As confirmed cases of COVID-19 in M&A activity continue to escalate around the world, so too does the economic impact. Worldwide, we have seen the rapid developments in the disease cause a significant decline in global share markets and businesses. Of all different sizes being to shut their doors, contributing to a rising unemployment rate. These impacts far and wide, with the federal government stepping in with sizeable stimulus packages to save jobs and boost the economy. But what does all this mean for merger and acquisition (M&A) activity? The following are some of the observations we have seen so far in the market. And what we anticipate and how things may evolve.
Since COVID-19 was first publicized through various media outlets, deal activity has dropped. Marsh estimates that 25% to 30% of live deals in the Pacific region are a result of COVID-19 concerns. Importantly, a key observation for these deals is that any valuation gaps between sellers and buyers have by the continued uncertainty associated with COVID-19. Especially when parties consider short-term versus long-term outlooks for the target business. Despite this, we have identified that many active deals are progressing well. And the parties continue to have the enthusiasm to transact.
In fact, there will likely be an increase in deal activity from opportunistic buyers. A key example is distressed asset investors, such as specialized investment funds. Who will be actively assessing opportunities to buy low-valued equity or debt packages? In this regard, businesses in certain industries, such as the travel and leisure sectors. Those who are under great financial stress, are likely to be susceptible. We believe that even traditional investors may seek to undertake transactions involving assets when the opportunity presents itself and there is a clear strategic fit.
Risk Management Concerns
It has become clear that financial investors are increasingly concerned with risk management. We expect this to result in more robust diligence efforts in an M&A context, especially regarding financial and tax warranties as breaches in these areas often represent significant financial exposure. Warranty and Indemnity (W&I) and specific tax insurance solutions are being used as strategic risk management tools to cover investors and their portfolio companies. However, it is also likely that W&I insurers may request a new exclusion related to business interruption or bodily damage caused by COVID-19, and this may need to be considered going forward.
In addition, we have observed that portfolio companies are looking to shore up their own operational efficiencies, reduce costs, and safeguard against any additional financial uncertainties to the extent possible. Ensuring adequate insurance coverage across the business. Mitigating potential exposures from operational tax risks is more important now than it has ever been.
MAC Clauses COVID-19 in M&A
For transactions that have been signed. Material adverse change (MAC) clauses have already and we expect this trend to continue. Related to this, W&I insurers are increasingly wary of offering coverage for new breaches (warranty breaches that occur and are discovered between signing and completion). New breach coverage typically contains an exclusion related to matters. This would constitute a MAC. But insurers are nevertheless not as willing to offer this coverage enhancement in the current environment.
Tax Insurance Implications COVID-19 in M&A
For coverage of specific tax risks either in an M&A transaction or outside the deal process, it is not expected that access to insurance markets will be adversely affected by COVID-19, or that any material changes will be made to policy terms. This is largely due to the bespoke nature of tax insurance policies. And because the risk profile for insured tax liabilities is not likely to be any higher because of the current environment.
Businesses Under Financial Strain COVID-19 in M&A
Moreover, the uncertainty in the economy is already causing debt capital markets to become more stringent. We expect this will result in the deferral of highly leveraged buyouts. More broadly, will impact the liquidity of businesses that are already under financial strain.
Lastly, it is evident that COVID-19 has had a profound impact on employees. As a result of the pandemic, it is important that employee retention. Including that of key management personnel, is proper when undertaking due diligence in a transaction. A deficiency in the in-house capability of an acquired business can significantly impact operations going forward.
COVID-19 has had far-reaching impacts beyond those that are regular. As the virus worsens around the world, it is expected that the impact the disease has on M&A activity will continue to evolve over some time. Businesses will benefit from monitoring trends around the world closer to guide steps that can during this time of uncertainty.
Earn-out and Clawback Provisions COVID-19 in M&A
Buyers are increasingly using earn-out provisions to secure themselves against potential losses if the company fails to meet their expectations. Under this provision, buyers do not pay the total purchase price to the seller at closing. They withhold a portion of the price for the future, with payment depending on how the company performs. The earn-out provision essentially protects the buyer from making an overpayment if the company’s performance declines or remains stagnant.
This can also benefit the seller; if the company’s revenue gets to pre-pandemic levels, the purchase price will increase. Consequently, the seller will receive a higher amount when the buyer makes the final payment.
On the downside, earn-out provisions also increase the risk of disputes between buyers and sellers. It is essential to account for these disputes. And how they will impact the value of a transaction before closing the deal.
There has also been an increase in clawback provisions. Equity clawbacks are provisions in M&A deals that allow a seller to benefit if a buyer sells the business.
Material Adverse Effect COVID-19 in M&A
Deal parties are also having prolonged debates on whether they should account for the COVID-19 pandemic as a material adverse effect or material adverse change. These are changes in circumstances that can have a significant impact on the value of a company. Including the material adverse effect clause allows the parties (usually the buyer) to abandon an M&A deal if a material adverse change occurs during the interim period of the transaction.
So far, numerous acquisitions are coming with the added condition that the pandemic has had no material adverse change on the company in question. Excluding the material, the adverse effect clause is currently beneficial for businesses and industries that are more likely to experience heavy losses due to the pandemic.
Factor the Impact of COVID-19 on M&A Deals
With the M&A market shifting, it has become essential for companies looking to sell to develop M&A strategies that account for the changes brought on by the pandemic. For instance, how has the pandemic impacted their revenue and expenses? Which expenses can the buyer expect to return post-pandemic? What can the company do to bring revenue to pre-pandemic levels?
It is also vital to take the long-term view when pitching to investors. Instead of discussing the company’s expected performance in the next six to 12 months. They must focus on the next few years. It can also allow sellers to present a more positive outlook where the pandemic is no longer a driving factor behind its revenue and losses.
Sellers must also answer questions such as whether the company is to address and handle the challenges posed by the pandemic and what it will do in the event of future shutdowns. One way to address these concerns is by highlighting how the company has embraced digital transformation and preparing future-ready business models.