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COVID-19 – How will the Pandemic affect M&A deals in the UK?
The COVID-19 pandemic and the response of Governments to it has had a catastrophic effect on businesses on a global scale. In the last financial quarter, the UK economy shrunk by 2%, the biggest contraction since the end of the 2008 recession. Economists predict that the results could be worse for the current quarter and the timing and shape of the expected recovery is unclear. Under the lockdown restrictions imposed on so-called non-essential businesses by the UK government, businesses in certain sectors such as leisure were forced to close which resulted in a sudden and total loss of revenue. Whilst other businesses have remained open, many are operating at reduced capacity. The amount of goods sold in April in the UK fell by 18.1%. This has led to reduced cash flow and a deterioration in net assets. Businesses also face serious reduction in demand and supply chain issues.
Despite the uncertainty and adverse trading conditions, M&A activity remains buoyant in some sectors such as technology, which have dealt seamlessly with working from home. For instance, Twitter have offered their employees the opportunity to continue working from home “forever”. As distressed businesses load-up with debt (from government or private lenders), companies with large cash reserves and strong balance sheets, will be at a competitive advantage. Those companies can consider the advantages of strategically merging with competitors to gain market share, share resources, and overcome supply chain issues. Over the last few years, private equity funds have held historically high levels of cash and the current market may provide the perfect conditions for them to purchase cheaper assets and invest in large, well-known companies struggling to refinance. The key factors therefore for principals to consider in new or ongoing M&A deals will be price and risk.
When assessing the current and future value of a target, buyers have traditionally relied on valuations based on historic performance and trends. This, however may prove to be wholly inappropriate due to the uncertainty in evaluating the long-term financial impact of COVID-19. A target at present, such as a hotel or a resort, with healthy profit levels in 2019 is likely to fall significantly short in the current year due to the government-imposed lockdown. Furthermore, as travel restrictions begin to ease, consumers may still feel uncomfortable travelling whilst the virus still poses a threat to their health or because of quarantine concerns etc. And what about the risk of a “second wave” affecting these businesses? Whilst some businesses may adapt, at least in part, to the restrictions (for instance, restaurants providing takeaway services) it is clear that many businesses will struggle to replicate recent past performance, perhaps for several years, especially if there is a second wave. Buyers may well insist on a “COVID discount” from such businesses. Buyers will avoid basing the purchase price solely on historic financial data and the parties should find innovative ways in which they can fairly distribute risk between buyers and sellers.
Purchase price mechanism:
Parties have frequently agreed on a target’s purchase price by using closed account mechanisms (‘locked-box accounts’). This involves agreeing a fixed price for a target based on its most recent accounts and with no post-closing adjustment to the purchase price, rather a series of vendor undertakings to prevent “leakage”. Due to the unpredictability of post COVID-19 trading conditions, parties could instead use a price adjustment mechanism that sets the price of the target at closing by adjusting for movement in cash and net asset value. This is likely to provide greater protection for the buyer by alleviating the risk of a drastic fall in a target’s profits over the last few months.
Purchase price negotiations can result in a conflict of interest between an optimistic seller wanting a high purchase price based on the previous year’s financial history (particularly if recent years show a strong upward trend in relevant KPIs) and a sceptical buyer who will not want to pay a high multiple applied to unsustainable, historic points. One solution to this predicament is to split the purchase price between cash up-front and a contingent, deferred ‘earn-out’. An earn out provision enables a seller to receive a proportion of the agreed or maximum purchase price at a future date upon achieving certain pre-determined financial targets. If the target fails to achieve these targets, the buyer will not have to pay (all or some of) the further consideration. Sellers may well be against the use of an earn-out, as they will have to wait for a longer period before they receive their full payment and they may have concerns about the buyer’s ability or will to pay the additional consideration if earned. Sellers should also seek contractual protections to prevent a buyer from unfairly manipulating the relevant KPIs once the business is under its control. Earn-outs can also have the effect in practice of accelerating the up-front tax bill of sellers, tax that will not be recoverable if the earn-out ends up delivering less than estimated. Parties should consider the potential risks of using earn outs alongside the benefit of achieving a sale now, which could be the only realistic lifeline for the business and its stakeholders, and increasing the overall purchase price.
