Private M&A transactions: Moving forward from the pandemic crisis

Introduction

Whilst global M&A deal volumes have inevitably suffered in the first half of this year, commentators express some optimism for the second half. This optimism is perhaps felt most strongly for well prepared and capitalized buyers eyeing target businesses which have experienced a demand surge during the pandemic such as those focusing on eCommerce, payments, video conferencing, gaming and cloud computing as well as technologies which are reshaping other re-emerging sectors such as food delivery and mobile technology. 

As some countries and states in the US start to pursue an unlock strategy, this briefing reflects on some of the issues and practices relevant to M&A deals which emerged whilst the early effects of the pandemic were felt and considers the likelihood of changed market practices going forward for those pursuing an M&A strategy.

Deal doing in a virtual environment

Long before the pandemic lockdowns, many aspects of private M&A deals were being managed electronically or on a virtual basis. This is possible for a large part of the work plan from diligence, document negotiation to deal execution. This trend has clearly accelerated out of necessity during the crisis and is likely to result in permanent changes in practice. However, whilst virtual meetings can be effective for resolving deal points, there is likely to remain a preference for at least some physical meetings for example so that parties can once again take comfort on “softer” issues such as personal chemistry and cultural fit when management teams meet buyers as well as buyers having the assurance of being able to visit key operational sites or assets.

New and enhanced diligence requirements

In an earlier briefing, COVID-19: Private M&A transactions: Issues and emerging trends, we outlined some areas of likely diligence focus for prospective acquirers. 
A continuing headline topic is the need to understand the changes in business operations necessitated by the COVID-19 crisis and the law and regulation in response to it¹, including the operation of contingency and emergency planning, cash flow management and cost tracking/containment – how good was the planning and how effectively was it carried into action?

Key focus areas for investigation continue to be:

• IT infrastructure: IT resilience or performance issues, particularly where the business has migrated to, or increased reliance on, digitization in order to supply goods or services to its customers or relies on a remote work force. Here the issues include whether the IT platform has performed satisfactorily or are there areas of concern where business operations are compromised or capital expenditure may be required to ensure that the IT is sufficiently robust?
• Cyber/data security: Increased or significant cyber or data security issues or breaches as well as compliance with government directions as to the protection of personal data and (related to the preceding bullet point) – have the systems, controls and processes proved effective?
• Employee issues: How are work force issues being managed, especially as furlough or similar job retention schemes are scaled back or brought to an end? For employees in a changed working environment, have safe working practices been respected and to the extent that workforce reduction measures are necessary, has proper process been followed? 
• Supply chain: Issues or concerns with suppliers to the business and their continued capacity to perform, including any existing or anticipated contractual breaches or insolvency risk – has the target business experienced or is it at risk of operational disruptions as a result of supply chain difficulties? For more information on supply chain issues, see our collection of separate briefings on this topic.
• Customers: Issues or concerns with the customers of the business – reductions in volumes, payment delays, contractual breaches or insolvency – is the cash flow and bad debt position of the target business under strain?²
• Insurance: Has business interruption or other insurance responded to claims to compensate for the effects of the pandemic?
• Government financial support: Has government aid, funding, lending or relief been secured and if so, are there problematic conditions attached to it? To what extent is this repayable if the conditions are not met?
• Regulatory issues: Where the target is regulated, has compliance with regulatory or licence requirements been maintained and are there reported or alleged instances of regulatory breaches?
• Taxation: To the extent that any tax liabilities have been deferred or a tax holiday obtained, what resources are in place for their discharge at the later date and are there tax risks in the manner in which the target has been run during the COVID-19 crisis so as to expose the group to any additional tax risks (such as unintended permanent establishments and/or employee tax liabilities)?

More scrutiny from national and supra-national authorities

A notable trend which has developed at pace during the pandemic crisis, is the imperative to protect targets which are considered to be inherently valuable but weakened by the pandemic. This has resulted in governments around the world strengthening and extending the regulatory and merger control oversight of M&A deals. This is a global trend (even for those countries which might previously have been perceived to be less protectionist) with a particular focus in the technology sector where competition authorities are looking closely at acquisitions of smaller emerging companies by large companies in circumstances where there is suspicion that the aim of the acquisition is to remove an emerging competitive threat – so-called “killer acquisitions”.

