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M&A in the Time of Covid-19

The outbreak of Covid-19 has weighed heavily on the level of M&A activity. Deal-making is hampered by lack of risk appetite fuelled by difficulties in valuing businesses in times of operational disruption and uncertainty of new waves and restrictions. A buyer may struggle to become comfortable with its own valuation of the target, and it may be difficult to get the seller to agree to the purchase price that eventually is proposed. Further, even if the two parties should have a meeting of minds, the buyer may run into difficulties if the transaction relies on third-party financing since a lender may have its own views and reservations on the valuation.

What deal types can we expect to see in this new environment?

While the current climate may deter many buyers from transacting and prevent many assets from attracting interest, we expect that deals may still be successfully completed in particular in the following circumstances:

• The environment favours a buyer who mainly takes a long-term view on the market and can afford to take short-term risk. Deals may be expected to be strategically or industrially motivated rather than based on short-term growth and turn-around cases.
• The environment favours a buyer who is well familiar with the market in which the target business operates. Such a buyer will be better placed to assess the current risks, and may accordingly be more comfortable with its own valuation of the target and more bold in seeking a deal.
• The environment favours a buyer who is not relying on third-party financing. Those with deep pockets, or with the option to conduct corporate mergers or use their own shares as consideration, such as listed companies, will be at an advantage. However, certain buyers will still be able to access, and complete deals on basis of, third-party financing.
  
• The environment favours a buyer who is not facing significant distress within its own business and markets. This may rule out not only certain types of buyers, but potentially also disproportionally affected sectors in general.

These factors indicate that deals in the current climate may be expected made by market-expert buyers who are cash-rich and/or listed, such as sector-specific financial buyers or larger industrial companies. We may see that industrials who are less able to finance the deal on their own and financial buyers with less experience within the relevant market seek to combine their strategic and financial muscles in joint bids. We should on the other hand not expect industrial buyers to enter into new markets. Further, although many generalist private equity firms have dry powder and are seeking to deploy capital, activity from this group has been modest since the Covid-19 outbreak, and their return to deal activity may be slow.

The deals can be expected to take place by these potential buyers within less affected sectors, such as technology, life sciences, renewable energy and essential consumer goods. In sectors where the industrials and the sector-specific financial buyers may already be facing challenges, such as e.g. offshore and certain parts of the shipping industry, no significant uptick in deal activity should be expected in the near term, although consolidations and mergers with no or limited cash consideration may be seen also in such markets, and buyers with cash may also use this time opportunistically.

How can the current uncertainty be expected to affect negotiation of M&A deals?

In terms of the negotiation and design of deals, certain potential conclusions may be drawn further to the key issue of valuation uncertainty:

• A buyer may be expected to push the seller to offer firm comfort on up-to-date financial information and current trading. Annual and even interim financial statements may easily be viewed as outdated or lacking detail, and there could be a move towards seeking further warranty comfort on recent management accounts. Conversely, the seller will seek acknowledgment from buyer that not all facts are reasonably known to the seller or the target. There may also be a move by sellers to de-risk through use of M&A insurance, which in turn will lead to discussions on the level of review carried out on the subject matter of the warranty.
• A buyer can be expected to request closing balance sheet adjustments and repetition of representation and warranties at closing in order to de-risk the valuation and operational uncertainty. In response, the seller will seek to reduce its exposure towards a falling purchase price and any interim warranty breaches by limiting the time period between signing and closing to a minimum.
• The parties may seek to resolve the uncertain valuation by agreeing earn-out provisions that enable the seller to take part in a positive development post-closing against accepting a low case initial purchase price. There will be a number of issues to resolve in terms of the basis for, and adjustments of, earn-outs, including the impact of any public support schemes.
• A buyer may be willing to accept a higher initial valuation if the seller offers favourable vendor financing, which could also be combined with earn-out elements.
• There are a number of concepts in M&A transactions that are normally agreed on basis of fairly standard wording, but that, in the current environment, may be negotiated more carefully. These include for example the use of "ordinary course" as a reference point for covenants and warranties, and the use of no "material adverse change" as a closing condition and warranty. Further, it may be expected that provisions relating to the buyer's right to information and negative control between signing and closing will be firmer.

In sum, some familiar concepts could become more prominent in M&A deals in light of Covid-19, such as management accounts warranties, M&A insurance, earn-out arrangements and vendor financing. Further, certain standard concepts are likely to become more specifically adapted to the current environment, such as ordinary course provisions, interim covenants and material adverse change provisions. In terms of the M&A process, sellers may expect that due diligence will become more intense, and that such diligence will include forward stress-testing of the target company, both financially and legally, on basis of various potential outcomes.

It could be expected that the tension around these negotiation points will be stronger the further removed the transaction is from a favoured deal setting on basis of the circumstances noted above.