COVID-19 has had and will continue to have a significant impact on M&A transactions in the UK. UK M&A deal activity is materially down on 2019. Whilst there is a school of thought that being an event-led and sector agnostic crisis markets will experience a swift rebound, there is by no means a consensus. What seems universal however, is the belief that when sentiment recovers and activity levels return the M&A process will have changed significantly.
This briefing considers some of the key areas of the private M&A transaction process likely to be affected by the on-going effects of the pandemic.
Wary buyers
Whilst there is unquestionably a lot of cash in the system - particularly amongst private equity buyers - not to mention considerable pent-up demand as deals previously paused are revived and distressed M&A appears on the horizon, as and when the market recovers it is likely to look very different from the one that existed pre-COVID. Irrespective of supply and demand, the likelihood is that buyers will be proceeding carefully meaning a selective approach, longer transaction timelines, granular due diligence and carefully negotiated acquisition agreements.
Transaction structures
Risk sharing and mitigation will be front and centre for most buyers. This in turn is likely to see an upturn in carve-outs, share for share exchanges as well as partial exits coupled with put and call options. Conversely sellers will want certainty and be keen to ensure that they don’t leak value as a result of the market’s volatility.
Due diligence
Due diligence will have increased importance for buyers who in addition to the usual investigations will want to evaluate the impact that the pandemic has had or may have on the target and its ability to handle similar situations in the future e.g. a further wave of the pandemic and national or regional lockdowns.
While the specific areas that may require enhanced COVID-19 related due diligence will vary according to the circumstances of the transaction (including factors such as the transaction structure - share purchase or asset purchase - and the particular industry or sector in which the targetoperates), examples of potential areas of concern for buyers include:
exposure to supply chain disruption
material contracts (including termination rights and force majeure provisions).
target’s compliance with applicable COVID-19 emergency laws and regulations.
cybersecurity and data protection risks arising from remote working
business continuity planning, and how effectively the target has adapted its business to operate during the COVID-19 crisis and its aftermath
insurance cover for losses arising from a business slowdown or stoppage
a range of employment related issues including details of:
furloughing of the target’s employees under the Job Retention Scheme or other COVID-related
changes to employment or cost-cutting measures introduced by the target
compliance with employment and health and safety laws as part of its COVID response plan and steps taken to discharge the target’s duty to protect the health and safety of its workforce
details of the target’s participation in any government support schemes, repayment arrangements and the impact of any change of control of the target
The logistical aspects of the due diligence process will also need to be reconsidered. While the use of virtual data rooms is an established tool of M&A transactions, sellers may experience difficulties in collating the information required to populate the data room e.g. where personnel or advisors are unable to gain physical access to the relevant documentation at the target’s locations.
Valuation issues
The current environment presents unique challenges for buyers when valuing businesses. The impact of the pandemic and its aftermath on the target’s underlying commercial operations, its supply chains, route to market and customer demand will undermine the accuracy and reliability of the buyer’s data. The lack of comfort in forecast future earnings and reliability of projections will inevitably impact confidence and valuations.
Where the target has experienced a significant economic downturn as a result of the current crisis, it is likely that buyer and seller will have very different views regarding the target’s recovery – both speed and extent - once the trading conditions stabilize.
These factors will in turn influence pricing, payment and contractual negotiations.
Price and payment
Given the continuing uncertainty created by the pandemic and the question of the reliability of due diligence exercises, buyers will be keen to adopt pricing and payment structures which help to mitigate their risk. The “4 R’s” will set most agendas – the buyer’s desire to mitigate risk and ensure recovery of over-payment through purchase price adjustments and the seller’s desires to receive and retain the purchase price.
This may mean a revival of contingent (e.g. earn-outs) and deferred payment arrangements as well a variety of postclosing price adjustment mechanisms. The seller-friendly locked-box arrangements may be placed back in their own box for a period.
Earn-outs - where part of the purchase price is conditional upon the future financial performance of the target – are a useful tool to bridge the gap between the principals' valuations. From a buyer's perspective the structure mitigates risk of over-paying, eases cash-flow and limits exposure in the earn-out period. From a seller's perspective an earn-out presents an opportunity for it to achieve full value and can be a reasonable compromise provided the earn-out payment reflects the risk inherent in these arrangements.
All that being said, earn-outs can be notoriously complex and represent neither a clean break nor certainty – key objectives for sellers.
There are a number of key issues for the parties from agreeing the financial metrics, monitoring performance and the length of the earn-out period to the element of control which the seller will have over the target business in the earn-out period.
Negotiations
If the purchase price is subject to post completion adjustment or contingent on future performance, the share purchase agreement will include a number of detailed provisions which can often be complex and time consuming to settle. These will include:
completion accounts involving a post-closing “true-up” of some aspect of the target’s balance sheet
earn-out mechanics including conduct of business “ring-fencing” protections for the seller
retention or escrow arrangements
deferred payment terms and security arrangements
conduct of business provisions during any period between signing and completion
Buyers will scrutinise their warranty and indemnity protection and seek to address specific COVID-related risks (e.g. compliance with new legislation introduced to manage the COVID-19 outbreak and the efficacy of the target’s business continuity, crisis management and disaster recovery plans).
Where there is a split between signing and completion (e.g. a 3rd party consent or approval is required) the buyer will look to negotiate a full material adverse change provision giving it the flexibility to withdraw from the transaction if there is a significant downturn in the target’s fortunes during that period.
Indeed it is plausible that buyers will look to introduce conditionality to protect against specific risks which could materially affect the value of the target’s business. These might include comfort letters from key suppliers and customers, as well as a range of COVIDrelated conditions e.g. no second or further wave of the outbreak having occurred, the introduction of COVID-related legislative measures that render the target’s business economically unviable or the re-opening or continued operation of the target’s key sites.
In the current climate these risk allocation measures will be more important – and more finely negotiated - than ever.
All this points to transaction documentation becoming increasingly heavily negotiated with all that entails for the parties, their costs and their businesses.
Deal process and timetable
It is perhaps inevitable that parties can anticipate extended transaction timescales as the logistical challenges and government restrictions have the potential to extend various phases of the transaction process from due diligence to tax clearances and regulatory approvals.
Parties should factor these elements into timetables to ensure that they are realistic. Similarly any notice periods and longstop dates in the transaction documentation should reflect these issues.
Government intervention
The UK’s current regulatory intervention regime is contained in the Enterprise Act 2002 which at present allows intervention if one or more public interest considerations are present – broadly divided into national security, media plurality and stability of the UK financial system.
Following an inquiry launched earlier in the year the UK government recently added a new public intervention ground enabling it to intervene in M&A transactions in order to deal with public health emergencies.
The government has stated that these changes are intended to mitigate risks in the short term and that more comprehensive powers to scrutinise and intervene in takeovers and mergers to protect national security will be introduced in the forthcoming National Security and Investment Bill.
Given these factors it is possible that UK M&A transactions will experience increased scrutiny and government intervention.
That said, with Brexit – in some form or another – fast approaching and the UK government’s unambiguous aim to encourage overseas investment and throw “our doors open” to global business, the sensitivity of intervention in this arena is obvious.
Watch this space.
In Conclusion
While there are good reasons to anticipate a recovery in UK M&A activity, the pandemic has ensured that transactions in the new order will look, in the near term at least, very different from the world pre-COVID-19.
Please contact Johnathan Rees if you would like to discuss any of the issues raised in this article.
