ability to properly value a seller in this environment. Valuations from comparable transactions, even those entered into very recently, will likely be no longer applicable.
Buyers requiring financing will encounter delays resulting from the unsettled state of debt markets and available liquidity, and M&A lenders may seek closing conditions that are even more stringent than those sought by buyers, increasing closing risk for both buyers and sellers.
3. Impact on Letters of Intent
Letters of intent, term sheets, memoranda of understanding, and the like are a common feature of the M&A landscape. Before investing heavily in due diligence and negotiating detailed transaction documents, buyers and sellers typically employ these preliminary, largely non-binding documents to memorialize their mutual understanding of all or some of the material deal terms. Further, since a grant of exclusivity by the seller (which frequently accompanies the execution of a letter of intent or completion of a term sheet) shifts negotiating leverage considerably in favor of the buyer, the seller will desire to nail down as many major deal terms as possible at this stage of the M&A process. Of course, it also is not unusual for a negotiated letter of intent or term sheet to address the purchase price and little else.
In light of the coronavirus pandemic, we expect to see buyers and sellers alike refraining from entering into (or even negotiating) a traditional letter of intent until the buyer first has performed incremental due diligence on the degree to which COVID-19 has adversely affected the seller’s business, results of operations, financial condition, customers, suppliers, workforce, and business prospects. The length of this period of incremental due diligence will depend upon the seller’s circumstances and the parties’ relative bargaining power. A buyer can expect the seller to push hard for a short period while resisting concurrent exclusivity.
Once the letter of intent negotiation begins, buyers should expect sellers (in the context of the pandemic) to attempt to include in the letter of intent provisions relating to closing conditions (including the scope of the material adverse effect definition), pre-closing covenants and drop dead dates (which are discussed in more detail below). For most letters of intent, these are unusual provisions. But during the pandemic, thoughtful sellers will want to take advantage of any bargaining leverage they have to address closing risk and closing certainty.
Buyers will feel justified in seeking longer periods of exclusivity than in the recent past since the pandemic poses new due diligence challenges. Until now, sellers—especially in the technology sector—in many instances had been successful in keeping exclusivity periods to 30-45 days or so (and sometimes even less). Now, it will be more common to see buyers insisting upon at least 60-75 days, with the ability to extend, in anticipation of coronavirus fallout interfering with or delaying the buyer’s due diligence investigation. In turn, well-advised sellers will seek provisions terminating exclusivity at the first sign that the buyer may be unwilling to proceed with the transaction on the terms set forth in the letter of intent or term sheet.
4. Availability and Terms of Debt Financing to Fund Acquisitions
Traditionally, a significant percentage of M&A deals are financed partially through debt, particularly in the private equity space. The volatility in the financing markets brought about by the coronavirus crisis has created challenges for transactions that depend on third-party debt financing, including injecting a fair amount of uncertainty about the availability and terms of such debt financing. The new financing-related questions and challenges facing buyers/borrowers will include the following:
Will lenders underwrite new financing commitments?
Will the buyer’s committed debt financing actually be available when the time comes to close the acquisition?
Will lead lenders whose commitments are conditioned on spreading the risk among a group of lenders have greater difficulty in syndicating the debt?
Will lenders be willing to conform their closing conditions to the closing conditions in the acquisition agreement, or will they insist on more stringent terms (such as the ability to declare a “material adverse effect” even if the buyer is willing to proceed with the transaction)?
Will the lenders increase pricing due to the risks of the coronavirus crisis, and insist on tighter financial covenants, increasing the risk of future events of default?
Will the amount of debt leverage available be decreased from the levels that had been customary in recent times, requiring private equity buyers to inject more equity into buyouts?
What additional due diligence will a lender insist upon, and how much delay will that involve?
How marginally risk averse will lenders be in acquisitions involving industries particularly hard hit by the crisis?
What obligations will buyers have in the event they cannot close a deal if debt markets become illiquid and lenders are unable to lend, and what remedies will sellers have in this circumstance? Will we see an increase in buyers seeking to use “reverse financing termination fees” in private company transactions to limit their financial exposure for broken deals?
Will lenders have a renewed focus on the “outside date” in their financing commitments and loan agreements, and potentially require increased payments for any commitment extension?
5. Effect on Dealmaking and Deal Terms
Invariably, when there is significant economic or other uncertainty in the world of M&A dealmaking, leverage shifts toward buyers and away from sellers. This was certainly the case with respect to dealmaking in the context of the burst of the dot-com bubble and dealmaking in the context of the Great Recession.
There is no reason to believe that it will be any different this time, in the context of the coronavirus pandemic. While strategic and private equity buyers are of course facing their own business and operational challenges, many continue to be “cash-rich” and generally can afford to bide their time to find the right acquisition targets at the right price.
Although public stock valuations have declined significantly since the end of February 2020, and the number of deals using all-stock or part-stock consideration had increased in the last few years, cash continues to be king in the dealmaking world. Many buyers continue to have plenty of “dry powder,” and the immediate slowdown in dealmaking as the crisis took hold in March 2020 will only serve to increase the relative leverage of buyers as the crisis continues to unfold.
Of course, some buyers may conclude that some of the cash that they would otherwise have used for M&A should be used for other obligations, including financing their own operating costs and replacing their own revenue lost as a result from the crisis.
