How to manage current M&A projects in the pre-signing stage
At present, the coronavirus pandemic (COVID-19) is having a significant impact on transactions and businesses across the globe, including those supported by private equity and venture capital. This article contains a checklist to help sponsors manage their current M&A projects in the pre-signing stage.
Firstly, it should be noted that transactions cannot be aborted on the spur of the moment during the pre-signing stage. Indeed, under Dutch law, pursuant to the duty of good faith, which extends to all phases of commercial relationships, including the pre-contractual stage, a party may be held liable for the performance of the terms of a contract even before it is actually signed. This will be the case if a party breaks off negotiations during an advanced stage. In other words, the duty of good faith may prohibit parties from simply walking away from a deal when the terms have been negotiated at a fairly advanced level
Possible remedies for such pre-contractual liability include actions for damages (ranging from reimbursement of the counterparty's costs to, in extreme circumstances, lost profits), as well as claims to continue the negotiations or for specific performance, if a party can demonstrate that it reached some form of agreement with the other party, even on a subject-to-signature basis.
As past bear markets have shown, sponsors with sufficient dry powder may be able to secure their best deals ever in the current environment. In particular, sponsors that are prepared to bridge challenging debt markets by going in 'all equity' could turn out to be winners in the long run. Sellers will likely prioritize deal certainty and speed, especially when keen to raise much-needed cash quickly. In addition, transactions with sponsors are less likely to be delayed for competition reasons. As a result, sponsors may be more attractive than other types of buyers that have to jump through certain hoops. Furthermore, in the current circumstances, corporates are likely prioritizing the management of existing businesses rather than M&A transactions.
This does not mean that deals will be easier for buy-side sponsors. In the present environment, buyers should consider adapting their customary due diligence and transaction structuring procedures.
Buyers should ensure that their diligence extends to:
- the potential implications of the coronavirus outbreak on forward-looking information in the target's business plan and budget; the existing business plan and historical (financial) information may no longer accurately reflect the target's positions or prospects;
- existing insurance business coverage, including interruption and health coverage;
- the effectiveness and use of crisis management procedures and business continuity plans;
- the supply chain risk and the availability of and costs associated with alternative sources of supply;
- exposure of the target's business (including key contracting parties, customers and suppliers) to countries highly impacted by the coronavirus pandemic;
- regulatory, licensing and data protection implications as a result of remote working arrangements, particularly in certain industries, such as financial services;
- the effectiveness of risk protocols and contingency plans in place to deal with higher-risk or higher-ranked employees;
- the communication and implementation of health and safety procedures in the workplace, adequate compliance with relevant health and safety guidelines and the potential impact of travel bans;
- the legal basis under privacy laws, particularly the GDPR in the EU, for the processing of health data relating to employees, visitors and customers and whether privacy policies cover the processing of sensitive personal data for COVID-19 purposes;
- solvency or going concern risks and the ability to service debt for the target and its key contracting parties, customers and suppliers;
- the ability of the target and its key contracting parties to perform, suspend or walk away from obligations under material contracts, including through the exercise of force majeure clauses or similar provisions;
- scenarios in which non-performance by the target’s contracting party could result in the target breaching its obligations under other contracts.
For contemplated transactions, buy-side sponsors should consider:
- cost coverage in the event the seller puts the deal on hold or terminates the sales process altogether due to the coronavirus outbreak;
- using the closing accounts mechanism rather than the locked box;
- applying price adjustments or payment postponements, an earn-out mechanism, escrow, equity roll-over or sell-side loans to have the sell side share in the current uncertainty;
- conditions tailored to the COVID-19 crisis, such as covenants, warranties and indemnities related to business continuity (e.g. in respect of emergency protocols, contingency planning, business continuity, key operations, clients and employees);
- seeking comfort on target financials (e.g. working capital, cash flow and EBITDA/revenue);
- enhanced interim financial reporting rights and tailored termination rights if pre-closing performance falls below certain pre-agreed levels (instead of the general MAC/MAE termination rights with customary exclusions and “disproportionally affects” qualifications);
- carefully shaping and negotiating debt commitment letters and credit facilities so that they are on a 'back-to back' basis with M&A transaction documentation in respect of COVID-19;
- checking any applicable W&I insurance policy for known or pandemic risk exclusions.
The sell side should be prepared for buy-side sensitivity to the abovementioned issues and proactively prepare information on the current and expected impact of the coronavirus pandemic on the target's business (e.g. COVID-19 impact analyses, stress tests and emergency scripts) and mitigating measures. The pandemic is likely to have an impact on various aspects of the target (or seller's) businesses, thereby diverting management's time and attention away from the transaction. Sellers should therefore also be prepared to manage due diligence expectations and facilitate the due diligence process in an atypical form, e.g. practical alternatives for management presentations and site visits.
For contemplated transactions, sellers should:
- consider whether the transaction remains the best strategic alternative in view of the changing market circumstances, including with a view to valuation and stakeholders;
- be prepared for delays in obtaining regulatory clearances and completing employee consultation procedures;
- be even more focused on deal certainty;
- when accepting a level of deal uncertainty, try to get something in return, e.g. break fees, a fiduciary out or non-exclusivity;
- focus on the firmness of equity and debt commitments received from the buy side and consider agreeing additional comfort, such as a break fee or escrow, should the funding nevertheless fail;
- seek appropriate COVID-19 knowledge, materiality and “subject to law” qualifiers, to resist forward-looking covenants and representations and warranties;
- scrutinize disclosure mechanics, such as disclosure letters, to address known COVID-19 risks;
- consider anti-embarrassment arrangements allowing the seller to share in the benefit of an increase in the value of the target's business (e.g. because of a sudden market recovery, a swift on-sale or if the target is active in a market which could benefit from the outbreak).
Finally, both sell side and buy side should carefully monitor the developments relating to state aid during the Covid-19 crisis, including tax relief. Please click here for an update on measures announced by the European Commission and the Dutch government to facilitate aid to companies in need.
Further guidance on developments relevant to private equity and venture capital portfolio companies will be provided in upcoming posts.