INSIGHT: M&A Trends to Expect in the Wake of Covid-19

The impact of the coronavirus pandemic on small businesses and local economies has been unprecedented and the global financial markets are in turmoil. M&A professionals should prepare themselves for a sporadic next few quarters.

Even as central banks utilize monetary policy to create liquidity for the markets, it appears investor confidence won’t be restored until there are clear signs of the Covid-19 pandemic flattening and a more certain path towards lifting “stay at home” orders. However, once things start to return back to “normal,” we should see M&A activity pick up, particularly with respect to distressed companies.

Q2 Activity

With all of these economic headwinds, it is not surprising that M&A activity is slowly grinding to a halt. While some transactions that had momentum before the Covid-19 virus hit the U.S. have either closed or continue to move toward their scheduled closing dates, those transactions that were in the early stages have generally stalled while buyers and sellers alike assess the pandemic’s effects on the global economy as well as their own balance sheets.

If a buyer and seller are willing to consummate a transaction amidst this current economic uncertainty, the extreme volatility and turmoil in the capital markets and restrictions on access to private debt financing have become strong inhibitors to financing a closing. As a result, most transactions that close in Q2 will almost certainly rely upon either cash on-hand or equity commitments.

When M&A activity does pick-up, we expect to see the following trends in purchase agreements.

Purchase Price Consideration

As buyers seek to preserve cash and realize traditional sources of debt financing may be more limited, buyers are likely to pursue transactions using their own stock as currency to fund the purchase price consideration.

While sellers may be hard pressed to give up the notion that cash is king, at least they will be able to share in the future growth of the business and may be able to defer the payment of tax on gain associated with the sale. The stock-for-stock deal may also help bridge the differences in valuation of the target business being offered by the buyer and seller.

Earnouts

As is generally the case when an economic crisis occurs, sellers will argue that the hit to earnings was an extraordinary, one-time event and should be disregarded, or at least minimalized, for purposes of determining the purchase price. Waving their hands, buyers will welcome sellers to the new normal.

If sellers require cash consideration to close the deal, then we should expect to see an increase in earnout provisions to allow the parties to close the bid-ask spreads on valuation.

Seller Notes

Perhaps more in the lower middle market segment, we should also expect to see an increase in the use of seller notes, allowing buyers the ability to (1) replace uncertain third-party debt financing with seller financing, (2) reduce total cash outlay and (3) easily set-off indemnification claims against the seller note in a period of time when the likelihood of claims may increase given recent volatility in business performance and a presumed rise in all types of litigation in a slower economy.

Representation and Warranty Insurance

Buyers should also expect changes to coverage under R&W insurance. Most insurers are currently requiring exclusions from coverage for the effects of Covid-19 and, depending on the industry or the profile of a particular target, such exclusions may be very targeted or extremely broad.

Given that many representations speak to periods of time prior to a closing, even once the effects of the virus have been substantially reduced, it is reasonable to assume that such exclusions will continue to be part of R&W policies through at least all of 2020.

Material Adverse Effect Clauses

Relying on an material adverse effect (MAE) condition to exit a signed transaction has always been a challenge for buyers due to the burden to show a long-term and disproportionate impact to the business, and even more daunting given the exceptions typically drafted into the MAE definition.

That said, the list of standard exceptions to any change, effect, event or occurrence that may cause a material adverse effect on the properties, financial condition or results of operations of a target business just got longer. References to pandemics generally and coronaviruses (including Covid-19) specifically are being included in MAE definitions of purchase agreements at a rapid rate.

We should expect that these pandemic references will have the same staying power as the acts of terrorism exception that exploded into MAE definitions shortly after the 9/11 attacks nearly two decades ago.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Steve Peterson is a partner in Locke Lord’s Houston office, focusing on corporate and securities law and representing public and private companies in connection with mergers and acquisitions and other transactions.

Greg Heath is a partner in Locke Lord’s Houston office primarily focused on mergers and acquisitions representing public and private companies in connection with mergers and acquisitions and other transactions

Joe Perillo is a partner in Locke Lord’s Houston office and co-chair of the firm’s Corporate and Transactional Department and chair of the M&A Section. He represents companies in connection with mergers and acquisitions and other transactions.