M&A trends in the tech sector in light of the Covid-19 pandemic
As is now well established, many businesses are suffering from the economic consequences of the Covid-19 pandemic. And many technological companies have been unable to avoid economic harm. Unsurprisingly, among those companies which took the most damage are those whose business model was shut down together with national borders, such as companies in the transport sector. Others suffered due to government requirements to shut down their activities indefinitely or because of other restrictions imposed.
The current situation leads to substantial cash flow problems for these companies, which in turn, causes them to seek additional financing to survive the economic crisis. Our firm has already advised on several deals in the tech sector during the pandemic and have noticed the following trends. Many common elements of distressed M&As apply in these cases too.
Deals are often structured as hybrid instruments involving both financing and equity elements. One example of such an instrument is a convertible loan agreement, under which the investor: provides a loan (typically with a high interest rate); and may convert the loan into equity at their discretion. An alternative instrument would be a repurchase agreement (REPO) which is described in greater detail below.
The investor would convert into equity if they feels the circumstances are right (eg, the company is doing well so it can enjoy the upside). However, the investor would also continue to enjoy the priority of a creditor, and be ahead of equity shareholders, should the company not do so well. This way investors at least partially compensate for the lack of proper buyer’s protection.
Given the circumstances in a distressed market, deals move forward very rapidly, in some cases deals close within three-to-five business days. This has several important implications for risk allocation and deal structuring.
In particular, the buyers (or creditors) do not have sufficient time to perform proper due diligence. Moreover, the transactional documents are often less complicated since the parties strive to close the deal as soon as possible. This means that the buyers have less creditor protection than usual (eg, lesser scope of warranties, indemnities, etc).
In such situations, the hybrid instruments we have described above come in handy.
We have seen three prominent security structuring trends in the transactions mentioned, which are distributed more or less equally: no security at all; a corporate or personal guaranty; and ‘REPO-like’ structures.
No security at all
As mentioned, an investor typically assumes more risk in distressed deals than compared to typical M&A deals. Compensation for this is usually a lower price the investor obtains. In this case it is either manifested as the high interest rate under the convertible loan agreement or a low valuation of the target at conversion.
However, an investor does not usually acquire an equity interest at the beginning of the deal (except for some REPO structures) and for a period of time remains a mere financial creditor. In other words, should the target go bankrupt, the risk of never getting the money back becomes substantial.
Obviously, an investor always insists on having at least some kind of security, but many technology companies, especially those with dispersed shareholdings and lack of actual ‘hard’ assets, are not in the position to provide any. An investor, therefore, should wisely weigh-up the risks.
Corporate or personal guaranty
In some cases, companies with a more concentrated shareholding and active founders agree to provide a personal or corporate guaranty. These documents are mostly standard and are, therefore, easy to structure. However, an investor should pay attention to certain provisions to make sure that the guaranty remains enforceable if the target goes bankrupt (eg, include an indemnity clause). Therefore, in a worst-case scenario, an investor will have a claim against the guarantor, even if the target becomes insolvent.
Some investors take more of an aggressive position and insist on having a REPO mechanism in place. This usually happens in the deals which initially finance transactions only (eg, the target intends to repay the loan without any conversion of the loan into equity). REPO structure implies that the investor acquires equity at the outset of the deal from the target’s shareholders. The target’s shareholders may then repay the loan (as in previous cases, with a high interest rate) and repurchase the equity in the target from the investor. In this case, the REPO mechanism plays a role of a robust share pledge that is already ‘enforced’.
To summarise, post-Covid-19 M&A transactions will necessitate the use of more sophisticated instruments, less time for due diligence, more hidden risks for investors and, as a result, more aggressive security structures. Inevitably, the market will recalibrate itself and investors will demonstrate a greater appetite for risk if they manage to obtain bigger discounts.