There is also a growing global trend to scrutinize and restrict foreign direct investment (FDI) in the context of M&A transactions. FDI restrictions can be highly politicized such that early focus on the application of FDI restrictions in the context of a proposed deal is of high importance. For example, the UK rules already allow extra scrutiny of mergers or joint ventures involving businesses providing military/dual-use technologies, computing hardware and quantum technology and are being amended to allow similar scrutiny of deals involving additional sectors including healthcare, artificial intelligence, cryptographic authentication technology and advanced materials. For further detail on the rules in the UK, see our separate briefing UK national security reforms move out of the shadows: National Security and Investment Bill proposed in Queen’s Speech.

Foreign investment reviews in the United States are, and will continue to be, impacted by the COVID-19 crisis. Regulations issued under the Foreign Investment Risk Review Modernization Act (FIRRMA), which expanded the jurisdiction of the Committee on Foreign Investment in the United States (CFIUS or the Committee) to review certain non-controlling and real estate investments in the United States, were adopted in-mid February, only weeks before the full impact of COVID-19 began to be felt in the United States. The Committee is expected to use the full scope of these new powers, as well as its pre-existing authority, to scrutinize transactions that may pose COVID-19-related national security concerns, as well as attempts by foreign persons to acquire sensitive US businesses that are distressed as a result of the pandemic.

A comparative analysis of FDI restrictions by jurisdiction (including more detailed reviews of recently introduced changes both in the US and the UK) is also available in our summary of Global rules on foreign direct investment.

Documenting deals – a rebalancing of the risk equation

Termination rights – direct and back door MACs

The need to satisfy conditions to enable completion to take place (such as regulatory approvals or merger control clearances) may necessitate a delay between signing the deal and completing it. With regulators and merger control authority staff themselves continuing to work from home, timetables required to satisfy such conditions may remain longer. This raises the question of who should bear the risk of a new or unexpected event occurring between signing and closing the deal.

In UK domestic deals and international transactions documented to UK standards, it has historically been relatively unusual to see express provisions entitling the buyer to terminate sale and purchase agreements in competitive processes for an event arising or coming to light in the period between signing and completion. This is because sellers in such processes have been successful in maintaining that “business risk” should, in large part, pass to the buyer at signing rather than completion of the deal, thereby delivering the seller important execution certainty.

However, during the pandemic, a significant number of high-profile deals (largely, but not exclusively, in the US) have been terminated or cancelled on grounds associated with the pandemic or actions taken in consequence of it. Such actions have been broadly characterised as being attributable to a material adverse change (MAC) or a material adverse event (MAE). However, due to the typical drafting of such clauses and the high bar set by the existing, albeit limited, judicial precedent in the US and the UK, buyer’s arguments have also been founded on allegations of a range of sale agreement breaches. Examples have included breaches of financial or operational warranties which have proved impossible to repeat (or bring down) at closing in particular breaches of pre-closing undertakings in the period between signing and closing where actions which the target has had to take in response to the crisis mean that it has failed to operate the business in “the ordinary course” and/or “consistent with past practice” and to refrain from taking certain specified actions.³

Pending receipt of further judicial guidance in this area, where the circumstances of a deal are such that a termination right is appropriate, the following principles may continue to guide the approach to such provisions:

• The courts are generally unsympathetic to attempts of sophisticated parties to escape a transaction to which they have signed up.
• Drafting will be construed against the party seeking to rely on the termination right imposing a high threshold and a tendency against clauses which are broadly drawn and do not capture specific matters or occurrences. To increase prospects of enforceability, triggering language may need to capture some specific, and ideally measurable, effects or events. Examples might include the destruction of identified production or operating facilities or the failure to achieve identified financial metrics, again over an identified timescale.
• A party may not be permitted to invoke a MAC to terminate a contract where it was aware of the circumstances which it seeks to rely on at the time of the contract, although it may be possible to frame a termination right around a trigger which captures a worsening or significant deterioration of those circumstances.
• The concept of materiality in this context is a high bar in terms of the magnitude and duration of the effect- a transitory circumstance will not usually be sufficient.