Inevitably, as in past crises, the effect on deal pricing will not be uniform—sellers in industries that have been more significantly impacted by the pandemic (including retail, hospitality, travel, coworking spaces, and automobile and aircraft production) will be more significantly impacted than others (such as cloud computing, software, videoconferencing, other online technologies, biotech, food delivery, and online shopping) that have either been less impacted or have even thrived during the crisis.
To be sure, an increase in leverage for buyers in M&A dealmaking generally should not be misconstrued as suggesting that buyers will now be more likely to prevail in negotiating each individual deal term. Sellers will strenuously pursue deal terms that protect them from closing uncertainty, arguing that buyers in future deals will have had their “eyes open” about the pandemic and its consequences when they enter into acquisition agreements. While the pandemic (at least in the United States) was arguably not “foreseeable” when deals were entered into prior to March 2020, it certainly has become not only foreseeable, but the most significant factor in dealmaking since then.
In contrast, with respect to deals signed before the crisis unfolded that have not yet closed, buyers may have a degree of leverage to seek to terminate and walk away from deals, or renegotiate deal terms because of the effect of the pandemic on the ability of the seller to perform its pre-closing covenants and satisfy the buyer’s closing conditions.
The following is a summary of a number of M&A deal terms that have already been implicated by the coronavirus crisis, or with respect to which deal negotiations will likely be impacted by the crisis:
“Material Adverse Effect” Provisions. In most M&A transactions, the acquisition agreement has traditionally included a term commonly known as the “material adverse effect” (“MAE”) or “material adverse change” definition. The most important use of this definition is in the closing conditions—the buyer is not obligated to close the acquisition if the seller has suffered an MAE since the signing of the acquisition agreement (or the date of the seller’s most recent financial statements). The MAE provision seeks to allocate between the parties the risk of certain negative circumstances occurring or existing during the relevant period.
The question of whether a significant event such as the coronavirus pandemic constitutes an MAE depends on the specific contractual language used in the clause, as well as the current (or reasonably anticipated) impact of the pandemic on the seller’s business. There is a good deal of variation among MAE clauses, but they typically include these two components:
First, MAE clauses frequently include a number of “carve outs,” which the parties agree in advance will not constitute an MAE. Some common examples include conditions affecting the industry in which the seller operates, the U.S. economy or financial markets or any foreign markets or any foreign economy or financial markets in any location where the seller has material operations or sales, and acts of God, calamities, acts of war or terrorism, or national or international political or social conditions.
Second, they often include an exception to certain carve-out provisions, providing that the carve out only applies to the extent that the adverse effect of the identified matter (e.g., an act of God) does not “disproportionately” adversely affect the seller compared to other companies in the same industry.
Prior to the outbreak of COVID-19, if an MAE provision had included a carve out specifically referencing an “outbreak,” “epidemic,” “pandemic,” or other similar medical event, then the coronavirus pandemic would pretty clearly not constitute an MAE with respect to such transaction (although the “disproportionality” clause could enable a buyer to still declare an MAE if the seller has been affected more than its competitors by the pandemic). However, historically only a relatively small percentage of acquisition agreements have included terms that specifically reference such dangers to public health.
Courts have traditionally construed MAE clauses very narrowly, and few buyers have successfully terminated M&A transactions on the basis of such provisions. In Delaware, for example, an event will only constitute an MAE if it “substantially threaten[s] the overall earnings potential of the target in a durationally-significant manner.” Thus, the question of whether the effects of the COVID-19 pandemic may constitute an MAE (where it is not specifically carved out from the definition) may depend on the ultimate duration of the crisis and the persistence of its effect on the seller in question.
In future deals, some buyers will likely seek to include specific contractual language, providing that the COVID-19 pandemic is itself an MAE, or at least seeking to exclude it from the carve outs. But just as surely, sellers will take the position that the pandemic represents a known risk that the buyer should fairly have taken into account in valuing the seller’s business and proceeding with the transaction. Certainly, at a minimum, buyers will likely insist on the inclusion of the disproportionality clause, so that they are protected against adverse pandemic-related developments that ultimately are not industry-wide but rather limited to (or with greater impact on) the particular seller.
Pre-Closing Business Covenants. M&A transactions that require regulatory approvals or third-party consents usually provide for a period of time between signing and closing during which such approvals and consents are pursued and obtained. During this period, the seller is required to continue to operate in the ordinary course of business, and to comply with a number of other business covenants. These obligations may be absolute, or the seller may be required only to use commercially reasonable efforts to comply with them. There are commonly permitted deviations from the covenants in order for the seller to comply with applicable law, to comply with the acquisition agreement, to carry out a directive from the buyer, or to take actions that have been pre-approved by the buyer.
One of the closing conditions is invariably that the seller has complied (or complied in all material respects) with these pre-closing covenants. Moreover, in private company deals where the buyer is entitled to post-closing indemnification, a breach of the pre-closing business covenants likely will be one of the indemnifiable matters.
The rationale for requiring these covenants is solid: the buyer wants the seller to protect and maintain the business being acquired, and thus wants the right to veto any actions or decisions by the seller that may threaten the value of the business. The seller, on the other hand, wants to continue to control the business in the manner tha