As disruption caused by the Covid-19 pandemic continues to take its toll on the global economy, leaving many businesses (particularly those in the travel and hospitality sectors) no choice but to re-visit short to medium term plans, it is no surprise that the UK has seen a rapid decline in M&A activity in recent months.
For many corporate leaders, their time and attention is still focussed on the internal operation of their business – protecting employees, preserving cash on their balance sheets and adapting to new operating conditions – with strategic agendas taking the backseat.
There are of course some sectors which have been less adversely affected by the pandemic, and for businesses operating within those sectors, who have been able to maintain a healthy balance sheet through the initial phase of the lockdown, there is still an appetite to move forward with any pre-planned acquisitive strategy. Afterall, for those positioned well, there are good opportunities to pursue.
With the long-term effects of the economic lockdown still very uncertain, we take a look at what the future may hold for M&A deal making activity in the UK.
Structuring a deal
Understandably, during this period of significant uncertainty, buyers are becoming increasingly selective about which opportunities they want to target and pursue and it may be that, initially, there are few sellers who are willing to sell at the price their buyers are willing to pay. As well as concerns over achieving full value, sellers will also be aware of potential complications with buyer funding and the detrimental impact which a lengthy deal process could have on their business.
In the cases where terms can be agreed, careful consideration will need to be given to how the deal is structured and, now more than ever, both parties will be focussed on ensuring a fair apportionment of risk between the parties.
It is likely that both parties will want to include some provisions in the sale documentation which relate specifically to Covid-19 and, whilst the extent of these provisions will largely depend on the impact of Covid-19 on the target company, we would expect the following protections to be considered at some stage in the negotiations:
- The possibility of the deal proceeding as a sale of the business and its assets rather than a sale of shares (which was often the preferred choice of sellers in the pre-Covid world, where both parties were on a much more equal footing). Going forward, it makes sense for risk-averse buyers to insist that deals be structured as business and asset deals as this will allow them to “ring fence” any liabilities that they are assuming and to retain more control over future risk;
- A mechanism to allow for adjustments to the purchase price or an element of earn-out in case profits are adversely impacted during a specified time period post-completion. This may result in those owners of SME businesses seeing themselves being tied in for longer than may be customary;
- Specific warranties regarding the operational and financial impact of the pandemic on the company (e.g. the use of government support packages, such as the furlough scheme, and the exercise of any force majeure clauses in key contracts), with greater ability to claw-back value in the event of any breaches; and
- In the event that there is a gap between exchange and completion, a specific Material Adverse Change (MAC) clause which would allow the buyer to walk away from the deal if certain specified events, which are detrimental to the target company, should occur during this period. Prior to Covid-19 the majority of MAC clauses in UK M&A deals would only cover specific adverse changes in the target company (e.g. a significant deterioration in trading performance) rather than external factors such as market conditions. Going forward, we would expect many buyers to place a greater importance on MAC clauses to ensure they are able to walk away from the deal if the business suffers a materially adverse impact due to Covid-19 between exchange and completion.
Due Diligence
It should come as no surprise that buyers are already taking a much more risk averse approach to transactions and are increasingly focussing their due diligence efforts on the impact of the pandemic rather than generic questions about material changes in the business or existing contracts with suppliers and customers.
Sellers should prepare themselves for heightened scrutiny and specific questions regarding the operational and financial effects of Covid-19 on the target business, including:-
- self-isolation rates and recent overseas travel by employees;
- any regulatory changes resulting from the pandemic;
- supply-chain resilience and business continuity/crisis management policies;
- the geographical scope and dependencies of a target’s operations;
- the ability for the buyer to terminate any pre-existing commercial contracts, as well as the scope of any force majeure clauses; and
- details of how the target has utilised the government’s furlough scheme and Coronavirus Business Interruption Loan Scheme (CBILS) – buyers will be concerned, particularly, with managing risks around claw-back or prosecution if the schemes have not been properly utilised.
Looking to the future
There was inevitably an immediate reaction to the pandemic which we saw result in an instantaneous slowdown in deal activity. Whilst transactions were not aborted, they certainly were paused whilst those involved took stock of the situation at hand. Priorities and focuses shifted to short term planning.
However, for those businesses that work this period of great uncertainty with strong balance sheets with consideration on the medium term, M&A activity will no doubt play a major role in their future, with the decline in valuations presenting opportunities to pursue deals which with will create real long-term value.
We are certainly anticipating an increased level of activity with management buyouts in the short term with an anticipated suppression of trade sales. Retirement plans may well still be at the forefront of business owners minds and progressing an exit via a carefully structured MBO remains a viable way forward. Securing solid advice in these unprecedented times will be key to the successful delivery of such projects.
Private equity houses have inevitably shifted their immediate focus onto existing portfolio assets, but with strong levels of liquidity, it would be no surprise if opportunities are seized in sectors that have shown resilience to the pandemic.
If you have any queries arising out of this article, please contact Martyn Tennant (mwt@swinburnemaddison.co.uk) either by email or telephone (0191 384 2441).
