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Many companies and their founders plan ahead for years before they go to market. And with the last few years of historically great sell-side M&A markets, it’s no wonder that many companies had intended to test the M&A waters in 2020 and 2021. Of course COVID derailed those plans for most with urgent matters (in some cases survival) prioritized over going to market.
As we head into 2021, though, many companies and leadership teams are re-assessing where they stand, where their exit window is, and what the current environment means for a go-to-market decision.
So what to do?
As a friend of mine likes to say: “the virus has picked winners and losers.” It’s a statement that rings true on many levels. COVID-19 has certainly been overwhelming from a both humanitarian and economic perspective. The crisis has had a global impact on companies and businesses on a massive scale- although the impacts have been unevenly distributed. While many businesses have been forced to cut down their operations, lay off or furlough workers indefinitely, or close their doors entirely… the exact opposite is true in other cases. (One common theme remains: forward-thinking business owners are focused on optimizing their company’s resilience by rebalancing risk and liquidity while assessing the market for growth opportunities.)
Understandably the market space for Mergers & Acquisitions (M&A) has also contracted rapidly. According to a report published by Accenture, “The deal volume in the first quarter of 2020 dropped to a seven-year low, with deal value down by 33% from the year 2019.” This is no ordinary slump – shift in consumer behavior, disrupted supply chains, and plummeting demand for oil and energy are throwing companies off- balance.
But like the spectrum of results for individual companies and industries, M&A has not withered across the board.
Understandably, companies are taking more strategic steps to safeguard their businesses and employees. Future sustainability certainly depends on prompt C-suite action. In the coming months, the pace of M&A will also change, depending on the impact of the pandemic on industry sectors and the geographic region. Tough conditions like the plunge of more than 30% in equity markets created unique buy-side opportunities.
In the past, financial and economic crises such as the dot-com bubble in 2000-2002 and the Great Recession of 2007-2009 have contributed to buyers either delaying or letting go of their business acquisition plans. But this time the impact of the pandemic exceeds beyond the financial systems, valuation, and the buyer’s motivation to get the deals done quickly.
M&A deals are affected by several other factors — like new due diligence issues, the way of conducting due diligence, pricing, the terms and conditions of deal financing, regulatory and other third-party approvals necessary for transactions.
Moreover, this time around there are considerable changes in the way M&A transactions are developed and discussed. Since all the key players are working remotely, the effective use of new collaborative tools and technologies is important for buyers, sellers, legal and financial advisors as they adapt and adjust to the new environment.
The Current M&A Environment
Against this setting, let us look at the current state of the M&A market and offer a few tips on how companies and dealmakers should proceed:
According to Forbes, M&A levels in the United States fell by more than 50% in the first quarter of 2020 to $253 billion compared to 2019.
Most of these transactions began or closed in the first quarter before the crises became global, all M&A activity came to an almost standstill by the end of March.
This change was sudden though understandable since all strategic buyers shifted their focus to the state of their own companies and had to put their long-term goals of growth through acquisition on hold. Private equity sponsors spent the majority of their time on either strengthening or saving their existing portfolio companies at the expense of any new deal activity. Several major pending M&A transactions of significant value were also abandoned – let alone likely hundreds or thousands of small to mid-sized deals. Notably:
- SoftBank canceled its $3 billion tender offer for WeWork shares.
- Xerox dropped its $34 billion offer for HP.
- Boeing suppliers Hexcel and Woodward called off their pending $6.4 billion merger of equal transactions stating the “unprecedented challenges” due to the pandemic.
There are industries that have been more affected than others — travel & leisure, transportation, oil & gas. These industries are more likely to see upward M&A activity this year.
M&A pipeline is certainly thin this year, the transactions most likely to fall through will focus on rescue deals, distressed companies, and restructurings.
Extended Time and Delay
Existing M&A deals and all new deals are seeing an extended timeline, from initial discussions between the two parties, negotiation of the term sheet or letter of intent, negotiation of the acquisition agreement, and the pre-closing. These delays are mainly due to pandemic-related aspects.
Buyers Looking to Understand (and Transfer) Risk. Every deal- and every valuation and price negotiation- ultimately is about risk. The simple fact is that buyers are acquiring a cash flow stream, and the value is based on their perceived risk to future earnings. And of course, in the best of times, buyers are risk-averse — no one wants to be stuck overpaying for an asset that turns out to be a lemon. In this context what does the current environment do for buyers’ perceived risk? It heightens it of course- meaning they are being more circumspect in the deals they approach… which quickly translates to longer deal timelines.
Negotiations will be extended. Not only is it is difficult to get everyone together at the same time and place, but buyers are frequently attempting to structure deals with more contingencies to account for the unknown. This can certainly bog down negotiations.
Delay in due diligence, the new M&A due diligence issues will have to be addressed. In the best of times diligence is a 30-60 day affair (and often 60-90). We’ve seen buyer’s pushing for 120 days – often under the guise of “we’re just going to need more time” — but that is often code for “we are going to look harder at this deal before we proceed.”