We may see break fees become a more prevalent feature of transactions to deter broken deals, particularly where there is uncommitted third-party acquisition financing or the deal requires the formal approval of the buyer’s shareholders.⁴ In any event, a well advised buyer will be mindful of the risk of a substantial damages claim for a wrongful termination.

Whatever the outcome of the debate on risk allocation between buyers and sellers as outlined above, “cash” buyers will continue to have considerable advantage in this debate bearing in mind that prized execution certainty for sellers will be undermined where acquisition finance facilities themselves contain conditions or termination events which may remove funding obligations in unforeseen intervening circumstances.

Pre-closing undertakings

A key area to consider will be the extent to which the drafting of the pre-completion undertakings remains appropriate for the target business in the current circumstances. As indicated above, this will particularly be the case where a termination right may arise for breach of such undertakings.

From a seller’s perspective, it may be more important than ever to ensure that it has maximum flexibility to take steps which potentially breach pre-completion undertakings in response to a changing landscape without the need to ask for, and associated risk of not obtaining, the buyer’s consent.

From a buyer’s perspective (and subject to normal gun jumping and competition law concerns) it will wish to have as much oversight and control of the business (and the implementation of emergency or contingency planning) as is possible.

Warranties

Although a seller would typically avoid giving forward looking warranties e.g. as to the financial projections for the target business, other typically encountered warranties may be at risk of being breached as a result of the effects of the COVID-19 crisis. Examples might include warranties which cover changes to the business since the date of the last accounts or warranties which mention known or threatened breaches of material contracts either by the target or by key counterparties. Even apparently innocuous warranties, such as those requiring the target business to confirm its compliance with law and regulation, may be challenging in present conditions.

Sellers may wish to amend or delete problematic warranties or to carve out from their scope (or disclose against) the expected effects of the COVID-19 crisis on the business. As the lasting effects of the crisis become clearer, some sellers may consider giving some limited warranties on the assumed financial and other implications of the crisis on the target business (suitably caveated as to assumptions and the basis of preparation of any such information) and framed on a “so far as the Seller is aware” basis. Alternatively, warranties which cover the target’s compliance with an identified action plan may be appropriate. In that case, ideally, sellers would wish to state also that such warranties are boxed – in other words, these are the only warranties given about the known or anticipated effects of the crisis and none of the other warranties extend to such matters expressly or by implication.

Depending on the financial standing of the seller, it may be more appropriate than would be typical to seek a retention or an escrow as security for warranty or other payments by the seller. Whilst such “hold backs” are fairly common in US deals, they are more unusual in UK deals unless the buyer has a strong bargaining position and the seller’s financial strength is poor.

Where the transaction is to benefit from W&I insurance, many of the areas highlighted in this briefing will be of concern to insurers – in particular, an emphasis on due diligence to understand the substantive effects of the crisis on the business and the manner in which due diligence has been conducted considering restrictions on travel and the due diligence timetable as well as any “gaps” or outdated due diligence reports as a result of any interrupted period of due diligence.

There is also likely to be an increased focus from insurers on the range of protections for buyers discussed in this briefing so that insurers can understand the allocation of risk between buyer and seller. In particular, whether reliance on warranties is the sole protection for a buyer or whether other measures such as the extent of any financial recourse to the seller or termination rights are also available to it.

Bridging valuation gaps

Although still less popular for US deals, private UK M&A deals have seen extensive use of locked box pricing structures over a number of years. However, locked box pricing structures are likely to be less attractive to buyers in future because the price is based on a historic balance sheet which buyers may be reluctant to rely on at the current time. Accordingly, the use of completion accounts to verify the financial position of the target at completion is likely to become more prominent. Even so, there may continue to a divergence in valuation expectations between sellers and buyers. Assuming the gap cannot be bridged to “cut” a financial deal, we may expect to see more transactions where sellers retain an equity stake or accept deferred and/or earn out structures pegged to the future resilience and performance of the target business. Care is needed with any such structures and they can be difficult to negotiate so as to achieve a balancing of the interests of the seller wishing to receive fair value for the target business and the buyer’s need to integrate, and possibly restructure, an acquired business.

Concluding reflections

The early stages of the pandemic saw some potential buyers focus on their “home estate” and on strengthening their balance sheet. However, opportunities exist for those buyers who are well advised and have the management bandwidth and financial resources to seize them.