As events unfold around us, there's no doubt the current situation will have an impact on ongoing acquisitions. From logistical concerns such as travel restrictions and office closures to more fundamental considerations such as valuation and the risk appetites of the parties, the COVID-19 pandemic adds another level of uncertainty to M&A transactions.
We're currently seeing this play out in realtime (so there will be additional updates over the coming days), but we anticipate the M&A deal process itself may be impacted in numerous ways.
Although we're yet to see specific questions around a target's COVID-19 protocols filter into an ongoing due diligence exercise, we expect the due diligence process to be extended. Potential buyers may take additional time to thoroughly assess a target's supply chain, the ability of its employees to continue to work effectively, and the durability of its IT systems.
Face-to-face management sessions with a buyer's key stakeholders and integration team will be difficult if not impossible. We also expect buyers to focus on the force majeure and termination clauses in the target’s key contracts as much as they focus on the revenue-generating aspects of business arrangements.
Moving away from the locked box and the continuing use of earn-outs
In recent years, we have seen a move away from a post-completion price adjustment based on a set of specific accounts drawn up at completion, towards the "locked box" valuation method. This is where the value of the target company is determined before signing the deal and is not then subject to any post-completion adjustment (unless there is "leakage" - unapproved payments made out of the company to shareholders in the run-up to closing - in which case the buyer would be reimbursed).
However, we expect buyers may be less amenable to a locked box valuation in the current climate, reverting to a closing accounts mechanism as a better way of balancing the acquisition risk.
Similarly, we anticipate the continuing rise of earn-outs (especially in technology and software deals). Used primarily where there is a gap between the valuation of a target in the mind of the buyer and that of the seller, earn-outs tied to financial metrics such as profit or EBITDA could become commonplace for buyers who want to minimise acquisition risk. Rather than pay out in full for a business at completion, an earn-out allows the buyer to pay a proportion of the overall price only if the target is successful.
For sellers facing earn-out negotiations, it would be prudent to try and move the focus away from rigid financial metrics (which the sellers may not be able to fully control) towards a set of achievable milestones. These could include integration steps for the joined business or the adoption of agreed COVID-19 contingency plans. Sellers should also consider pushing for catch-up payments in future years, if the acquired business is able to grow substantially once the pandemic eventually comes to an end.
Gaps between exchange and completion
If the acquisition has been structured as an asset sale of a business, it is likely that there will be a gap between signing the sale agreement and actual completion of the deal - usually in order for the target to comply with its obligations towards its employees under legislation governing the transfer of employees (TUPE). However, this may also be the case in share sales if, for example, a regulator or private third party needs to consent to the deal for it to go ahead.
During the interim between exchange and completion, the parties typically agree that the buyer has the ability to pull out of the deal and walk away without consequence if there is a material adverse change (MAC) to the financial position of the target or its ability to close the transaction. However, as usual, the Devil is in the detail; most MAC clauses contain exceptions: events which may impact the target, but do not give rise to a right for the buyer to walk away. Typically, changes in the market or the industry as a whole which affect businesses like the target would be carved-out from the MAC provision. If the sellers have been properly advised (and so have excluded fluctuations in general economic conditions), the buyer may not have solid grounds for exercising its right to terminate the transaction, regardless of the impact the coronavirus has had on the sales and revenues of the target business in the gap between signing and closing.
We expect these types of provisions to be negotiated harder than usual in upcoming deals. Parties will no doubt be putting additional thought and effort into the wording of MAC provisions in order to try and address and allocate COVID-19 risk.