UK M&A in a post-COVID-19 world
We consider how M&A activity and structures may look in a post COVID-19 world.
As the COVID-19 pandemic spread across the globe, mergers & acquisitions activity, like the rest of the global economy, rapidly slowed, with many transactions being placed into hibernation or being completely aborted as businesses started to focus internally on managing their way through the crisis and looked to preserve cash on their balance sheet.
As lockdown restrictions across the globe start to be eased and businesses begin to consider their plans beyond the initial phase of the pandemic, we consider how M&A activity and structures may look in a post-COVID-19 world as it is likely that there have been significant — and potentially long-lasting — implications for future M&A deal‑making in the UK.
Whilst there is likely to be a prolonged downturn in M&A activity as compared to recent history, there are already signs that businesses and private equity funds, having put in place the measures to protect their own businesses or having triaged their portfolios, are looking to identify opportunities from the economic slowdown caused by the pandemic.
On the buy-side, for those businesses that have managed to maintain a strong balance sheet and preserve cash, boards will be looking for good value deals, particularly when valuations were beginning to look inflated in certain sectors before the pandemic.
Similarly, the private equity funds that have raised significant new funds over the last few years still have cash to deploy into the market and, with interest rates likely to remain low for some time, private equity will remain an attractive asset class for many investors. There will be no shortage of cash to deploy into the M&A market and buyers seeking opportunities.
The question will be whether there are many willing sellers at the value buyers may be willing to pay. We can, of course, expect to see an up-turn in distressed or accelerated M&A activity as companies struggle to adapt to the changed economic and social landscape.
There will also be many business owners who, having managed their businesses through a decade that has included the banking crisis, Brexit and now a global pandemic, decide that de-risking their position both emotionally and financially may be attractive, even if valuations may be significantly lower than they were six months ago.
This, combined with the likelihood of a higher tax regime (a process that was started only a couple of months ago with changes to Entrepreneurs’ Relief), may see an uptick in company owners being willing to sell at lower valuations.
There is a possibility that cross-border transactions will take some time to come back. Firstly, there are the obvious logistical challenges that restrictions in movement will cause to deal execution, whether it is an ability to build relationships with management or to carry out meaningful due diligence remotely. Secondly, with a prolonged restriction on global movement, there is a possibility of an increased move to localism, with supply chains and customers being sourced and supplied locally, leading to increased national vertical integration. Multinationals may have to look at how they achieve this within a wider corporate structure and look to make small acquisitions to secure their supply chain and customer base at regional levels, which may be an opportunity for many Owner Managed Businesses.
As mentioned above, the significant level of private equity capital that needs to find credible investment opportunities, combined with post-COVID-19 undervalued stock markets, means that we may well see a surge in mid-market public to private deals, particularly involving those companies listed on AIM that have still retained significant family ownership.
In terms of sectors, you would expect there to be some winners and losers. Businesses involved in technology (particularly those specialising in work from home applications), biotech, pharma, diagnostics and personal safety would expect to see an upturn in M&A activity, whilst those industries such as travel, entertainment, events and food service will struggle as society adapts to new work and social behaviours.
There will be opportunities for M&A activity in the post-COVID-19 world, but buyers will be more selective and opportunistic about which opportunities to target and spend time on. This more targeted approach will mean that sell-side corporate finance and other M&A advisers will need to run different processes, spending more time identifying the right pool of potential buyers and working with them much more collaboratively so every party to the transaction can see the value in progressing it. It will be easier for many companies to do nothing so advisers will have to work harder to identify and present the potential value of an M&A deal.
The vast majority of non-distressed M&A transactions prior to the COVID-19 pandemic were structured as the sale of shares as opposed to the sale of a business and its assets. This was principally driven by the desire of individual sellers to access the benefit of Entrepreneurs’ Relief or corporate sellers to benefit from the substantial shareholder exemption to tax on the sale of a subsidiary.
Whilst buying a company, and all its assets and liabilities, was seen as riskier to the buyer as compared to a business and assets deal, the issues around obtaining assignments of key contracts, property leases and other assets, as well as the timing issues and risks of dealing with a TUPE transfer of employees meant that most buyers were prepared to accommodate a seller’s desire to sell shares, provided a thorough due diligence exercise was concluded and appropriate protections included in the transaction documentation.