Third-party consents (contract novations, intellectual property licenses, landlords, etc.) will take more time. In the best of times these things are often the “ankle biters” that delay deals. And while in some cases parties solve for consents by structuring deals as an asset sale, the increased buyer-risk that comes with an asset deal can make this a challenge right now.
Delay in obtaining necessary regulatory and antitrust approvals. The Department of Justice has added 30 days to the deal agreements for firms involved in M&A. While this doesn’t apply to smaller deals it’s definitely a hurdle for larger transactions. Have you tried working with a government agency? Have you done it recently? I’ll say no more…
The unsettled state of private capital markets (private equity and debt) and liquidity availability will cause further delays for buyers requiring financing. This is an interesting one. We always talk about how the private capital markets are a deal participant too. And while there is ample capital available, the question is whether the capital source is willing to provide it and on what terms. We’ve definitely seen a credit squeeze in certain sectors. On the other hand, buyers that are willing to “over-equitize” a deal (e.g. put in more cash than is typical at close and potential recap later) find themselves in the driver’s seat right now.
Effect on Letter of Intent
So let’s assume that a deal gets through the early stages and parties are ready to sign a Letter of Intent. What changes are we seeing there?
First, in the light of the current situation, it is expected that both buyers and sellers will refrain from entering/negotiating a traditional letter of intent until the buyer performs at least some incremental due diligence on the effect of COVID-19 on the seller’s business, the outcome of operations, finance, customers, suppliers, workforce and business prospects. This likely isn’t “formal” diligence- more likely a quick litmus test assessing “is this a space we believe in and want to invest in 2021?”
The timeline of this incremental due diligence will depend on the seller’s conditions and the bargaining power of both parties. Once the negotiations for the letter of intent begin sellers are expected to include requirements related to closing conditions, pre-closing agreements, and drop-dead dates to eliminate the possibility of extension. Provisions will be made by sellers to address any type of closing risk and uncertainty.
Similarly, buyers will negotiate for a longer period of exclusivity owing to new due diligence challenges. It is likely that buyers will insist upon a longer exclusivity period of 60-75 days with the provision of extension considering fallout or delay due to COVID-19. On the other hand, sellers will make provisions to allow them to terminate exclusivity, in case the buyer is unwilling to proceed further on the same terms as mentioned in the letter of intent.
Debt Financing: Terms & Conditions and Availability
Unlike the past, where a significant chunk of M&A deals was financed through debt, especially in the case of private equity. Current instability has led to challenges for financial transactions that depend on the 3rd party debt financing. There is also a lot of uncertainty regarding the availability and terms of debt financing.
Both buyers and borrowers will face the following financing related challenges and questions;
- Timely availability of committed debt financing for the acquisition.
- What will be the conditions for lead lenders who spread the risk amongst a group of lenders? Will they face more difficulties?
- The consent of the lenders to confirm their closing conditions to the closing conditions in the acquisition agreement. Will the lender insist on more strict terms?
- Will there be an increase in pricing and tighter financial covenants which in turn will increase the buyer’s risk in case of defaults?
- Will there be any change in the amount of debt leverage available recently? If yes, this means that buyers will have to inject more equity into buyouts (remember – increase leverage = increased returns…. and less leverage can thus translate into lower valuations).
- Will the additional due diligence required by the lender cause further delays?
- What will be the terms and conditions for buyers in case they are unable to close a deal if debt markets become illiquid? What will be the outcome of such a situation for sellers?
- Will there be an increase in buyers asking for ‘reverse financing termination fees to limit financial exposure for broken deals?
Due Diligence: New Issues
Buyers are conducting additional due diligence to properly assess the effect of the COVID crisis on the seller’s business. The additional due diligence will include the following questions:
- Many acquirers view human capital as the most important element of a transaction. In the “old days” buyers found meetings and interviews with senior leadership pivotal in deciding to move forward with a deal. How can the buyer understand the seller’s management and employees in the absence of a physical meeting? Will a Zoom meeting alone suffice before they stroke a pretty darn big check?
- Seller’s financial projections — are they justified? Are there scenarios which have been “stress tested” for various potential outcomes?
- What is the impact of the pandemic on the seller’s workforce, are there enough employees to continue the business?
- In the case of furloughs and layoffs, has the seller complied with the State and Federal laws?
- What is the cost of continued healthcare benefits to furloughed employees?
- Does the seller have enough liquidity to take care of its near future cash obligations?
- Are there any defaults on contracts and/or leases?
- Are the other counterparties to the seller’s business performing well under the contracts?
- Does the seller’s contract include a ‘force majeure’ clause that may allow it or its counterparty to terminate the agreement or payment?
- Is the seller in compliance with debt instruments, and financial covenants?
- Has the seller taken advantage of loans granted under Coronavirus Aid, Relief, and Economic Security (CARES) Act? If yes, what are the terms, and what is the effect on the buyer’s plans?
- Is the seller vastly dependent on suppliers from certain locations that are hard hit by the pandemic?
- Is the seller in compliance with Federal, State, and Local orders concerning COVID-19?
- Is there any solvency risk to the business?
- Are the crisis management procedures and plans in place?
- What is the long-term business liability of the seller?