Prospective buyers heavily rely on due diligence in transactions to assess the risk of purchasing a target. As a result of COVID-19, prudent buyers will, in addition to fully understanding the impact of COVID on the target and its prospects, want to carry out enhanced legal due diligence to determine how a target has coped and might cope in the future during any further lockdown. Buyers should focus in particular on the following when conducting their legal due diligence:
- IT systems: due to the increased number of phishing attacks reported since employees have started to work from home, buyers need to consider the safety of the target’s IT systems and use of data and question whether it can adequately protect confidential information. More generally, do such systems adequately support WFH for all workers.
- Employees: We are likely to see a greater emphasis on employment due diligence in future transactions. Buyers will want to review how a target has acted in response to the ‘Stay at Home’ guidelines. A well-advised buyer should check to see if any employees have made claims against a target based on how it has handled the crisis: Did the target company provide sufficient support and equipment for its employees to work from home? Did the target exercise its duty of care toward its employees by providing mental health support? Prior to the lockdown, did the target allow employees exhibiting symptoms of the coronavirus to self-isolate? If employees of the target were unable to work from home (i.e. supermarket workers), did they receive the correct protection, and were they entitled to receive paid sick leave?
In the event that a target has made employees redundant, buyers need to examine whether the target has complied with the correct procedures. Has the target followed relevant employment regulations? Has the target claimed relief from government initiatives such as the Coronavirus Job Creation Scheme (furlough)? To be eligible for the furlough scheme, employers need to keep a record of furloughed employees for five years. A company making a dishonest representation under the furlough scheme to HMRC commits a serious criminal offence.
- Finance: The UK Government has provided up to £31 billion in loans to businesses in initiatives such as the Coronavirus Business Interruption Loan Scheme (CBILS). Buyers should consider whether a target has any liabilities owed under such schemes and whether they made accurate representations when they applied for such loans. For instance, to be eligible for the CBILS, a company must have a turnover of no more than £45 million.
- Rent: many businesses have sought to defer and/or reduce rent on their leases without the consent of their landlord. Whilst landlords are prohibited for now, from evicting tenants, what are the long term consequences arising from such a material breach of the lease?
- Commercial: buyers need to review the geographical scope of supply chains and determine whether certain countries account for the entire supply of materials necessary for running the target’s business. Buyers need to question whether the target could maintain its core functions if there was a disruption in the supply chain. Would it be possible for the target to switch suppliers in a short time period and could it do so with no legal liability, no loss of quality, or no additional cost?
In light of extensive WFH, buyers may well be looking at the pooled office or space capacity of the enlarged group and drastically changing their assumptions. Their focus might switch from how do we make best use of the target’s existing leases/ capacity to how do we terminate as quickly and cheaply as possible?
- Buyers may also seek to insert a MAC clause into an SPA to cover future COVID-related disruption. However, this will only be relevant where there is a gap between exchange and completion and given what we now know, sellers are likely to vigorously oppose such provisions.
Once buyers have completed the due diligence process, they should carefully study the information discovered and consider including specific ‘COVID-19 warranties’. These could provide protection against any misdeeds the target has committed during the pandemic. Buyers should consider, in particular, including the following warranties in acquisition agreements:
- The target has correctly followed and implemented the furlough procedure: no furloughed employees have been asked to work while on furlough.
- The target has complied with relevant employment laws when making employees redundant.
- There is no new or ongoing threat of litigation or claims by disgruntled employees against the target for failing to protect its employees adequately.
- The target has performed all key commercial and customer contracts and has not walked away from its binding commitments, even where commercially justified. Conversely, suppliers have not failed to perform, citing force majeure for COVID-related circumstances.
Sellers should, as always, try to ensure that they have no liability for matters disclosed or for unquantifiable or future risks whilst buyers will want to ensure full disclosure and drive down deminimis claims thresholds.
If you have any queries with respect to any of the above please get in touch with your Memery Crystal contact or Greg and Amrit to find out more.
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