Key Considerations in an M&A transaction in times of Covid-19
The ongoing vaccination against Covid-19 is certainly a breath of fresh air and is a cause to believe that the worst is behind us. What we have witnessed in last one year is nothing short of a roller coaster ride. However, it is also apparent that this is still a few months away. The pandemic has been a timely reminder that external crises continue to impact businesses and business decisions in more ways than one, and that these impacts need to be addressed on an ongoing basis. Strategic decisions like mergers & acquisitions are no different. Few points that must be considered to account for the challenges presented by Covid-19 for executing M&As are:
1. Due Diligence
The impact caused by the environmental disruptions to the operations and financials of the incumbent targets have now become a critical part of the due diligence process. Obviously, the entire process must be customised and tailored to the specific industry & company and the following may be applicable to a different degree in each case:
- Compliance with laws relating to COVID-19: A significant number of federal, state, and local laws, orders, and guidelines have been created, structured implemented in response to COVID-19. Some of these are changing and evolving constantly and thereby adhering to a set template is getting complicated at times. Buyers must carefully analyse each and every change applicable to the industry in general and business in particular and ensure that the same is being complied at various stages by the seller. Apart from ensuring compliance of these laws at the due-diligence stage, the buyer must ensure that the seller has a mechanism or system in place to ensure that this is constantly updated and complied for till the transaction is completed as we have often seen that the transactions don’t close within the timelines and negotiations generally delay the process
- Supply chain management: When the world got hit with pandemic and lockdown situations across globe, supply chain of each businesses got badly affected. The importance of a good supply chain cannot be overemphasised and arguably is the most critical aspect of any business. Buyers should analyse and understand the changes in supply chain and the target’s dependence on its supply sources. Additionally, they must focus on the degree of disruption and whether the changes in supply are only short-term in nature or there are permanent changes or damages to the firm’s supply sources. Accordingly, buyers should understand the availability of alternatives, existing and projected inventory levels and forecasts of demands along with target-specific lines of inquiry. Buyers should also ensure that there is no material breach of contract with the existing suppliers of the Target if they have developed an alternate channel of sourcing
- Human Resource Impact: All industries, irrespective of the level of human involvement in their operations, have been impacted by this crisis. In the light of this situation, the scale of impact and the organisation’s response to the human resource challenge becomes a very important consideration for buyers. They must ask questions such as: Has the target firm been able to successfully create a virtual working environment? If the nature of operations requires physical presence, like in the case of manufacturing industry, how soon can employees enter the workplace in accordance with national and local guidelines? How drastically has the workforce been disrupted? The business world has responded to this crisis by extending ‘Work from Home’ policies. Has the organization been successful in granting satisfactory technical infrastructure for the same? Have they passed on the company’s financial strain to the employees in the form of termination or pay-cuts? The target firm’s response to other HR challenges like virtual onboarding and training, data security and employee morale must also be analysed carefully. Answers to all these questions give an important indication towards the management’s thought process as well as the company’s health.
- Financing: Buyers need to be certain of the financial position & debt repayment capacity of the target company. In these times, companies are being led to re-forecast their liquidity needs on account of decreasing liquidity and tightening of credit. Therefore, it is important to assess the target’s financial arrangements in terms of loan modifications, agreements with lenders, alteration in original contract clauses and chances of loan renewal upon maturity, if any. The firm’s reserves and security cover’s present value must be evaluated to analyse the liquidity of the firm. At the same time, one must also review their ability to fulfil payment obligations. Speaking to the target firm’s banker is extremely crucial in this regard, as they are capable of providing accurate data as well insights on the same.
2. Representations and warranties
Buyers’ traditional reliance on representations and warranties as a backstop to their due diligence means that they must pay special attention to these terms. COVID-19-related changes during an interim period could substantively change the facts underlying buyers’ diligence and may significantly impact their risk assessment of a target. The implications of the pandemic are quite large and multi-dimensional and hence, representations and warranties in a share purchase agreement could impact significantly. Some representations that could likely be impacted include representations regarding the firm’s operations and questions around its continuity, counterparty and default risks, material contracts, commercial relationship status and full disclosure. Consideration should also be given to the impact of COVID-19 on other typical representations and warranties, such as: labour and employment matters (e.g., layoffs and potential COVID-19-related health and safety claims); compliance with laws in a rapidly changing regulatory environment; and specific financial impacts of COVID-19 on accounts receivables and a target’s bad debt expenses. Determining which breaches of representations and warranties, if any, would give rise to a termination right may be difficult. As a contingency, a certain portion of consideration is being withheld in escrow accounts towards fulfilment of any breach of R&W. Additionally, addressing the appropriateness and adequacy of remedies for breaches may be challenging. Sellers will need to balance trying to limit their potential indemnification exposure by including broad disclosures regarding the impact on COVID-19 on the target’s business when the representations and warranties made as of the signing date are “brought down” to closing and providing the buyer with a potential walk away right as a result of such disclosure updates.
3. Grants & Support
Governments as well as regulatory and administrative bodies around the World have been providing financial reliefs to businesses in the form of grants, rebates and allowances to alleviate the economy and maintain financial stability. In the Indian context, financial reliefs include additional credit lines from public sector banks, loan moratorium or interest rate reduction for Small and medium enterprises, Covid-19 start-up assistance scheme, rebates, allowances and tax extensions, among others. In almost all of the above cases, the company needed to be pro-active to avail these support measures. Buyers must ensure if the target company availed all applicable benefits and analyze its financial & long-term strategic implications. Disclosures to all stakeholders and relevant regulatory body with no violations of agreements must also be ensured to mitigate liabilities for the buyers. Buyers must also understand & verify the processes for the same and get to know the planning and process for availing benefits like these in the future, since certain relief programs are relatively long term.
The traditional deal evaluation and diligence methodologies require a shift in this new normal as the economic environment, geographic risk, market and competition risk are evolving every day. M&A transactions are stressful environments for all stakeholders of both sides, even during the best of times. A scenario like the one we are in injects an unprecedented level of doubt and uncertainty around deals and transactions. Thus, it is imperative for buyers to think beyond the obvious while working on and closing M&A transactions & place an even greater effort on staying connected and remaining focused on achieving deal objectives.