M&A transactions under the shadow of Covid-19

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Resat Moral

Moral & Partners, Istanbul



Karaca Kacar

Moral & Partners, Istanbul



Melis Menkü

Moral & Partners, Istanbul



In a short period, the effects of the Covid-19 pandemic can be stated as unprecedented, having profound social and economic impacts – even before you consider the tragic human loss.

The record decline in Brent Oil prices indicates that growth has decreased due to production. The economic indicators show that the economic contraction caused by Covid-19 has spread all over the world. The United Nations Conference on Trade and Development (UNCTAD) warned that global growth has fallen below two per cent this year and that the world economy will lose $1tn. Due to the magnitude of the impact, legal repercussions ­– especially regarding M&A transactions – are becoming the centre of attention. 

M&A activity has decreased by 31 per cent in the first quarter of 2020 compared to the first quarter of 2019, ‘cruising’ at a low level of $564bn globally.[1] This article discusses the effects of the Covid-19 pandemic in respect to the present and future of M&A transactions.

Potential general effects of Covid-19 on M&A transactions

For the transactions on which transaction agreements were commenced prior to the pandemic, purchasers tend to prefer that the closings (long stop dates) are at least postponed while they renegotiate purchase prices or walk away entirely without liabilities.

The main reason behind this attitude is that purchasers are inquiring about the success ratio of the economic outcome, accuracy and realisation success chances of business plans and are inclined to wait out for a more stable climate. Despite purchasers’ attitudes, sellers prefer to maintain the course of transactions towards closing and compel the purchasers to carry on the transactions. Even though there is a possibility to negotiate the transactions before signing, there may be limited room to rearrange the terms of signed transactions according to market volatility. Moreover, due to the practical effects of Covid-19 some transactions also cannot be closed due to the physical and/or administrative obstacles such as travel restrictions, or the inability for original copies of the crucial documentation to be delivered in a timely manner, especially for cross-border transactions. Another factor that may cause delay on closings are changes of working schemes of authorities such as competition, market regulatory authorities or foreign direct investment offices. In this regard, the parties have no other choice to suspend closings due to physical obstacles or, even worse, cancel the negotiations if structural expectations and estimations are materially affected due to Covid-19.   

Covid-19 effects on share purchase agreements

In the unfortunate case that the parties are affected by Covid-19, an analysis should be conducted on the share purchase agreement (SPA) to decide upon the future of the transaction. This should determine potential liabilities while keeping in mind the necessities of the closing, indemnification clauses, representation and warranty clauses, material adverse change clauses and termination rights.

Material adverse change clauses

All SPAs include material adverse change (MAC) clauses (or force majeure clauses). Such clauses allow a purchaser to not proceed with the transaction if the target company goes through a downturn which puts the financial or legal future of the company in jeopardy to the point where it may adversely affect the investment decision of the purchaser between signing and closing. Even though MAC clauses are implemented in nearly every SPA, such clauses are usually never invoked. After Covid-19, the interpretation of the MAC clause will surely change. Parties will implement provisions stating whether they are ready to accept or decline the possible risks of events such as Covid-19 that may lead to disruption of businesses, depending on the vulnerability of the business. In future, the parties could use the MAC clauses as a tool to renegotiate the terms of the transactions rather than walking off.

Representations and warranties

Representations and warranties will become another hot topic during negotiations in the post- Covid-19 period. Purchasers are likely to want more protection regarding customer, supplier and vendor relationships, as well as workplace safety and employment compliance. The risks of smart working and information technology systems are another field that the parties should discuss, as ensuring the security of such systems will be more complex than ever in the future. From the seller’s perspective, such representations should also be calculated meticulously as the chance of exposure or breaches will be more unpredictable after Covid-19. To combat this, sellers could also try to mitigate the outcomes of the situations out of their control by limiting the projections made by the purchaser.

Interim period covenants

Interim period covenants became more important through the Covid-19 period, since the target companies and/or sellers have been in action to keep the ship on course while under obligation to inform the purchaser regularly on or before every significant action. In this regard, parties should increase the diligence on communication and also tolerance under good faith, while bearing in mind that the management should be proactive to protect both parties’ interests.

Covid-19 effects on due diligence

Purchasers in M&A transactions conduct due diligence to evaluate the legal, operational and other risks that can be caused by the respective party before closing. The scope of the due diligence will depend on the context of the transactions. It can be expected that, after Covid-19, due diligence procedures will undergo serious and essential changes and adaptations in structure. The due diligence to be conducted following Covid-19 will be more detail-oriented to address the dependencies of the respective party and how future events similar to Covid-19 can affect the transaction or, in a more general sense, the parties.

Covid-19 demonstrated that health, safety, employee welfare and continuity planning should not be overlooked when assessing the future viability of a target company. Due diligence processes may also take longer as site visits are nearly impossible under the Covid-19 restrictions. Though this hardship may be a temporary situation, the social and medical attitude changes will surely affect future implementations and applications. The content of due diligence process will now include the security of supply chains – especially those operating at trans-national levels – termination and force majeure clauses in third-party agreements, the ability of the company to perform under conditions such as Covid-19 and many other risks deemed unimportant or not applicable during the bull market period.

