2020 has been a shock to the system. After many banner M&A years, mergers are grinding to a virtual halt. We anticipate that activity will pick back up once things return to normal, but normal is relative, and the specific timeline varies from place to place and company to company. Although central banks are using monetary policy to build liquidity, investor confidence is not likely to be restored until the pandemic curve flattens significantly. In the meantime, here are some things to keep in mind.
Quarter 2 Activity
M&A has virtually stopped. While some transactions that were nearing completion have closed, those that were in the early stages have stalled as both parties evaluate the effects of the pandemic on the deal.
Even where parties are willing to move forward with a deal, the market is extremely volatile. That means financing is going to be difficult, and closing will take time. Most Q2 transactions will therefore rely on equity or cash on-hand.
Purchase Price Consideration
When mergers and acquisitions pick up again, we will see some changes in purchase agreements. Buyers will seek to preserve cash, and debt financing may become more limited, causing buyers to use their stock as purchase price currency. Sellers will still hope for cash, but may have no other options. With stock, they can at least share in the growth of the business and potentially defer taxes related to deals. Stock-for-stock deals may also help the parties address differences in valuation.
During economic downturns, sellers have traditionally argued that the earnings hit was a one-time extraordinary event that should not factor into the purchase price. When they require cash at closing, we will likely see an increase in earnout provisions. Down the road, this could mean more deal-related disputes.
In the lower middle market, we will likely see an increase in reliance on seller notes that allow buyers to:
reduce cash outlay
offset indemnification claims against the seller
replace uncertain third party financing
Seller financing will become more popular, and sellers with the ability to finance deals may be better positioned for stronger valuations and more favorable deal terms.
Representation and Warranty Insurance
Changes to R&W insurance are inevitable. Most insurers are now demanding exclusion of coverage for any effects of COVID, and depending on the target and industry, such exclusions may be very specific or incredibly broad. Many representations include periods prior to the closing. Even when the effects of COVID decrease, such exclusions will likely affect R&W policies through the end of 2020, and possibly beyond.
Material Adverse Effect Clauses
Relying on MAW to leave a transaction has always been difficult for buyers because of the burden to prove a disproportionate, long-term effect on the company. This is even more daunting now, as MAE provisions may directly speak to COVID. Acts of terrorism exceptions in the post-9/11 world had and have significant staying power. The same will likely be true of COVID-related clauses.