M&A and the Never Normal
On the heels of record deal volume in 2018 and 2019, 2020 was supposed to be another banner year for M&A activity in the U.S. and worldwide. Then COVID-19 crashed the party, and the M&A loco- motive came to a screeching halt. Deal volume in 2020 has dropped to a seven- year low, with deal value in the U.S. down 83% in the second quarter of 2020 from 2019. Moreover, as a result of the lock- downs and other emergency measures imposed during the pandemic, strategic buyers and private equity firms alike have had their hands full shoring up their own businesses and those of their portfolio companies, further diminishing the appetite for acquisitions.
Nonetheless, rumors of M&A's demise are greatly exaggerated. Cash idling on the sidelines was at record levels last year as private equity firms - holding a record $1.5 trillion cash hoard in June 2019 - kept their powder dry. Well-heeled strategic buyers like Amazon, Apple, Google, Microsoft, and Walmart similarly are looking to take advantage of difficulties facing less fortunate competitors. What had been a seller's market for a decade has shifted to favor buyers, many of whom are preparing to step back into the fray with renewed fervor as soon as conditions stabilize, albeit under a drastically altered landscape.
Valuations, of course, have been materially affected, to the point that buyers committed to deals negotiated pre- pandemic are dusting off those seldom invoked "material adverse change" and "force majeure" clauses to renegotiate agreements. With respect to new deals, valuing a business and its future prospects has become much more complicated. Purchase price formulas based on trailing earnings that may now be largely irrelevant will have to be re-calibrated. In turn, earn-outs and other post-closing purchase price adjustment mechanisms will be affected. Formulas also will have to take into account the impact of Paycheck Protection Program loans, with sellers wanting these loans not counted as debt or reimbursed once forgiven as permit- ted under the law. In contrast, buyers will want to exclude forgiven loans from earnings calculations as non-recurring income. Likewise, the expanded opportunity to apply net operating losses retro- actively under the CARES Act may be a boon to buyers that sellers will want taken into account in pricing.
Sellers will be required to explain how their companies are weathering the COVID-19 storm and the effect on future earnings streams and expenses. A seller's contingency plans and risk mitigation strategy for COVID-19 and other risks will be closely scrutinized and may become fodder for additional pre-closing covenants. Working capital requirements are likely to increase, as is the definition of "working capital" itself to exclude deferred payroll taxes and other payroll tax credits under the CARES Act that do not constitute cash. With so little predict- ability, many of these mechanisms will largely be guess-work and will challenge deal lawyers to craft provisions that are flexible and far-seeing.
The pace of deals has been significantly slowed. Each stage of the transaction is taking longer due to communication logistics and other factors. The days of "getting everyone in the room" to get a deal done are probably over, replaced with interminable virtual meetings to resolve issues. Third-party consents and regulatory approvals will take longer to obtain and require the satisfaction of additional conditions. Finding scarce third-party acquisition financing will be challenging, and nervous lenders may require terms that are tougher than the parties deem necessary.
Letters of intent and non-disclosure agreements may now require a greater degree of initial due diligence before an offer is even put on the table, and certainly between signing and executing a definitive agreement. Exclusivity provisions during this period will be hard- fought, as sellers try to limit the period during which a buyer must fish or cut bait. Buyers understandably will want additional time to conduct due diligence in trying circumstances Agreements will take longer to finalize as attorneys for buyers and sellers alike will be anxious to provide maximum protections for their respective clients in an era of great uncertainty. Representations and warranties, the bane of every sell-side lawyer's existence, will become more complex as buyers demand additional representations as to how COVID-19 has affected and will continue to affect the business.
Due diligence has been transformed. Although much due diligence already was conducted virtually through digital "data rooms," kicking the tires of a potential seller is still an important part of a buyer's due diligence process. How this will work in the age of face coverings, social distancing, and mandatory quarantines for travelers from shifting COVID-19 "hot spots" is a work in process. Lien and litigation searches, surveys, background checks, title searches, and other similar due diligence procedures will take much longer than is typical to complete.
Pre-closing covenants requiring the seller to conduct the target's business "in the ordinary course" until closing will become more difficult to comply with because of the stretched period between signing and closing and fluid governmental and other requirements on businesses. Terms such as "commercially reasonable efforts," "past practice," "consistently applied," and other terms implying continuity or adherence to a prior objective standard will be more problematic to define and interpret in the new normal. Post-execution governmental restrictions or other requirements implemented as a result of the on-going pandemic may conflict with these covenants, placing sellers on the horns of a dilemma between complying with these new requirements or violating covenants.
Indemnity escrows and holdbacks are likely to increase, as is the survival period of representations and warranties. Caps and baskets, on the other hand, are likely to shrink as buyers become increasingly unwilling to absorb risks from breaches of representations and warranties. The cost, availability, and requirements of reps and warranties insurance also are likely to tighten, as carriers assess the impact of the pandemic on underwriting risks.
Closings, too, will be an adventure. Face- to-face closings already were becoming an anachronism, and COVID-19 is likely the death knell for these quaint gatherings.
However, delivering "wet ink" documents required for certain instruments such as deeds and notes, as well as the notarization and recording of the same, are now a major challenge. Online notarizations have not been universally embraced, and many government offices continue to require traditional notarizations and other requirements. The advent of electronic signatures mercifully had commenced before the pandemic hit, and the trend toward totally virtual closings will now accelerate.
Lastly, post-closing efficiencies and synergies, to which every buyer aspires, will become more difficult to achieve and may take longer to materialize. Companies are still adjusting to employees working from home and the changes demanded by governments, clients and suppliers. Achieving efficiencies and synergies in this fluid environment will require patience and ingenuity, often in short supply with buyers trying to hit quarterly IRR and other benchmarks.
The M&A world has endured and recovered from past economic crises, including the burst of the dot-com bubble in 2000-2002 and the Great Recession of 2007-2009. M&A will survive this crisis also, but survival will require patience, flexibility, and ingenuity from M&A participants working collaboratively to put deals together successfully.
