Although we still face an unprecedented business environment, given the scale and speed with which the coronavirus situation has hit all aspects of public- and social life, the economy is beginning to slowly recover from the COVID-19 shock. Against this background, we expect that both strategic investors as well as financial sponsors will, for various reasons, consider and pursue new transactions in the months ahead. Acquisition opportunities in distressed entities will arise, in our view particularly in the areas that are heavily affected by the crisis, such energy, automotive, leisure, retail. Also, as the COVID-19 crisis is temporary only and it – more or less – affects almost all industries, parties of M&A transactions will in many cases normalize company results in valuations, isolating the effect of the temporary disruption, which we expect will facilitate transactions at reasonable prices.
To assist clients in navigating the M&A process in this unprecedented environment, here are some of the key points for the near future from our perspective:
Material adverse effect or material adverse change (MAE or MAC) clauses have, as opposed to M&A deals in the US, only been seen very rarely prior to the hit of the Corona crisis in Germany. And even if a purchase agreement contained such an MAE/MAC clause, it was not certain if such a MAE/MAC covered a pandemic such as COVID-19. In the (near) future, the COVID-19 experience will most likely cause parties to an M&A deal to place a greater importance on MAE/MAC clauses and to negotiate explicit language to address COVID-19 risk-allocation: Sellers will want to negotiate more specific carve-outs to prevent matters originating from events such as COVID-19 from constituting a MAC, whereas – conversely – buyers might insist on a clear walk-away right from the deal if the business suffers a materially adverse (even if only short term) impact due to COVID-19 and similar events.
Parties should pay extra attention to the seemingly routine “outside date” termination provisions since government approvals, particularly mandatory merger clearances, and further closing conditions might get delayed as public authorities suffer from the COVID-19 backlog. The risks of delay need to be balanced between the parties, and so do potential changes in the target’s financial results if the period prior to closing is particularly long.
In addition, in such cases it is important to synchronize termination rights under the financing commitments on the one hand and the purchase agreement on the other hand.
In a post-COVID-19 world, buyers may be more inclined to undertake extensive due diligence investigations to determine legal and financial risks and vulnerabilities – from reviewing supply chains to understand dependencies and potential shortfalls, analyzing key contracts to assess, inter alia, termination rights and force majeure provisions, to reviewing liquidity shortages and potential insolvency risks. It will also be important to understand the geographical scope and dependencies of a target’s operations and how COVID-19 or other events in the future might affect them or cause similar disruptions to the business.
Reps & warranties
The COVID-19 crises will not change a seller’s approach of not giving forward looking warranties, e.g. as to the financial projections for the target’s business. Nevertheless, 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.
As COVID-19 is a known risk, insurers will most likely specifically exclude coronavirus-related losses from their policy coverage. In addition, an insured’s “knowledge” of a situation typically excludes that situation from policy coverage. For that reason, the scope of specific diligence regarding COVID-19, which would also apply to post-signing “updates” from a seller, and their effect on the insured party’s knowledge should be carefully addressed with legal counsel in the context of W&I insurances.
We believe that the amount of Distressed M&A transactions in the immediate “post-Corona” time will increase. Insolvency administrators are always reluctant and mostly not willing to provide any reps & warranties and the standard W&I insurance products often do not match this situation. To this end, some M&A insurers offer special products for such cases – the keyword is Distressed M&A Insurances (DMA).
Interim operating covenants
In the interim period until closing, sellers normally undertake to operate the target’s business in the “ordinary course” to protect its value. However, given the current economic situation, “ordinary course” might be counterproductive for the target’s business and could increase liability risks for the seller under the purchase agreement. The target may need to respond to sudden challenges raised by COVID-19, such as local government restrictions, liquidity issues and supply chain disruptions, all in a manner that might breach a typical operating covenant. Therefore, the parties might need to discuss and tailor “emergency” measures to put the seller, without obtaining prior consent of the buyer, in a position to preserve the target’s business without committing a breach of the undertakings under the purchase agreement. This applies particularly to liquidity maintenance, debt refinancing and working capital management, but also to exceptions for changes required by law or regulation.
Also, both parties should consider the ability of the target to participate in and accept funding from government relief programs, such as KfW-Förderdarlehen, and to apply for deferment of payment of taxes during the pre-closing period. Buyers and sellers may have differing perspectives on whether such relief is desirable or appropriate, particularly with regard to certain restrictions on the repayment of shareholder loans and the distribution of profits to shareholders.
Now even more than before, transactions need to be structured insolvency proof, avoiding unpleasant surprises and later disputes with an insolvency administrator or the authorities in the interests of all parties. This relates to analyzing and mitigating the risks for (a) the seller in case of an insolvency of the target and/or the buyer and (b) the buyer in case of an insolvency of the seller. There have been changes in the insolvency law aiming at reducing such risks, however, it needs to be carefully reviewed if the conditions of the new law are met.
Purchase price adjustments
Regarding the current uncertainties, we expect that locked box mechanics will be applied less often in the near future. Rather, we expect that closing accounts will be used instead more often in order to verify the financial position of the target company as of closing.
Further, we have noticed an increasing demand from buyers to employ earn-out mechanics as deferred consideration to the future resilience and performance of the target’s business which may help to get a buyer comfortable that adverse economic effects of the COVID-19 crisis, which might not already be clear at the closing of a transaction, will be reflected in the amount to be paid as a final purchase price.
Whether or not an earn-out is, however, appropriate under the current circumstances may depend on the time frame of the performance period, the potential sensitivity of the performance metrics to the adverse effects of the pandemic, and the ability of a seller to generate a strategic plan that can be executed under so much uncertainty. For obvious reasons, sellers are usually hesitant to put a significant portion of deal value at risk based on near-term projections of future financial performance. However, given the current uncertainty even post-Corona, appropriate earn-out clauses could help bridging the gap and balancing the risk of the unknown between sellers and buyers.
Potential employment reorganization measures following closing should be addressed in the course of the transaction already – from adhering to essential employment-law procedures to negotiating the effects of potential post-closing reorganization issues on the purchase price.