The volatility and uncertainty of the COVID-19 crisis is having, and will continue to have, a significant impact on M&A transactions. What distinguishes this period from previous financial crises, is the level of uncertainty the impact COVID-19 will have on the economy and the extent of that impact. One thing is certain though: the quantum and structure of consideration in M&A transactions will be impacted. This article considers how vendors and purchasers may consider approaching purchase price structure and negotiation.
The uncertainty around the short and long-term impact of COVID-19 will undoubtedly make valuing businesses challenging. Valuations based on expected future cash flows and earnings of a business will be hard, given the difficulty in accurately assessing earnings and cash flow generation capability, as well as the timing of recovery for a business from the impact of COVID-19. Valuations based on historical earnings may not be reliable, as it is unlikely that any business will be unaffected by the current crisis.
Traditional valuation methodologies will need to be carefully considered in the current environment and appropriate adjustments or discount rates to earnings are cashflow forecasts can be expected.
Locked box working capital adjustment
Where a business is in decline, a vendor will typically fare better with a locked box structure. The economic and financial benefit and risk of a business passes to a purchaser from the locked box date, with no opportunity for the purchaser to adjust the price post-closing, even where the business declines in performance between the locked-box date and the date of completion. The purchase price is locked in when the sale agreement is signed. Purchasers will need to consider whether locked-box mechanism carries too much risk in this environment.
A post-completion working capital adjustment mechanism ensures that the purchase price paid on completion reflects the state of the target business on completion. Vendors will bear the financial and economic risk of the target business between signing and completion.
In Australia, most private M&A deals have a post-completion working capital adjustment mechanism and we expect that will continue to be the preferred approach. Agreeing the target working capital figure, as well as any adjustments or normalisations that historical working capital are typically areas of significant negotiation in any M&A transaction. In the current environment, we anticipate there will be considerable discussion with respect to adjustments to be made to working capital calculations to reflect the impact of COVID-19. The principles used in determining working capital will require careful consideration as inventory, payables and receivables may be abnormal and lead to dispute between the parties as to the adjustment calculation.
With the recent changes to the FIRB regime (see our article Putting the brakes on foreign investment – zero tolerance from FIRB for further information), more transactions will require FIRB approval which may extend the period between signing and completion. This may also have an impact on the adjustment mechanics, as what a purchaser is willing to pay now, in this rapidly changing landscape, may not be the same in 6 months’ time.
Deferred and contingent consideration
In private M&A, we are likely to see an increase in deferred consideration structures (such as earn outs and holdbacks) to bridge valuation gaps between vendors and purchasers.
Holding back a proportion of the purchase price until the target business’ supply chain returns to normal or the target business achieves certain milestones can provide the purchaser with valuable down-side protection.
With an earn out, part of the purchase price is made contingent on the target’s future performance, with the vendor and purchaser sharing the economic risk of the business after completion. Earn outs can create tension between vendors and purchasers. While the vendors may simply view the earn out as a deferred consideration, for the purchaser, the earn out will be highly contingent on the performance and continued success of the business post-acquisition.
Agreeing appropriate earn out hurdles may prove difficult in the current environment. Parties may consider including specific arrangements to deal with the consequences of COVID-19. For example, the earn out period could be extended or delayed by 12 months and vendors could have the benefit of a catch-up right so that outperformance in later earn out periods can be appropriately rewarded. Negotiating earn out covenants (being the matters which a purchaser is prohibited from doing or must do during the earn out period) will be particularly important for both parties.
Including appropriate normalisations will require careful drafting. Purchasers may no longer be willing to accept normalisations for abnormal or non-recurring losses (or gains).
Earn outs can sometimes be resisted by vendors due to the lack of certainty of payment and the loss of control of the business after completion. Vendors can consider seeking to mitigate that risk by ensuring they have appropriate information rights, as well as a suitable dispute resolution mechanism.
Ability to fund the purchase price
COVID-19 will continue to impact the revenue and solvency of businesses in certain industries. This, in turn, will adversely affect the ability of certain trade purchasers to obtain acquisition financing. Vendors should be aware of the credit risk of their counterparties and consider the use of structures such as deposits, escrow arrangements, parent company guarantees, third party guarantees and break fees to reduce the risk of purchasers defaulting on their payment obligations under acquisition agreements.
The COVID-19 crisis provides a unique set of opportunities and challenges for both purchasers and vendors when it comes to valuing assets. Parties can expect to see unique completion accounting mechanisms that will seek to counter some of the uncertainty provided by the COVID-19 crisis. Parties will also need to consider whether deferred consideration targets can be achieved and the use of appropriate structures to reduce counterparties credit risk.
If the M&A transaction involves a formal insolvency process the above adjustment mechanisms will most likely not be available to counterparties. The sale will usually be conducted on an “as is, where is” basis with any potential purchaser having to factor the associated risks into pricing. For more details around distressed M&A please see our previous article Distressed M&A - What you Need To Know.
About Hamilton Locke
Hamilton Locke is a corporate law firm specialising in complex corporate finance transactions, including mergers and acquisitions, private equity, finance and restructuring, insolvency, litigation, property and fund establishment.
The Finance and Restructuring team has considerable restructuring and turnaround experience across all relevant areas including finance, debt-trading, loan to own transactions, distressed M&A, safe harbour, enforcement and insolvency.