However, the combination of the Chancellor’s announcement in his last Budget in March to reduce the Entrepreneurs’ Relief benefit down from £10 million to £1 million of gain (making share sales less attractive for sellers) and the changed risk profile of transactions for buyers in a COVID-19 environment means that more deals are likely to be structured as business and asset deals. This will be cleaner for buyers as they will be able to ring-fence the liabilities they are assuming, although they may have to accommodate liabilities with key customers or suppliers or other creditors such as landlords and asset financiers in order to secure the goodwill of the business being acquired.
Valuation and purchase price adjustments
One of the key challenges after any economic crisis is how to properly value a company, particularly when, prior to the COVID-19 pandemic, its financial and trading position was good, but where it has been materially impacted by the pandemic.
Certainly, it is likely multiples will reduce (in some sectors pre-pandemic they were getting frothy anyway), but the challenge becomes what you apply that multiple to. Some accountants are already talking about EBITDAC (earnings before interest, tax, depreciation, amortisation and COVID-19), but, given the fundamental disruption and economic shift caused by the pandemic, it is more likely that multiples will be applied to future projected post-COVID earnings.
It is for this reason that we believe that there will be a change in deal structures, with deferred consideration and earn-out mechanisms becoming increasingly prevalent so the future earnings and valuation risk becomes shared between buyer and seller, especially when there may be concerns of second and further waves of the pandemic and associated government restrictions. As part of this, we can expect a debate between sellers and buyers as to who should take the risk of earn-outs not being achieved due to further outbreaks or periods of lockdown.
However, the increased risk of deferred consideration may create concerns from the seller’s perspective. In a volatile market, where the liquidity of the buyer may be an issue, sellers may become increasingly concerned about a buyer having the funds to pay the seller when they are due to be paid.
This will lead to some difficult and potentially unresolvable discussions around security for deferred consideration, whether charges, cash deposits in escrow accounts or some form of insurance solution. This issue may increase the deal risk profile for a seller and should potentially be factored into the headline price.
In addition, after a period of the M&A market being seller-friendly, the immediate post-COVID-19 market will be a buyer’s market, except in certain sectors.
In order to address the risks of shifts in the value of a business in the course of a transaction, pre-pandemic, there was a prevalence of the seller-friendly locked-box mechanism (where the purchase price is determined by reference to a set of management accounts, drawn up to a date up to a few months prior to signing, that have been diligenced by the buyer and its advisers, meaning the risk passes to the buyer at that earlier time.
The parties then negotiate restrictions on the seller's ability to extract value from the date of such locked-box accounts, including the items that will constitute permitted "leakage" of value before closing). However, there will be a movement towards the more buyer-friendly completion accounts mechanism (where the price is determined post-closing by reference to a set of accounts made up to the closing date (usually prepared by the buyer), so price risk passes to the buyer at closing).
Completion accounts adjustments can reference numerous financial metrics, but are most frequently tied to changes in cash, debt and working capital. This gives the buyer greater certainty on receiving the balance sheet it expects, but will leave sellers exposed to post-completion adjustments to the price, which may be unwelcome.
Whether a locked-box or completion accounts mechanism is used on a transaction, agreement on what constitutes a normalised level of working capital for a business may be challenging given that the working capital pattern of a business may be materially different during the lockdown period — will this mean a more forward-looking test is required as opposed to the traditional look-back methodology?
Further, thought will need to be given as to the impact of agreed tax deferrals (whether the VAT deferral scheme introduced by the government or individual Time to Pay (TTP) agreements reached with HMRC for other taxes) on the valuation of the business as they may impact on the debt or working capital levels.
These arrangements may significantly decrease the cash payments due to sellers on completion of a transaction as HMRC and banks who have advanced funds under the Coronavirus Business Interruption Loan Schemes may use the change of control of a business to require payment of deferred tax under TTP arrangements and loan agreements, respectively.
One other consideration for valuation is that many businesses may have generated significant tax losses during the last few months, having suffered a severe downturn in trading. These losses may have a significant value to any purchaser and sellers may seek to receive some value for those losses in any transaction.
Finally, we could see some of these valuation challenges being met head-on by buyers through simply offering a fixed completion payment to sellers. This is likely to require sellers to accept a lower overall valuation for their business, but the opportunity for certainty in an uncertain economic environment may be quite attractive for many sellers.
This all may look rather gloomy for sellers. However, proper pre-sale planning in the business, such as managing working capital and profitability, as well as reviewing personal cash-flow requirements and pre-sale tax, estate and wealth planning can mean the impact of a period of likely suppressed valuations can be minimised and the impact on the overall return to sellers reduced.