The importance of digitalisation will definitely demonstrate its importance in the future. The due diligence operations in the light of Covid-19 will increase demand to virtual data rooms. Like every technology-oriented services provider, virtual data room service providers will be on the rise. Teams conducting due diligence should not overlook the logistical obstructions as holding meetings in person will not always be possible. The teams should also specialise in communication technologies to perform virtual examinations, as well as participating in virtual meetings and learning to build trust-based relationships through virtual connections. Teams with the right experience and the ability will prevail by conducting faster due diligence processes through virtual data rooms.

While purchasers’ diligence and sensitivity will increase, sellers should also increase their awareness on due diligence in order to reach a smooth closing. In this regard, vendor due diligence is set to be a key tool and something to invest in due to the potential positive effect, both on the target company’s valuation and to strengthen sellers’ position against purchasers during due diligence.

Moreover, from the purchaser’s perspective the interim periods could be insufficient to conduct a meticulous examination. Detail-oriented due diligence will outline the weaknesses of the companies hidden in plain sight and will force the parties to be more open during such periods.

Covid-19 effects on valuation and purchase price adjustments

Another topic that should be addressed is the risk of change in the value of the companies during the transaction and after closing. Parties usually implement purchase price adjustments or locked-box mechanisms to mitigate such risks. Purchase price adjustments are more likely to be favoured by purchasers via changes in cash, debt and working capital through accounts prepared by the company. Therefore, the risk passes onto the purchaser at the closing. On the other hand, with a locked-box mechanism the purchase price is identified through management accounts sometimes prepared months prior to signing, passing the risk to the purchaser earlier even though the parties decide upon restrictions that prohibit the seller to diminish or extract the value of the company before closing.

With all this uncertainty in the M&A market, locked-box mechanisms are being deemed obsolete. With MACs more in sight then ever after Covid-19, locked-box mechanisms are becoming ticking time bombs for both parties.

Another point to note is that sellers may be forced to adopt precautions to maintain the liquidity of their companies by duly preparing for adjustments. Although such new risks have surfaced, only a few cases of withdrawn financial commitment have been faced due to market disruption. There are no cases of banks cancelling the acquisitions because of the crisis at hand.

It is still too early to say what exactly the future holds due to the fact that companies are still acutely oriented towards mitigating the possible negative impacts regarding payment and liquidity after Covid-19. Covid-19 has had an unprecedented impact on businesses, economies and life as we know it, all around the globe. The parties of M&A transactions have been reminded of the fragility of the climate and how swiftly the conditions can change as a result of unexpected events.

Finally, earn out mechanisms have been causing disputes between parties. On one side, there are purchasers trying to implement agile management in the post-Covid-19 period with the aim of fostering a successful operation to grow and continue, and on the other side there are sellers with expectations of realisation of the earn out at the end of a limited term, which are dependent on conditions and thresholds. The longer the period, the higher the conflict over the earn out. In order to avoid any earn out-related disputes for the transactions closed or set to be closed through the Covid-19 period, parties may review and mutually agree on a potential effect coefficient on target revenues or profits that are the basis of the earn outs.

Tips and predictions for the new normal

Once the Covid-19 pandemic subsides and the ‘new normal’ is initiated, the first major change will be the transfer of core industries to states: airlines, entertainment, and food and beverage being leading examples.

Many states will be more inclined to salvage the companies rather than investing. This attitude will cause a drift away from shareholder value to stakeholder value, with a more inclusive approach. Companies that have more stakeholder value will likely be targeted for salvaging. A tip for the dealmakers is to keep all stakeholders, including creditors, in the loop by fully informing them – not forgetting that timing is the essence of the deal and may lead to higher value deals.

Another point to keep in mind is the continued volatility of the financial markets. Transactions which rely on third-party financing (mostly banks) can face obstructions in these conditions. Purchasers should not overlook the risk arising from the inability of third parties to provide sufficient funding. To ensure third-party financing, purchasers who do not provide lenders a way out will be forced to close the deals. This will cause high risks for sellers where the purchasers will not have required funding to perform under specific performance.

Moreover, earn out clauses can be utilised to bridge the pricing gap caused by Covid-19. However, this tool should be utilised with utmost care. Sellers might be affected much more than anticipated due to the bust of third-party or related businesses. This will push sellers to attempt to invoke force majeure provisions. Therefore, if an earn-out clause is used to mitigate the pricing gap, the uncertainty factor should be drafted carefully due to the fact that nobody is able to predict the final or ongoing effects of the Covid-19 pandemic.

In conclusion, the Covid-19 crisis has highlighted the fragility of M&A transactions. Even so, in these conditions the strong market participant will try to establish more resilient business models at the expense of multinationalism. Such actions can stimulate M&A transactions, but it should be accepted that the spring days are mostly gone. This period is a wake-up call for companies to adapt their strategic plans by putting liquidity over earning forecasts.

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