The novel coronavirus (COVID-19) has rapidly swept across each continent, leading to unprecedented levels of market disruption and uncertainty. The full impacts of COVID-19 on the domestic and global markets are still unknown but it is safe to say these are unchartered territories for most dealmakers. We consider what issues should be front of mind for dealmakers at these times.
Deal viability & pricing
What is clear right now is that irrespective of how far along the transaction timeline a deal is (be it pre or post signing term sheets, mid due diligence, or post exchange), an inevitable question facing a buyer is whether the transaction is still financially viable. Where the transaction sits along the transaction timeline will certainly change how this question is answered as parties balance the costs of completing the deal, pulling the pin on it, or attempting to renegotiate its terms.
It seems consistent in the market right now that frequency of new deals has slowed down in the midst of the COVID-19 pandemic. However, many parties are already contractually bound or have no option but to sell at a discounted price. For those businesses that have progressed their deals along the transaction timeline, some buyers will be considering their options with respect to abandoning deals, whilst some sellers will be looking out to enforce them.
Nonetheless, it is prudent for each party to weigh up the costs associated with each option as they may not be immediately clear. For instance, it may be in the interest of both parties to renegotiate the purchase price if the seller does not have the resources to enforce the contract or the amount of damages that may be recovered are less than a renegotiated purchase price. There are many reasons why a seller might seriously need to entertain a buyer’s request to renegotiate a deal but that will very much depend on the circumstances of each deal.
Renegotiating a deal does not necessarily need to be of the purchase price. An alternative is to consider varying the deal with the inclusion of a deferred consideration mechanism, which can be absolute with a portion of the purchase price being paid at a later date, or incorporating earn-outs which are subject to the future performance of the target. Although not all such options are ideal for a seller, they could be a better option than having to enforce an existing arrangement.
If you are a buyer continuing or pursuing a new acquisition, a comprehensive due diligence process is still strongly recommended despite tighter deal budgets being put into place.
Some specific due diligence considerations would likely include:
- The status of material contracts and the risk of termination or non-renewal of such contracts;
- Any contractual rights or principles that favour the target in relieving itself of unfavourable contracts;
- Detailed enquiry into potential supply chain or demand-side disruptions and whether a disruption can be cured an alternative supplier;
- Whether the target’s IT, cybersecurity and data protection measures are adequate as business shifts online;
- The general status and adaptability of the target among its competitors in the market;
- The risk any change of law may have on future operations of the business; and
- The adequacy of internal policies and employment related matters, and any foreseeable risks of liability,
and the impact that any of the above may have on the day-to-day operations of the Target and its profits.
The outcome of these due diligence enquiries may then cause greater complexity when parties negotiate warranties and indemnities. For instance, it is typical in distressed sales for limited warranties to be provided which puts greater importance on a comprehensive due diligence review. But what then must also be considered is whether there is adequate security in place should the seller be in breach of such warranties. This could be in the form of a parent company guarantee that has (and will have) adequate financial capacity to meet any breach of warranty claim, or the requirement to have in place warranty and indemnity insurance (although we are becoming aware now that the majority of insurers are specifically excluding claims which relate to a COVID-19 event). Another option may also be the requirement for a portion of the purchase price to be retained as security for a period of time following completion of the transaction (a ‘retention sum’).
For transactions that had been committed before the effects of COVID-19 were widely felt, many buyers are looking for ways to get out of the deal altogether as it is simply no longer financially viable. From a buyer’s perspective, termination rights would typically be found in conditions precedent (such as a Material Adverse Change clause) or a Force Majeure clause (Buyer Termination Clauses). While most Buyer Termination Clauses will contain quantitative thresholds and definitions, others may provide broader thresholds and definitions (which will likely complicate their enforcement).
Parties entering new deals now may find these types of contingency measures to be particular sticking points subject to extensive negotiations as buyers will likely insist on broad, unrestrictive provisions to provide for a flexible way to pull the pin and sellers will insist on carve-outs for COVID-19 related matters and provide some certainty to the deal. Sellers should also look to specifically carve-out COVID-19 effects from warranty and indemnity provisions (where possible). What we will likely see however in the coming months is a large disparity in bargaining power between parties, with new buyers having the upper hand and many distressed sellers having to accept what would typically be considered harsh conditions.
Conditions precedent set preliminary conditions for parties to a transaction which, if not satisfied, may cause the deal to not proceed. These conditions are typically to account for certain items requiring to be satisfied in order for a deal to complete and which are beyond the control of the parties such as finance, regulatory approvals or consents to material contracts being assigned. What we envisage in the next few months is buyers seeking the following conditions precedent to be included in sale agreements, which were not commonly agreed to prior to the COVID-19 outbreak:
- Extended sunset dates for finance and regulatory approvals;
- No material adverse change to the operations of the business (referred to above);
- No loss of material contracts (these would typically be identified in the due diligence process);
- No change to local laws affecting operations of the business;
- Lifting of certain government restrictions; and
- Satisfactory completion of due diligence (and an extended period to complete due diligence).
The result of the inclusion of these conditions may mean many deals remain in ‘COVID-19 Limbo’ and so regardless of who holds the bargaining power, a seller should ensure that a reasonable sunset date for satisfaction of such conditions is in place so that when the market picks back up a seller is not left at the mercy of the buyer.
While the outbreak of COVID-19 has slowed the M&A market, there are other options still available to businesses looking to weather the storm, or to make strategic gains amongst the volatility.
Businesses looking to make defensive moves until markets re-stabilise will look to bolster their balance sheets by raising equity for instance (although with many companies holding severely devalued assets this may not be the first option to consider). Given the RBA’s decision to cut interest rates to record lows debt financing looks increasingly appealing.
While many companies will struggle during this unprecedented period, we will likely see proactive businesses with strong financial positions looking to make opportunistic acquisitions.
HWL Ebsworth’s M&A team has the breadth and depth of experience needed to help businesses navigate these uncharted waters. We advised on the 2nd highest number of small cap and mid-market M&A deals Australia wide in the first quarter of the year as announced in Refinitiv’s Global Capital Markets Review – Legal Advisors. Please contact our M&A team to discuss any aspect of the above.
This article was written by Paul Brown, Partner, Alex Beagley, Senior Associate and William Crammond, Graduate.