The global pandemic has impacted deal making in 2020 in a number of ways, from contributing to buyers' decisions to delay or postpone acquisition plans in some instances to the widespread adoption of virtual meetings and execution processes. The impact for transactions that we have completed in 2020 has been evident in valuation and the structure of the consideration package aswell as other M&A deal terms and the manner in which M&A deals are progressed and completed with the effective use of technology having become paramount. The shift in dealmaking terms and practices is likely to continue for some time as the resurgence of M&A is expected with lockdown now eased and Buyers and Sellers begin to navigate the risks of a subsequent waves of the pandemic. We consider in this article some of the evolutions and approaches which we have seen developed in transactions in 2020 to address the business risks and new circumstances arising from the pandemic.
New areas for DD have arisen or at least certain areas of established DD will now have a different perspective in the DD process (DD issues). For example, diligence will now be required on the extent to which a target group has participated in any Government COVID-19 related support package available in any territories in which the target carries on business (list of measures adopted across EU below). This will involve a consideration of the financial terms and consequences but also the impact of measures such as the furlough scheme in the UK and generally the changes in trading and the impact on cash, the financial condition and results of the target and its projections and prospects, such as the future impact of any rent payment holidays. Diligence will also consider the impact for the business on covenant compliance in debt instruments aswell as compliance with applicable laws introduced to deal with the pandemic generally. Any defaults under customer or supplier contracts will also be reviewed, as well as termination and force majeure provisions, with particular emphasis on material contracts, leases or parts of the business where cost cutting may be appropriate. With the lockdown and the shift to homeworking, diligence on workforce related issues and cybersecurity have taken greater precedence.
Warranties and Representations
As a result of the pandemic, enhanced or specific C-19 related warranties and representations may be developed in the acquisition agreement to enhance a buyer's protection not only post completion with respect to the condition of the target business that is being acquired but also where possible to enhance a buyer's termination rights where a split exchange and completion is necessary. Areas where such warranties and representations may become necessary include matters such as the effects and consequences of the pandemic on the financial condition, operations or prospects of the target, compliance with specific C-19 response legislation or generally with applicable laws due to changes in business operations, such as cyber security, the effects on the workforce and the effects on customers and suppliers. The changes in emphasis for certain DD matters and the use of enhanced warranties and representations to flush out certain issues for the buyer pre signing by specific disclosures made by the Sellers. This provides protection to the Buyer, enabling matters to be brought to the Buyer's attention prior to completion and enables planning for the post completion integration phase. Buyers are addressing specific identifiable risks, such as data privacy and security, through indemnity protection, backed with termination rights or a claim for damages, often secured by a holdback.
Walk away rights
Buyers seek to protect against the risks associated with the pandemic through pre-completion covenants where a gap between exchange and completion is required, for example where a regulatory consent is required (eg merger control but also with respect to national security or public health grounds to restrict FDI) or where the Buyer requires certainty that material contracts will continue and third party consents are to be obtained. Generally this will provide a buyer with a claim for damages in the event of a breach of the covenants or where successfully negotiated by a buyer, a termination right. The pandemic increases risk for the Sellers of their non compliance with these covenants where a target business may require flexibility given that these covenants include matters such as there being no changes to the workforce, no capital expenditure and no changes to salaries or benefits. The extent to which non-performance of Sellers with pre-completion covenants arising as a consequence of the pandemic is to be excluded will need to be considered carefully by a Buyer to ensure that the Sellers do not have a general right to take unilateral steps (subject to any regulatory issues) and the Buyer is not put in a position that it will be purchasing a business at completion which is different to the business it had agreed to purchase.
As a result of the pandemic, we have seen an increase in the negotiation of specific Buyer termination rights and the inclusion of material adverse change provisions. Whether a pandemic generally is covered by a material adverse change clause will depend on the language used. It has been more common for specific material adverse change events to be defined with reference to the economic impact that this has or us likely to have on the business and this in itself raises some concern for Buyers that the impact of the C-19 pandemic may not then meet the relevant threshold(s) set in the acquisition agreement but the impact would be such that the Buyer would be put in a position where it is required to purchase a business at completion which is different from the business it had agreed to purchase. As such Buyers are increasingly seeking to include a pandemic in the definition of a material adverse change at least to the extent that the target business is disproportionately affected, although this requires the consideration of specific materiality thresholds to be agreed. Where there is a gap between signing and completion a Buyer will often also seek to have warranties repeated at or given at completion and to provide the Buyer with a termination right at completion and/or a claim for damages in the event of a breach. Sellers will typically resist a buyer termination right for breach of a pre-completion covenant, material adverse change, or a specific termination right or buyer termination for breach of warranty or indemnity on the basis that risk passes to the buyer on signing, however, increasingly we are seeing Buyers obtaining some right to terminate or renegotiate terms as a result of changes due to the pandemic because the threat of a second wave in the pandemic remains.
