Equity markets around the world are suffering their worst performance since the Global Financial Crisis, with the COVID-19 pandemic causing the S&P 500 to suffer its worst quarterly losses since 2008, oil prices plunging dramatically and the global economy looking increasingly shaky. As businesses in virtually every sector feel the impact, it is very likely the pandemic will have significant, and potentially long-lasting, implications for future M&A deal‑making globally.
This article discusses how parties in the United States, the United Kingdom and Hong Kong have historically addressed certain key aspects of private M&A deals, and suggests how the COVID-19 experience could impact the ways they approach these points in the post‑pandemic world.
The pandemic will significantly shape how parties to an M&A deal view, and perhaps negotiate, Material Adverse Change (MAC) clauses in their transaction documents. These are contractual provisions that essentially seek to give a buyer the right to walk away from a transaction before closing, upon the occurrence of events that are detrimental to the target's business during the period between signing and closing. In an M&A deal they can take several forms:
- The parties may include a standalone condition to closing that no MAC has occurred;
- The seller may give a representation or warranty that no MAC has occurred (which is then "brought down", or repeated, at closing); or
- The occurrence of a MAC may give the buyer a standalone right to terminate a signed agreement before closing.
When MAC clauses are included in an agreement, the definition of an MAC is often heavily negotiated. Broadly-drafted definitions (which buyers typically favour) will permit buyers to walk away from a deal if there is any adverse change in the target's business or general market conditions, and may even reference specific events such as the loss of a certain number of key customer relationships. Conversely, a narrower MAC definition (which sellers will want to achieve in practice) will limit the universe of events that constitute an "adverse change", including by carving out any "adverse change" with a wide-ranging economic impact that does not disproportionately impact the target's business.
In the US, MAC clauses are fairly common in M&A deals as either standalone closing conditions or representations that no MAC has occurred. Such clauses of any kind permitting a buyer to walk away from a transaction are less common in the UK, where the prevailing view is often that a buyer should take risk on a transaction from signing, except for any required consents such as antitrust clearance. Market practice regarding MAC clauses is less settled in Hong Kong, but when they are included they are likely to be narrowly defined, limited to events within the seller's or target's control and include the broader, seller-friendly, carve-outs described above.
In the future, the COVID-19 experience will most likely cause parties to an M&A deal in any jurisdiction to place a greater importance on MAC clauses – sellers are likely to want to negotiate more specific carve-outs from them to prevent matters originating from events such as COVID-19 from constituting a MAC (with specific references to COVID-19, epidemics and pandemics carved out from the circumstances that would trigger a MAC). Conversely, buyers might insist on a clear walk-away right from the deal if the business suffers a materially adverse (even if only short term) impact due to COVID-19 and similar events. These more specific walk-away rights may take the form of closing conditions tied directly to potential vulnerabilities or issues of concern with the target or its operations.
Buyers in M&A deals in all jurisdictions will conduct some degree of due diligence on a target company to identify legal, operational and other risks before signing or closing a transaction. The focus and degree of diligence will vary on a deal-by-deal basis due to a variety of factors. Additionally, it is customary in some jurisdictions for a seller to expedite the diligence process by providing the buyer with its own diligence report. These "vendor due diligence" reports are rare in the US, but reasonably common in auction processes in the UK and Hong Kong. Even where a vendor due diligence report is provided, however, buyers will typically conduct some level of limited or confirmatory due diligence of their own. In any event, given the unpredictable nature of cataclysmic events such as the current pandemic and its effects on businesses, buyers may in the future review any vendor due diligence reports with heightened scrutiny to avoid missing potential risks.
In a post-COVID-19 world, buyers may be more inclined to undertake more detailed due diligence on certain areas to better understand the geographical scope and dependencies of a target's operations and how COVID-19 or other events in the future might affect them or cause similar seismic disruptions to the business. Areas of increased focus from an operational perspective may include supply-chain dependency and resilience, as well as business continuity planning. From a reputational perspective, the COVID-19 pandemic has also shown that matters of health, safety and employee welfare can present significant concerns, and may therefore warrant enhanced focus on future diligence exercises. There may also be an increased focus from buyers on reviewing the target's key commercial contracts to assess parties' ability to terminate, as well as the scope of any force majeure clauses. Ultimately, as potential diligence pitfalls and reputational risks abound in this environment, buyers will take the current need for heightened scrutiny in the diligence process as an opportunity to identify weaknesses in their own existing processes and improve going forward.
Valuation and Purchase Price Adjustments
One of the key issues in all M&A transactions involves addressing the risk of shifts in the value of the business over the course of the transaction. Parties to an M&A transaction often take one of two principal approaches in addressing and allocating such risks: purchase price adjustments, also known as completion accounts mechanisms, and locked-box mechanisms. A purchase price adjustment is a mechanism (which is generally viewed to be more buyer-friendly) in which price is determined post-closing by reference to a set of accounts made up to the closing date (usually prepared by the buyer), so price risk passes to the buyer at closing. Purchase price adjustments can reference numerous financial metrics, but are most frequently tied to changes in cash, debt and working capital.
Alternatively, under a locked-box mechanism (which is typically considered to be more seller-friendly), the purchase price is determined by reference to a set of management accounts, drawn up to a date up to a few months prior to signing, that the buyer and its financial advisors have put under significant scrutiny as part of the due diligence process. Under this mechanism, risk passes to the buyer at that earlier time. The parties then negotiate restrictions on the seller's ability to extract value from the date of such locked-box accounts, including the items that will constitute permitted "leakage" of value before closing.
In the US, purchase price adjustments are most common, but locked box mechanisms are not unusual. Both purchase price adjustments and locked-box mechanisms are used in the UK, though locked-box mechanisms are now the most common approach (they are the default position where the seller is a financial sponsor). Hong Kong agreements generally take an approach similar to the UK, although the latest audited accounts will normally be used as the locked-box accounts if the gap between the accounts date and the signing date is relatively short.
Buyers in future M&A deals that occur during similarly uncertain times will likely give closer consideration to provisions in transaction documents relating to the purchase price and related adjustments to it, as the uncertainty surrounding the likely impact of significantly disruptive events such as the COVID-19 pandemic makes valuation particularly challenging. This is especially true where a locked-box mechanism is used to value a target company in an industry sector or geographic location that is materially and adversely affected by the current pandemic, or that could be by similar events in the future. In those cases, buyers may want to shift back to the more traditional completion accounts/purchase price adjustment mechanisms in the transaction documents to limit a buyer's risk from a target's declining working capital, increased reliance on debt or diminishing asset values. Additionally, parties will likely be acutely attuned to potentially negative impacts on certainty of payment and corresponding liquidity concerns arising out of future disruptive events, as well as the effects that a situation like the COVID-19 pandemic could have on more exotic purchase price adjustment mechanisms such as earn-outs and deferred consideration arrangements.
It is difficult to say with certainty whether events such as the present pandemic will have any lasting effects on the approach parties adopt in future M&A transactions and the impact on deal-making more broadly, particularly as the situation continues to evolve on an almost daily basis. However, given the speed and frightening ease with which COVID-19 has impacted businesses, the economy and life in general across the globe, M&A dealmakers are poignantly reminded of how quickly things can change as a result of events beyond their control. Accordingly, it would not be surprising that our experiences today, in the current environment, forever shape the approach to M&A deals in the post-pandemic world.