- What happens to the seller’s business if its key employees succumb to COVID-19?
- Can the seller reduce or control its operating expenses? Are there any contacts that can be renegotiated at a lower cost?
- Has the seller encountered any IT, cybersecurity, and data breach issues?
- What additional equipment & facilities expenses are the sellers incurring for its ‘work from home’ employees?
- Does the seller have business interruption insurance to contain losses?
Effect on Terms & Conditions of the M&A Deal
Even amidst the current uncertainty, the leverage is with the buyers. Despite private equity buyers facing their own operational and business challenges, they are still ‘cash-rich’ and can afford to wait for the right acquisition targets at the right price.
As seen in the past (dot com bubble and the great recession), the effect of the pandemic on deal pricing is not uniform. Some industries like retail, hospitality, travel, automobiles, etc. are more affected as compared to industries like software, biotech, food delivery, online shopping.
The increased buyer leverage does not mean buyers will have an upper hand while negotiating deal terms. Sellers will be more alert while pursuing deal terms to safeguard themselves against the closing uncertainty.
In case of deals signed before the pandemic but have not closed yet, the buyers have the advantage to either terminate or renegotiate the deal terms based on the seller’s ability to diligently perform pre-closing covenants and to satisfy the buyer’s closing conditions.
Deal terms affected by COVID-19 which are most likely to have an impact on negotiations:
Material Adverse Change (MAC) Provisions in M&A transactions
MAC provision divides the risk of negative circumstances that occurred or existed during the said period between the two parties. The buyer is not bound to close the acquisition if the seller has suffered an MAC since the signing of the agreement.
Whether an event like COVID-19 is considered, an MAC depends on the specific contractual language as well as the effect of the pandemic on the seller’s business.
Pre-closing Business Covenants
In between the signing and closing of the M&A deal, several regulatory approvals and third-party consents are pursued and obtained. The logic behind seeking these covenants is simple, the buyer wants the seller to maintain and protect the business operations, and so wants the right to stop any action that might have an effect on the value of the business. Similarly, the seller on the other hand wants to maintain their control over the business in a manner they see suitable.
M&A transactions that begin amidst COVID-19, have led to the seller being incapable of complete compliance with such covenants (limitation on manpower reduction, limitation on capital and expenses, changes in compensation and benefits, etc.). In such a case the seller may be able to argue that governmental laws allow them to deviate from these covenants.
If the buyer pre-approves the contingency plans then such disagreements can be avoided.
Provision for Working Capital and Price Adjustments
M&A transactions have provision for a purchase price adjustment on the basis of the seller’s cash and indebtedness at the time of closing.
M&A transactions that had already been signed before the “next” crisis; these adjustments result in reductions in the net purchase price at the time of closing. For deals that are yet to be signed, the pandemic will certainly lead to a change of practices that are linked to such provisions.
Buyers may try and ask for a higher level of working capital to ensure sufficiency for continued operations of the business. Sellers who are illiquid may be pressured by buyers to leave behind purchase price credit that they would have otherwise received for closing cash balance.
Overall, the necessity to adjust these new and complex provisions may cause a delay in transactions.
Your Game Plan
To outmaneuver the current uncertainty, leaders must reposition their approach to be ready and resilient. It is time to make the important and necessary moves for business stability while keeping the growth opportunities at the forefront.
How to do this?
Take a complete stock of your company’s position: Identify risks, need for liquidity, partners who are struggling, hostile takeover bids.
Prioritize items on M&A: Decide what can be put on hold, what needs a different timeline, and what should be stopped, define the most critical aspects that should be addressed on priority.
Look beyond the immediate: The crisis impact will continue, so assess how the industry structure will evolve in the coming months.
Leverage M&A for growth: Understand if industry consolidation is necessary, vertical integration and consolidation are not ideal for all businesses but understanding what might happen and how to react is important.
Mergers & Acquisitions play an important role in shaping resilient growth and each crisis creates an opportunity to be better prepared for the future.
Bottom line: you can’t fight the market.
First, let’s get the doom and gloom out of the way: If you are in an underperforming industry (and this is doubly true if your company is *also* underperforming), then it’s a fool’s errand to think that the market is going to be kind to you. There are no white knights. If you’re in a tough spot then the cold, hard truth is that you are either going to have to ride it out or take a deal that is likely going to be pretty bad for you.
Second, let’s talk about industries and companies that are still making it happen. While you still can’t fight the market, what you can do is outperform your peers. In a recent webinar, one of our guests made the comment “A players are always A players.” Top performers always attract capital – even in a down market. So if you are a) in a performing industry and b) also a rockstar… we’ll there is a pretty good chance that you can still go out and get a deal that feels a lot like it would have in late 2019. Sure, diligence may take a little longer. Drafting might be a little more complicated. But the overall value? Should still be good.
In the end the decision to go to market in 2021 will depend on the confluence of the health of your industry, the health of your company, and the Founder’s willingness to accept a valuation based on what the current environment will bear. If you can check those blocks, then get to work on your “pre-flight checks” and hit the market running. If you can’t, it’s time to get to work battening the hatches and preparing for your next window of opportunity.