In some cases we have been experiencing changes to the structure of consideration packages and in particular an increase in the use or size of holdbacks, deferred consideration or earn outs thereby reducing the initial cash consideration payment made to the sellers in order to bridge the risks around the uncertainties caused by C-19. A holdback will be considered by buyers as security particularly for specific risks which are foreseeable or predictable as a result of the pandemic and which are to be addressed in the transaction documents through specific indemnities. Where consideration shares can be used also instead of cash consideration and there is some certainty with respect to the valuation for such consideration shares we have also been seeing this as an element of the overall consideration package to reduce the initial cash consideration payment that a buyer would need to make and to preserve cash within the buyer's business. Controls for the buyer during an earn out period remain an area for negotiation where Sellers wish to retain as much control as possible to maximise earn out potential whereas the Buyer will seek to manage the uncertainties of the pandemic by having control to adapt and integrate the target business as it considers necessary to protect the acquired.
For certain acquisitions, W&I insurance has become more common in recent years, particularly where there is a potential gap in liability coverage. Insurers may be reluctant to cover certain losses arising as a consequence of the pandemic, particularly known risks or matters of which the buyer is aware and more enhanced due diligence may be required by insurers before underwriting policies. As a result, the liability coverage provided by sellers and bridging any gap is likely to be one of the main areas for discussion with more pressure on sellers to increase the amount of any holdback, escrow or deferred consideration.
Changes to a target's business operations resulting from the pandemic are likely to impact on how a normalised level of working capital will be calculated, particularly where reduced revenues and new areas of operating expense can be expected, and may also result in increased indebtedness either from Government support or other sources. The accounting principles and provisions to be applied as part of any post completion price adjustment mechanism to review actual and normalised working capital and the amount of cash and indebtedness at completion may need adjustment for the changes that the business has experienced. Buyers are likely to now scrutinise the level of working capital required in more detail and to be more resistant to a locked box adjustment mechanism as this may not provide adequate protection for the risks associated with the pandemic. However, for certain businesses where debt has remained low and there have not been swings in working capital requirements we continue to see the use of locked box mechanisms.
|Some C-19 Response Measures adopted across EU|
|UK||Coronavirus Business Interruption Loan Scheme and Coronavirus Large Business Interruption Loan Scheme
Covid Corporate Financing Facility (commercial paper)
Coronavirus Future Fund (convertible loans matching private funding)
Bounce Back Micro Loan Scheme
Coronavirus Job Retention Scheme (furlough)
Insurance cover availability for pandemics/government ordered closure
Deferral of VAT payments
Small business grant fund
Retail, Hospitality and Leisure Grant Fund and relief from Business Rates
Support for Businesses paying tax – (support for businesses and self employed through time to pay service)
Statutory Sick pay
Self Employment Income Support Scheme
Protection from eviction for commercial tenants
|France||Exceptional state guarantee of Euros 300 billion for loans to businesses
State equity loans for very small and small enterprises
Repayable advances and subsidised loans to SMEs
Public reinsurance of insurance cover
Public reinsurance for short term outstanding export credit insurance
Aid to very small enterprises and independent workers funds and to workers
Aid in catering, tourism, events, sport and culture sectors and increased loan capacity
Aid to traders
Special financing of startups under the aid for innovation programme
Special aid to innovation companies, state guarantee for loans
Loans to SMEs
Partial activity (furlough), employee sharing, exemption from social security contribution
Daily allowance if children at home
Special assistance for start ups
Postponement of social security payment due March – May and of direct tax payments
Accelerated refund of tax credit/VAT credit
|Germany||Corona Euros130bn recovery package through bridging aid, non wage labour costs and electricity costs
Corona emergency aid for micro enterprises and sole proprietors
Bridging aid up to Euros25 bn for small and medium sized companies
Training/education grants of up to Euros500m
Economic Stabilisation Fund providing Euros400 bn in government guarantees for liabilities, Euros100bn for direct state participation and Euros100bn for refinancing
KFK Special Programme 2020 for grants and loans of up to Euros10m
Guarantee scheme for guarantees up to Euros20m
16 German states providing aid in form of grants
Programme for the self employed
Landlord's termination rights prevented
Government export credit guarantees
Temporary right to refuse performance of contracts
Deferral of tax payments
|Italy||Temporary financial measure to sustain companies liquidity – state guarantee for financial institutions providing loans
Guarantee fund for small and medium enterprises
Fund for medium size companies
Tax credits for medium sized companies
Assets allocated by CDP – a state owned fund providing temporary investment including loans, guarantees, equity subscriptions and acquisitions
Non repayable contribution by Italian Revenue Agency
Measures aimed supporting innovative start ups and SMEs
Fund for Technology Transfer
