Are M&A Deals Getting Infected Too?

Whilst these are still early days and the impact of the COVID-19 pandemic on the future of M&A transactions is not completely clear, one can safely argue that the general template through which the buyers and sellers negotiate a deal is likely to undergo significant changes to cover the uncertainties caused by the pandemic and to mitigate the risks associated with such events. Some of the potential mid-term to long-term impacts on M&A deal templates are being analysed below.

MAC clause

For ongoing deals where there is a firm commitment, the buyers have been reviewing the transaction documents to see if there are possibilities to re-negotiate or exit the commitment under the material adverse change (MAC) clause. Usually, a MAC clause does allow the buyers to exit, if there are any changes, events or circumstances, which has or would likely to have a MAC on the condition (financial or otherwise), business, assets, liabilities or results of operations etc. of the target. The Sellers typically build in some carve outs for change in financial or securities market, economic, political, or regulatory conditions in general etc. Globally, several lawsuits have been filed where buyers have used the MAC clause to exit the transactions. It will soon be seen as to how the courts are interpreting the MAC clause in light of the pandemic. Historically, the courts have narrowly construed the MAC clause. However, buyers are found to be using the MAC clause as a tool to renegotiate the terms of the transaction. For future transactions, buyers are more than likely to negotiate to include such pandemics as one of the events for the MAC clause to be triggered. On the other hand, the sellers are likely to argue that such events should be specifically carved out. However, this may not work as otherwise changes made in response to the COVID-19 pandemic would not be considered as a breach of typical ordinary course covenants. A balanced position may need to be arrived at to make the transactions work and one may have to look at linking the MAC clause with the valuation of the target.

Pricing

Typically, the purchase price is arrived at as a multiple based on historical financial information of the target. The transaction documents also allow for appropriate adjustments to the purchase price on closing to account for any variations, between signing and closing, to the working capital from a ‘normal’ level. However, the pandemic has caused the “normal” to change significantly and the historical information will no longer be relevant to measure the target’s financial situation. The buyers may therefore demand a higher threshold of available working capital and liquidity and mayalso like to make a larger adjustment to the purchase price in case the working capital has been impacted. The sellers may argue that a floor is set for such adjustments. Buyers would be extremely watchful of unusual declines in working capital and therefore would like to put responsibility on the sellers to maintain higher than ‘normal’ working capital ratio.

Interim Operating Covenants

There have also been significant changes to the interim operating covenants or standstill obligations. The usual carve-out for “ordinary course covenant” may look different given that the sellers need to make decisions to comply with the changing environment and they may have to take steps to salvage the situation of the target such as to reduce salaries, lay-off employees, raise debt, close down the factories etc., and if the sellers are expected to go back and seek buyers consent for each of these steps it would become extremely burdensome. The buyer on the other hand, would require much more detailed information on the events that transpire with the business of the target. However, even if the sellers are seeking consent, they will have to argue that such consent cannot be unreasonably withheld and will be provided at shorter notice.

Representations and Warranties

The Parties may relook at the representations and warranties section to see specific coverage related to Covid-19 and the afterlife. The parties will also have to be mindful of the fact that the sellers should be willing to confirm such representations and warranties on closing. Some of the areas where the buyers may like additional comfort are: (a) employment related matters such as layoffs, furloughing, and safe working practices for employees; (b) supply chain related matters and any unexpected disruptions; (c) customer contracts and the ability of the target to perform such contracts; (d) contractual force majeure; (e) the ability of the target to collect accounts receivables; (f) IT resilience for remote-working of the employees and security issues; and (g) any unusual accounting treatments. There may, however, be additional representations and warranties sought based on industry specific requirements which are fundamental to the buyer’s valuation of the target. The sellers may also request for changes to some of the challenging warranties, specially warranties which are forward looking in nature, warranties on assumed financials, and effects of Covid-19 on the target business. The parties should also carefully negotiate the language of the applicable disclosure schedules to balance permitting disclosure of known issues and providing protection for the myriad unknown problems arising from the rapidly evolving COVID-19 situation.

Resurgence of Earn-outs, Escrow mechanisms and All-stock deals

Whilst both earn-outs and escrow mechanisms are quite prevalent in deal making, we are surely going to see more of these in future transactions. This will go back to the earlier point that since the buyer may no longer have confidence on the historical financial data, earn-out structures are the quintessential deferred consideration mechanism that may be used in transactions to bridge the gap around the Covid-19 uncertainty. Usually, when the markets and valuations are strong, we do see less of earn-out structures as they at times become difficult to implement. In a sellers’ market, the sellers do not necessarily need to take the earn-out risk and often like to close the transactions based on upfront consideration. However, as we move to a buyers’ market, such requests would become more prevalent and reasonable. The buyers may request for a cleaner (challenge free) earn-out clause which provides for very objective tests and a single point measurement of financial data. However, the sellers may like to ring fence the clause based on: (a) structuring the clause as a waterfall of pay-outs rather than one payment; (b) safeguarding against adverse financials due to unforeseen circumstances such as Covid-19; and (c) providing for weighted average of the financials. In case of a non-resident buyer/seller, the Indian exchange control regulations provide for a maximum of 25% in delayed consideration over a period of 18 months. If the earn-out period is longer, it may have to be structured into the employment contracts.

The Buyers may also want to conserve cash and may approach deals on an all-stock basis. Stock deals could be a viable solution for both parties during these difficult times as it could provide some upside potential for the sellers. However, sellers accepting stock consideration will also need to consider the business outlook of the buyer in the current environment. Indian exchange control laws do allow for share swap transactions with a caveat that at least one leg of the transaction should be a subscription.

In the period prior to Covid-19, many deals were being settled on the principles of a fixed purchase price with a locked-box concept (during the interim phase). As a result, the buyer typically assumed the risk relating to the transactions of the target and labelled as ‘ordinary course of business’ during the interim period or between the balance sheet date and the closing date. However, such fixed price concept may become a difficult sell in the current environment. The buyers may not be comfortable with locked value and require a true-up on closing based on the actual financial position of the target. The buyers may highlight several reasons for their discomfort including: (a) uncertain environment and the impact on the business being even more; (b) corporate and regulatory clearances may take much longer to obtain than in normal times causing a further delay to close the transaction; and (c) possibilities for substantial changes to the working capital and debt situation of the target. It is also likely that the accounting principles used for preparation of accounts on the closing date may be negotiated to allow for limited deviation to take care of the changing environment.

Closing remarks

It may be difficult to predict whether the new trend of deal making will have a permanent effect on the template adopted for M&A transactions. However, given the impact of Covid-19 on the economy and the businesses, the parties would be wary of how quickly things can change and would therefore want to protect themselves from the uncertainties. These are difficult times and finding a creative solution to help both the parties to navigate through these challenging times, would be at the forefront of deal making.