Buyers in M&A deals will conduct some degree of due diligence on a target company to identify legal, financial, operational and other risks before completing a transaction. In recent seller-friendly years, many sale processes have been run as auctions, with sellers providing buyers with pre-prepared due diligence reports. Even when such vendor due diligence reports are provided, however, buyers will typically conduct some level of limited confirmatory due diligence of their own.
As mentioned above, with sellers and their advisers likely to be running M&A processes aimed at a carefully selected short-list of suitable acquirers, it is likely that there will be fewer auction processes and buyers are more likely to want to carry out their own due diligence processes focused on the key areas that are likely to be of concern.
Given the unpredictable nature of an event like the current pandemic, sellers should prepare themselves for heightened scrutiny as most buyers will take a risk-averse approach.
For example, buyers may be inclined to undertake more detailed due diligence on certain areas to better 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 levels of disruption to the business. Areas of increased focus from an operational perspective may include supply-chain resilience, as well as business continuity planning.
The COVID-19 pandemic has also shown that matters of health, safety and employee welfare can present significant concerns, and may therefore warrant an enhanced focus on future diligence exercises.
There may also be an increased focus from buyers on reviewing the target's key commercial contracts to assess parties' ability to terminate, as well as the scope of any force majeure clauses.
Given the breadth of the government support and initiatives, such as the furloughing scheme and the Coronavirus Business Interruption Loan Scheme (CBILS), and the speed in which they have been implemented, sellers can expect detailed questions around their utilisation of, and eligibility for, such schemes to manage risks around claw-back or prosecution if the schemes have not been properly accessed.
Warranties and indemnities
Linked to due diligence will be a move towards buyers seeking greater protection in sale and purchase agreements, whether through the changes to the pricing structure (and how it is tested) referred to above or in seeking wider coverage for warranties and indemnities to ensure that there is a greater ability to claw-back value if the business turns out to have a raft of issues, particularly arising from the pandemic and the use of government support packages.
Specific warranties about access to government grants or CBILS, the use of the furloughing scheme, employee welfare and safety and the exercise of force majeure rights in contracts, for example, can be expected and any sellers considering a sale process in the next few years should keep careful records of the decisions they make now and retain copies of all relevant paperwork to support the due diligence process and the provision of warranties.
Warranty and Indemnity (or W&I) insurance has become an increasingly used risk management tool in M&A transactions for both buyers and sellers, particular where there is a private equity seller involved in the deal.
It will be interesting to see how the insurance industry re-prices their W&I policies given the likely more stringent warranty and indemnity suites being requested by buyers.
Perhaps more important than price, careful consideration will need to be given to any additional policy exclusions that may be added by underwriters; for example, will they cover for warranty claims relating to health & safety issues at work arising from COVID-19 as this may be seen as transferring employer liability risk from one insurer to a different one. There will be the question for all parties to M&A transactions whether W&I insurance represents the same value as it may have had before the pandemic.
The pandemic will significantly shape how parties to an M&A deal view Material Adverse Change (MAC) clauses. These are contractual provisions that essentially seek to give a buyer the right to walk away from a transaction before completion, upon the occurrence of events that are detrimental to the target business during the period between exchange of contracts and completion.
Most MAC clauses in UK M&A deals usually only cover specific adverse changes in the target business (such as the loss of a certain number of key customer relationships, loss of key personnel or a material deterioration in trading performance) rather than changes in general market conditions.
In the future, the COVID-19 experience will most likely cause parties to an M&A deal to place greater importance on MAC clauses — sellers are likely to want to negotiate more specific carve-outs from them to prevent matters originating from events such as COVID-19 from constituting a MAC.
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.
It is difficult to say with certainty whether the present COVID-19 pandemic will have any lasting effects on the approach parties adopt in future M&A transactions.
However, the experience of previous economic crises, however caused, would indicate that after the initial shockwaves have died down and businesses are able to assess their impact, M&A transactions, whether opportunistic or strategic, slowly creep back onto the corporate agenda.
There is a range of studies that indicate that M&A transactions carried out in a downturn tend to create more long term value for the acquirer than those made towards the peak of the market, so businesses cannot afford to discount M&A as part of their strategy for recovery and growth in the post-COVID-19 environment. However, how these deals are structured and how the risks associated with M&A activity will be managed will have changed, certainly for the foreseeable future.
Sellers need to prepare themselves and their businesses for not only the scrutiny any buyer is likely to place them under in any deal process, but also start to reconfigure their businesses for the likely future COVID-19 world to make them more attractive to potential suitors.
For further information, please contact Duncan Reid at email@example.com or 0191 244 4228.
For advice or support on an M&A deal, contact our mergers and acquisitions lawyers.