Fund to safeguard employment levels
Financial support provided by loan authorities
Funding for relevant development projects
Export credit in defence and tourism sector
Revolving fund for exports
Moratorium on banks calling default
Conversion of deferred tax assets to tax credits
Financial measures to promote production and supply of medical devices and protective equipment
Tax credit for PPE and refund for expenses incurred for purchase of PPE
Tax credit for inventory, for leases of non residential buildings
Suspension of Regional tax on Productive activities, tax exemption from local municipal tax for tourism sector
|Spain||ICO Guarantee Facility to provide financial institutions with a guarantee for loans
ICO Guarantee Facility scheme for tourism to provide financial institutions with a guarantee for loans
CESCE Credit Insurance Coverage scheme to boost export contracts
Business Performance: changes in business operations caused by C-19, the impact on cash and operating expenses, revised financial projections and working capital position. What is the bad debt position? Can the business function under lockdown if no physical contact is possible. Can the business lower its operating expenses and terminate contracts where necessary? Can the business meet its long term liabilities, are there any solvency or going concern risks? Are there business continuity and crisis management procedures in place? Has the target complied with local laws applicable to the places where the business is being operated?
Government support: What Government grants, loans, funding or other relief has been applied for/received, including for the workforce. What are the conditions and repayment terms attached to any such support. How does this support affect the target's projections?
Taxation: Has the target deferred any tax liabilities or secured any tax holiday, what resources are in place for their discharge at the later date? Does the way in which the group has been run during the C-19 crisis expose the group to any additional tax risks (such as unintended permanent establishments and/or employee tax liabilities)?
Employees: has the target complied with applicable laws in connection with furlough, redundancies, health and safety of employees, statutory sick pay requirements? Have all applicable laws been complied with if employees have moved territory to work from home (eg tax, data privacy). Is the target generally managing workforce issues well with employees working from home and what additional expenditure has been incurred providing equipment to employees working from home. What would the impact to the business be if key employees fall ill with C-19? What are the costs for providing health care to furloughed employees? Have there been changes to HR policies, manuals or procedures as a result of C-19 either temporarily or permanently?
Property: what property does the target lease? Has the target obtained or is likely to seek to obtain a rent payment deferral or other suspension to performance of an obligation? Has there been or could there be any breach of the terms of the lease? Has a rent deposit or other security (parent guarantee) been provided?
Debt Instruments: what debt instruments is the target a party to and has the target obtained or is likely to seek to obtain any payment holiday/payment deferral? Has there been or could there be any breach of the terms (including covenants) of the debt instrument? Is the debt instrument secured?
Cyber/data security: what has been the impact of employees working from home with respect to data security and data privacy, has there been compliance with EU data security and data privacy legislation? Have there been any problems with hackers or other security breaches? Has there been compliance with respect to the protection of personal data for those infected with C-19?
IT system: Does the target have an IT system in place that is secure for employees working from home and where relevant in multiple territories. Is the IT system resilient and capable of performing with the entire workforce working remotely. Does the target have an adequate products / applications to enable employees who are homeworking to communicate and function eg videoconferencing and is this secure? What has the cost to the business been to implement changes to the IT system necessitated by C-19? Is any capital expenditure required to improve the IT system?
Suppliers: What is the financial position of key suppliers and are there any insolvency risks? Have there been or could there be any breaches by the target or the supplier under the contract? Have there been any other changes to contract terms, eg reductions in volumes, payment terms, etc. What are the termination provisions? Are there force majeure provisions or other provisions enabling suspension of performance? Have there been protections introduced as a result of C-19 to the applicable law to prevent / restrict termination? Have there been or could there be any interruptions in supply and what risks or disruption could this cause the target? Is the target business overly dependent on any suppliers and which territory are these suppliers located in?
Customers: What is the position and risks on accounts receivable? What is the financial position of key customers and are there any insolvency risks? Have there been or could there be any breaches by the target or the customer under the contract? Have there been any other changes to contract terms, eg reductions in volumes, payment delays? What are the termination provisions? Are there force majeure provisions or other provisions enabling suspension of performance? Have there been protections introduced as a result of C-19 to the applicable law to prevent / restrict termination? Is the target business overly dependent on any customers and which territory are these customers located in?
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