COVID-19 – An M&A Nightmare or a Dream? - Zyna Shoukat

Background

The effects and the mere scale of the COVID-19 crisis were beyond unprecedented and prompted global responses from companies and governments as well as resets of equity markets. Due to the pandemic, both deal value and volume fell rapidly; deal volume dropped 49% in the first half of 2020 while deal value was down 22% from the previous year. This sharp drop operates consistently with some other financial changes: valuations change, liquidity is at a premium, and companies are inwardly focused. However, the drop is historically most pronounced with mega-deals. In contrast, smaller deals continue to take place as companies shed assets and distressed businesses seek M&A solutions to solvency. While challenges defer between companies, the magnitude triggers many common M&A decisions for leaders and the actions companies take now will impact their viability. Shortly, M&A will move at different paces by sector and location depending on how badly each is impacted and depending on the certainty of demand shifts in the market.


Impact on the Legal Industry

Risk Management Concerns

Financial investors have become increasingly concerned with risk management. This is expected to result in vigorous diligence efforts in the context of M&A. This is especially true regarding financial and tax warranties (because breaches in these areas often represent significant financial exposure). Strategic risk management tools like Warranty and Indemnity (“W&I”) and specific tax insurance solutions can be used to cover investors and their portfolio companies. However, it is also likely that W&I insurers may request a new exclusion related to business interruption or damage caused by COVID-19 which must be considered. Also, portfolio companies are trying to improve their operational efficiency. Thus, ensuring adequate insurance coverage across the business is more important now than it has ever been.


Deal Activity

Since COVID-19 was first declared by the World Health Organisation as a pandemic, deal activity has seen a drop. In the United States, M&A levels (deal activity) fell by more than 50% in the first quarter compared to 2019. However, most of those transactions were closed earlier in the same quarter before the crisis became an enormous worldwide crisis. A key observation from these deals is that valuation gaps between sellers and buyers have been exacerbated by uncertainty caused by the pandemic, especially when prospective buyers compare the short- and long-term outlooks of their acquisition targets.


However, even considering this, many active deals are progressing well and parties continue to have the enthusiasm to partake in transactions. Opportunistic buyers who wish to take advantage of lower deal prices are likely to lead to an increase in deal activity. An example of this is distressed asset investors (“DAIs”), like specialized investment funds, who will be actively assessing opportunities to buy low-valued equity or debt packages. Such a DAI can be seen where Thai Oil Company had over $2 billion of debt outstanding in the late 1990s. After it defaulted, its debt was traded in the market at prices in the region of 30% of face value. The company bought back almost 50% of its own debt at prices from 50% up to 96% of face value. It agreed on a debt restructuring, in which it issued clean debt and gave ½ of its equity to creditors.Improvements in its business and the decreased amount of outstanding debt propelled the new debt to trade at par, and made its once-worthless equity very valuable. Thus, in this regard, businesses in certain industries which are under great financial stress, are likely to be targeted by distressed asset investors.


However, since said declaration of the pandemic, there have been numerous changes. In the second half of 2020, deal activity saw an acceleration with a rebound in deal making. In the fourth quarter of 2020, deal values and volumes were up by 18% and 2% respectively, compared with the last quarter of 2019. An increase in announced mega-deals meant that across Asia, EMEA (Europe, the Middle East and Africa) and the Americas, M&A activity saw an increase between 17% and 20% during the second half of 2020 as compared to the first.


Businesses Under Financial Strain

The uncertainty in the economy is already causing debt capital markets to become increasingly stringent and this is expected to result in the deferral of leveraged buyouts and, more broadly, will have an effect on the liquidity of businesses that are already under substantial financial strain.


Employee Retention

COVID-19 has undeniably had a big impact on employees. Due to the pandemic, employee retention must be properly considered when undertaking due diligence in a transaction. The worsening of the pandemic has led a significant number of employers across the country to seek to control costs through massive workforce reductions and furloughs. It is of the utmost importance that a law firm advising on an acquisition must be aware of whether layoffs at the acquisition company are underway or have been planned given that it would involve additional costs to re-hire personnel if required. Companies considering these reductions must consider the impact of the Worker Adjustment and Retraining Notification Act of 1998 , and careful compliance with relevant laws impacting employment will be important for sellers considering participating in M&A in the near future.


Tax Insurance Implications

For coverage of specific tax risks in M&A transactions, it is not expected that access to insurance markets will be adversely affected by COVID-19, or that there will be a material change to policy terms. This is largely because of the bespoke nature of tax insurance policies.


MAC Clauses

For transactions that have already been signed, material adverse change (“MAC”) clauses have already been triggered and this trend is expected to continue. MAC clauses are used to protect parties against the risk of unforeseen events or circumstances. Related to this, W&I insurers are becoming more cautious of offering coverage for newer breaches. Newer breach coverage usually contains an exclusion related to matters which would constitute a MAC, but insurers are not as willing to offer this coverage enhancement in the current economic climate.


Moving Forward

It is believed by some that M&As can be a particularly effective route for getting through the coronavirus crisis. As Rick Smith (managing director of insolvency and business rescue specialists Forbes Burton) said, "Restructuring post-COVID could start a bidding battle for the most promising businesses. Assets, trademarks, and patents will all be in a state of flux, so M&As could mean we see businesses with real potential being either saved or brought to the fore." However, successful M&A completion is challenging. Executives must evaluate potential liabilities and hidden solvency issues, which could be an issue as they may be masked by current government financial support and policy that is designed to encourage businesses to trade e.g. the government’s export strategies.


It is of the utmost importance that due diligence is done on distressed companies. Anyone involved in purchasing must be aware of the motives of sellers of shares. Purchasers of assets, as opposed to shares, must make sure there is no security attached to assets. Additionally, acquirers must ensure that each takeover is rooted in their overarching corporate objectives and that the cultures are compatible. Despite these possible issues, many companies pulling through despite the pandemic have relatively healthy balance sheets which support M&A activity.


Additionally, business restructuring requires integration plans. Russ Lidstone, group chief executive of The Creative Engagement Group, has recently overseen successful M&A deals and said (in the later end of 2020) "M&A will become more important in the coming months and I think deal flow will increase. Challenged businesses will look for security in consolidation or front-foot businesses like ours will look to invest to emerge strongly from the crisis."


In 2020, the market for M&As evolved rapidly in phases. It is, however, expected that 2021 will be a strong period for M&A. Business owners have seen a massive shock to the way their businesses operate, and many may have reflected on their mortality. This may increase the number who are considering selling their businesses. The M&A market has already begun by carrying over momentum from a large number of deals in the latter half of 2020 and stands ready to accelerate. Though there is plenty of uncertainty due to the pace of COVID-19 vaccinations and a new political administration in the United States, a multitude of factors are expected to further drive up M&A activity.


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