When COVID-19 led to a lockdown in March of this year, many planned acquisitions were put on ice as companies grappled with immediate concerns such as managing their cash flow, accessing Government support and claiming under any relevant insurance policies. With the immediate crisis response beginning to subside, financial sponsors such as private equity houses and venture capital firms are now looking to build their portfolio and, where possible, acquire assets for unprecedented low prices. This new phase will also give entrepreneurs the opportunity to both acquire assets at reduced prices and generate interest from competing buyers, as well as giving established companies the chance to consolidate by acquiring synergistic ventures.
However, conducting an acquisition in this climate necessitates careful consideration of the legal mechanics to minimise the risk for the buyer and provide a clean break for the seller. Whilst buy-side protections such as post-completion price adjustments are often used in transactions, the current market will see a shift in favour of the buyer to mitigate the existing economic uncertainties.
COVID-19 has had an uneven effect on the economy and a number of companies have found that while demand for certain areas of their business has plunged, others have seen a dramatic increase. Where companies consider that the drop in demand in the relevant area is unlikely to subside in the near future, they may be considering ring-fencing that area and selling it. In order to do so, the seller will need to undergo a corporate reorganisation. Where the prospective buyer is already identified, their advisers will likely input on this process to ensure that the target company owns all the assets the buyer requires.
The scope of due diligence carried out by the buyer's advisers is likely to be broader than a traditional transaction where the buyer may have been comfortable relying on warranty and indemnity protection. Given that there will naturally be a concern about financial recourse to the seller post-completion, the buyer will want to unearth all the warts prior to putting pen to paper.
Inevitably, financial diligence will be of paramount importance to ensure the long-term viability of the target's business and its ability to withstand the COVID-19 storm. However, legal diligence is also likely to be more extensive and in particular, there will be issues regarding:
- Insurance: Where business operations have been impacted by COVID-19, buyers will want to understand the ability of the target to recover under any insurance policy.
- Employees: The nature and size of the target's workforce is likely to play an important role in valuing the business. To the extent that the target has relied on the Government's Job Retention Scheme, the buyer will want to: (i) understand how any furloughing has been carried out, (ii) ensure the target's compliance with the regulations and (iii) understand whether a redundancy exercise is intended.
- IT infrastructure: Given the expected longevity of social distancing restrictions, the technology underpinning home working is likely to be a key area of focus for buyers.
- Historic acquisitions: If the target group has previously carried out acquisitions, the terms of these transactions will need to be reviewed carefully to identify any live warranties or indemnities that could be claimed under.
- Key contracts: The terms of key contracts and the ability to terminate these will be of particular importance in a distressed sale. Any onerous or unnecessary services are likely to be scrapped in favour of cost savings and the buyer will therefore want to ensure it has the contractual ability to do this.
- Site visits: Where the target's business is primarily in the real estate sector, traditional site visits as part of the due diligence process are likely to be limited for the time being. More extensive desktop diligence on items usually covered during a physical site visit will be necessary.
Warranties and indemnities
As identified above, buyers are likely to be concerned about recourse in the event of a breach of warranty where there is a distressed seller. The parties may therefore look to warranty and indemnity (W&I) insurance to cover the transaction risks. The W&I market has responded varyingly to COVID-19 with some insurers requiring an overarching COVID-19 exclusion whilst others have taken a more case by case approach. Where W&I is not financially viable or the exclusions offered are too wide, parties may consider setting aside a portion of the completion funds to be held in escrow for a prescribed period and these can then be called upon in the event of a warranty claim.
In terms of the scope of warranties, we would expect a focus on key areas of risk such as commercial contracts, supply chains and accounting records. Given the relaxation of certain accounting rules in light of COVID-19, buyers will want the seller to warrant a recent set of management accounts. We would also expect the inclusion of COVID-19 specific warranties addressing the target's readiness for a second downturn; for instance, in terms of the viability of the target's IT infrastructure for work from home arrangements.
Risks on a split exchange and completion
A split exchange and completion may be of greater concern in the current climate given the unpredictable nature of the economic landscape. However, at times, this is inevitably required due to regulatory clearances, funding needs or contractual consents required.
Whilst the prevailing view has been that the risk passes to the buyer on exchange of a transaction, weaker sellers may be forced to accept a material adverse change (MAC) provision. This allows the buyer to walk away if the target's business suffers an unforeseeable decline in the period between exchange and completion. However, MAC clauses generally exclude overall market conditions unless the target is disproportionately affected. Given that COVID-19 has already hit the economy, a MAC clause will likely be limited to any further legislation or restrictions disproportionately affecting the target's business.
While often contended for by buyers, we may see that the approach of warranties being repeated at completion becomes the accepted market position. Given the restrictions placed on a target between exchange and completion, sellers are likely to continue to resist such a provision; however, this may be a necessary concession in order to placate buyer's fears over a possible financial worsening between exchange and completion.
Post-completion price adjustments
The use of post-completion price adjustment mechanics will take on a renewed significance as buyers seek to ensure that the impact of any further economic downturn on the target's assets is mitigated against. These provisions may also provide reassurance for buyers who, in the current context, may have difficulty valuing a target business; some price adjustment will provide greater reassurance that buyers are paying a fair price. In particular, there is likely to be a renewed focus on deferred consideration mechanics, including earn-outs or completion accounts. These mechanics will help reassure the buyer that it will be protected should the economic climate worsen.
While M&A activity is likely to be muted over the next couple of months, financial advisers are predicting an uptick in transactions in the fourth quarter of 2020. Such predictions are likely to provide some optimism for market activity but the success of these early transactions will hinge on incorporating the risk mitigation strategies set out above.