The M&A market has entered into uncertain times. Potential purchasers have become more reluctant to buy businesses as the impact of COVID-19 on results, revenue and ultimately valuation is unclear and potential sellers need all their time and efforts to navigate through this storm.
Organizing a sale process is not a priority now. Nobody knows when and how fast life will turn normal again and hence whether we are facing a short temporary performance gap or a much longer period of uncertainty.
In addition to simple mutually agreed postponements of deals, the last few weeks we have seen the following developments and discussions in transactions that have not yet been signed, but for which parties have entered into (non-binding) letter of intents, term sheets or heads of agreements:
- Due diligence
Potential purchasers are focussing in particular on actual performance and revised projections and budgets in light of changed market circumstances. How is or may the business become affected and what will be the road to recovery?
- Purchase price
Apart from discussions on enterprise value, we see that upfront purchase price payments are renegotiated and replaced partially by earn-outs to cover the uncertain results for 2020 and beyond. For potential purchasers this is a way to share the risk of future performance, but for sellers this means that there is not an immediate full exit in financial terms. It really depends on the terms of the earn-out period and the protection the sellers have that the purchaser is doing all it can to achieve the earn-out milestones, whether or not this is a solution where both parties can benefit from. In order to incentivise sellers to accept an earn-out, we have seen the opportunity offered to them to realize higher sales proceeds than in the original scenario without an earn-out.
- Locked box versus completion accounts
Especially in Europe, locked box transactions are very popular. The purchase price is calculated on the basis of historical financial figures (year end results) and no purchase price adjustments (net debt and working capital adjustments) need to take place after completion. We have seen that potential purchasers are no longer keen to accept an effective date of 1 January 2020 (whereby the purchase price is fixed on the basis of the 2019 financial statements), which basically means that the business is for their risk and account as from 1 January 2020, including the negative impact of COVID-19. Purchasers are now persuading sellers to agree to an effective date equal to the completion date with an envisaged completion after the summer break, all in the hope that the world looks better then.
- Material adverse change (MAC)
MAC clauses are typically used in non-binding letters of intent, but you do not see these very often in binding purchase agreements, especially not in highly competitive auctions where sellers are looking for so-called `deal certainty´. MAC clauses typically cover events and risks that nobody could foresee and typically exclude generic events that affect the whole economy, industry or market. If you want a MAC clause to work in the current market, you need to tailor it to the target business and include specific performance parameters (e.g. loss of a specific % of revenue compared to the period prior to COVID-19).
- Financing condition
This especially applies to private equity deals or strategic deals sponsored by private equity. These purchasers depend on attracting debt financing and they need to show to the debt providers (including credit funds) that there is sufficient cash flow to pay interest and principal instalments. If financial projections and hence cash flows are becoming less reliable, financial institutions may only accept a lower leverage multiple. Typically, financing conditions are included in (non-binding) letters of intent or similar documents, but not in binding purchase agreements. Potential purchasers may ask for a financing condition in these binding agreements, if they need to go back to their financing banks due to changed circumstances or because there is a MAC-clause in the financing term sheet.
- Vendor loans
If debt financing is an issue, we have seen that sellers and purchaser put in place a vendor loan or increase the amount of the already agreed vendor loan in the original financing structure. These vendor loans are typically unsecured and subordinated to bank financing and are structured often as bullet loans for a period of 3-5 years, with no interim repayments or interest payments being required. In consideration for accepting these risks, the provider of a vendor loan (the seller) receives a high return on the outstanding vendor loan. These vendor loans are therefore a good instrument to bridge any liquidity gap in the financing structure of a M&A deal.
- Convertible loans
In some VC-transactions, we have seen that a VC-investor has postponed its equity investment but in return has pledged to provide a convertible loan to show commitment to the target company and its business.