Transacting in the time of Coronavirus
22 April 2020
The current Covid-19 coronavirus pandemic presents a number of unique challenges for dealmakers. Accepted truths and processes need to be challenged and adapted for the current circumstances.
New focal areas for due diligence
At the same time as sellers are pushing for rapid deal execution, due diligence processes may need to dive much deeper to understand the direct and indirect implications of the pandemic on the business, its suppliers and customers, not to mention the access to Government stimulus.
Business continuity plans and risk management frameworks will become key items of focus, like never before. In short, are the plans, people managing them and the various contingency scenarios adequate? Acquirers would also do well to contemplate lasting and permanent changes to the target's industry as part of any diligence exercise: difficulties in valuation assumptions and pricing may make some deals impossible at present.
Just as important as the static data room assessment of contractual terms are the very current discussions as to how commercial arrangements may be varied which may be changing on a daily basis, where parties are seeking to avoid or delay performance. Indeed, diligence will need to extend to an assessment of the financial stability of key counterparties when that information is not going to be available in the data room.
Closing difficulties for existing deals
For existing deals, closing will be incrementally harder. Parties will be reviewing termination or repricing events whether in the form of material adverse change conditions or pre-completion commitments. What had seemed a simple consent, may no longer be simple. Earn-out or net assets adjustments will be significantly stressed. Regulatory conditions may take longer to satisfy, running up against long-stop dates and lengthening the period of risk. And obligations to co-operate and share information may leave the contract vulnerable. Time will tell and everything will depend on the specific wording in the contract, but one thing is certain – parties will be getting the microscopes out to review these provisions and meticulous compliance with the terms of the contract will be key.
Emergency equity raisings
The big question is how long will the first phase of the pandemic continue? In the global financial crisis, there were massive levels of over-gearing and distressed companies often waited far too long to de-lever. This time round we have seen a limited number of companies tap the equity markets to provide some buffer, but probably not as much as we would have expected at this stage globally (although some markets are ahead of the curve). Given the volatility, those that do raise, may seek to use multiple underwriters or only seek to have the institutional offers underwritten, where accelerated offers are available. Just like the corporates, the banks do not want to be on risk for any extended period. Governments are also stepping in, with support schemes and funding packages easing the pressure for some.
Deeply discounted and dilutionary emergency capital raises also provide an opportunity for new investors to jump up the register and we are starting to see regulators being far more proactive to introduce temporary measures. Entities looking to raise equity capital in the near term who do not have the benefit of extant relief should consider petitioning for ad hoc relief in light of the conduct of regulators in other jurisdictions.
Structuring the equity
In terms of structuring, investors will invariably be more innovative with the type of their investment. While there will be some vanilla equity, we should expect parties to look at secured and unsecured debt, convertible notes and preference shares to provide downside protection in an insolvency, not to mention governance rights to give them greater visibility. Indeed, it will not just be credit funds looking at buying secured corporate debt at a discount – corporates will need to understand who owns their debt (just as much as their equity), as the debt to equity pathway has become finely honed since the GFC.
Is debt funding available?
In terms of funding, we will see more involvement by special situation and credit funds, as while we expect banks to continue to lend to good businesses (particularly having regard to any Government stimulus), they will likely be able to be more flexible and able to transact more quickly.
Payment security will also be a much bigger issue than usual, for the simple reason that completion failure or delay may lead to entity failure. Expect more scrutiny here on both the buy and sell side with parties looking to manage this through greater use of letters of credit, deposit, break fees, escrow and warranty risk insurance – though availability, terms and pricing of financial products are changing in reaction to the current crisis. Of course, the time to put these arrangements in place will need to be factored into the accelerated timetable dictated by a distressed situation.
Changes to sales processes
In ordinary times, sales processes run by the banks and accountants are a standard feature of divestment processes. However, if parties need to move quickly, those may be scaled back, even to a bilateral deal, as speed will be critical. The inability to negotiate face-to-face will also be culturally difficult for some.
Boards in assessing proposals may be evaluating different transactions against each other (e.g. a capital raise, whole of entity transaction, joint venture or an asset sale), whilst also potentially considering looming cash constraints and financial restructuring requirements. They will put an increased premium on transaction certainty and speed of execution. This is perhaps at odds with the increased risks bidders will have to consider in shorter periods. Expect parties to look at creative ways to address this – whether bridging away from conditions to mechanisms such as price adjustments or claw backs.
Regulatory risks for new and existing deals
On the regulatory side, anti-trust and foreign investment approvals are just going to take longer. Where there are numerous horses in the race, bidders needing those will have a real handicap unless they can structure (through consortium partners (especially local)) to reduce the need for them. On the other hand, if overseas or trade bidders are the only option for keeping the target business afloat, those bidders may be presented with an opportunity not available in ordinary times, although there are signs of Governments being alert to, and making temporary changes to address concerns over opportunistic overseas buyers. Currency volatility may also influence cross-border appetite at this time.
PE and alternative investors
Private equity funds and other financial investors will be focused on managing their existing portfolios, but they may also see opportunities to invest in good businesses which, up until now, haven't wanted or needed them. The PE industry certainly has a pile of cash available to it. Minority investments, consortiums and club deals might be options for reducing exposure to risk. Activist investors will also need to be pre-emptively managed.
Simple structures will be preferred
Pre-sale reorganisations, implementation of separation and integration plans, and transitional service arrangements may also be challenging for parties enduring operational difficulties and staffing constraints.
Standard structures to be challenged
Indeed, even very standard deal structures will need to be tested in current circumstances. For example, the need for two court processes and a scheme meeting may lead to schemes of arrangement being more challenging relative to a takeover.
While significant uncertainties remain for all participants, what is certain is that transacting in Covid times will be fundamentally different.