As the novel coronavirus (COVID-19) continues to impact our communities and workplaces, our primary concerns are for the well-being of all those affected by this crisis.
As the leading cross-border law firm for global clients on their most complex transactions, we are helping our clients navigate the significant internal and external challenges that they are facing. A summary of our global perspective follows below. The assessment of our cross-disciplinary, cross-jurisdictional transactional teams is that there shall be, at a minimum, significant short to medium term negative consequences on transformative transactions, particularly within strategic M&A and private equity markets. However, the reactions to the ravage caused by this crisis should provide market participants with valuable lessons as they address the implications of the crisis on their transactions and mitigate risks in addressing future global adverse events.
General Market Outlook
Prior to the outbreak, due to, among other things, Brexit, global trade wars, US election uncertainty and commodity and other market volatility, global deal pace had already slowed, with deal activity hitting a 6-year low by some metrics. While some of this was predicted, the pace at which individual transactions will be completed, and deal volume, in general, are likely to continue to slow. Driving this conclusion are the following factors:
Sentiment – Navigation of almost any urban center entails seeing multitudes clad in facemasks, demonstrating a cautionary attitude, that is spilling into the M&A and financing markets. Recent anecdotal evidence abounds regarding the spread of this circumspection, including public companies, PE funds and other deployers of capital holding their cash dear and decelerating the speed of transactions. Parties to commercial agreements closely studying or invoking force majeure clauses and analyzing whether a material adverse effect or change has occurred to determine if a party can exercise termination or other rights under the relevant agreement have also arisen as a recent phenomenon, some of which may test the limits of recent Delaware case law on what constitutes a material adverse effect. An increasing number of major multi-national companies are disclosing in periodic reports and on earnings calls financial and operating issues which have arisen due to the pandemic. Changes in consumer behavior are telling signs of the overall perspective of the deal market. The negative mood will likely feed on itself, leading to more significant deal inertia.
Logistics – In China, Korea, Italy, Japan, and France, among other places, quarantine and other restrictions hinder travel and in-person meetings, negatively impacting deal making. A number of multinational entities have instituted travel bans and meeting limitations. United Airlines’ recently disclosed that AsiaPac travel demand has so severely been affected that if current travel levels remain, it would constitute a material adverse effect on United’s results of operations. Moreover, court/tribunal hearings have been adjourned and governmental officials and other workers in certain countries have been compelled to work remotely, thereby potentially slowing the pace of considering and granting necessary consents or approvals. Examples include: in Hong Kong, court/tribunal registries and offices remained closed for over a month during which all court/tribunal hearings were adjourned (except for urgent and essential matters). Also, civil servants were asked by the Hong Kong Government to work from home for over a month. These factors are likely to slow down deal processes and potentially undermine deal making, financing road shows, site visits and the overall deal-making process.
Supply Chain Issues – Global companies, especially with operations in China, are facing material supply chain challenges that could have longer term implications on inventory, revenues and operations. Managing these issues are causing C-suiters to look inward, distracting focus from both existing and new transactions. Prioritizing operational issues over transactional opportunities will undermine deal flow and erode transaction momentum.
Capital Constraints – Global enterprises facing supply chain issues, hence potentially higher operational costs, lower inventory and the prospects of lower demand will be loath to expend resources and time to engage in M&A and financing activities, particularly if valuations of targets remain high. In addition, potential higher costs will cause companies to manage cash, hampering the ability of companies to acquire assets.
Financing Constraints – The new-issue loan market had been characterized as being fairly firm until mounting concerns about COVID-19 brought the forward calendar of net new volume issuance to a 13-month low as February came to a close. Loan fund and high-yield fund outflows also reported significant withdrawals. Opportunistic financing activity has slowed and various financings in the pipeline with an aggregate value of at least $4.0 billion of potential issuance have been put on the shelf. For the financings that have been achieved during this tumultuous time, such transactions have been characterized by increased pricing, reduced debt quantums and more lender-friendly documentation, including a tightening of terms for borrowers around call protection and financial reporting requirements. Credits within the travel, entertainment and energy sectors have been hit particularly hard in recent weeks.
Off-Setting Positives – The pandemic can potentially lead to at least a modest correction in transaction pricing (as already experienced in the stock markets) which could stimulate buyers to transact (and to acquire/increase stakes in or privatize listed companies). Moreover, capital commitments to private equity funds and other asset managers hit their all-time high in November 2019 with much of that capital undeployed. These financial buyers are likely to continue to engage in significant M&A transactions, and, as sellers, they will likely continue to seek to dispose of assets.
On the financing front, US middle market financing activity for private equity transactions may continue to remain busy, particularly with respect to credits which have little exposure to hard-hit sectors or supply chains. We have seen continuing evidence of middle market direct lending activity, albeit with increased scrutiny by borrowers and lenders concerning the negotiation of financial covenants and covenant waiver requests.
We may see a rise in distressed transactions (including the acquisition of non-performing loans and other distressed assets), capitalizing especially on financially distressed businesses in the more adversely affected industry sectors. On the other hand, online and tech businesses that are gaining ground may become targets for strategic acquisitions by industry buyers who are driven by an accelerated demand for such capabilities. The epidemic may also expose gaps in sub-sectors in the healthcare industry representing significant growth potential which may present PE investment opportunities.
Market participants facing the COVID-19 turbulence, as well as future significant challenging events, should consider some of the curative actions described below in connection with M&A transactions.
- Extensive Due Diligence – Heightened due diligence investigations to assess business vulnerabilities while traditionally important will be more essential.
- Detailed reviews of supply chains to understand geographic scope of operations, dependencies and business risk and legal rights will need to be conducted.
- Analyses of key contracts to assess the parties’ rights and obligations, including with respect to termination and force majeure. Such an investigation will also mandate a broader review of governing law provisions, legal rights afforded to the parties under controlling laws, and risks of litigation.
- Solvency reviews will need to be carefully undertaken to assess the ability to withstand liquidity crunches and the impact of the crisis on financing sources (particularly in hotels, food and beverage, travel-related and traditional retail industries). This will be meaningful for crafting and negotiating covenant packages in credit facilities.
- Reviews of potential changes in laws or behavior anticipated to arise due to the crisis, such as work place leave policies resulting from COVID-19, and how the same will impact ongoing operations and compliance matters.
- Reviews of compliance with existing and new laws and regulations relating to the epidemic. In particular, employers may have liabilities to employees who contract COVID-19 for failing to provide a healthy and safe workplace, and to employees in general relating to the termination or suspension of work.
- Assessments of risk management protocols and operational and compliance redundancies to ensure business continuity in the case of change of laws or crisis in specific geographic areas.
- Contractual Provisions – Additional flexibility for contingencies, locally and globally, have risen as an immediate response to the epidemic. Whether negotiating provisions now or reading purchase agreement provisions in light of the current effects of the epidemic which were drafted prior to knowledge of it, negotiations are occurring and we think will continue to occur on the following matters.
- Representations/Warranties – Buyers and sellers will need to carefully examine purchase agreement representations and warranties to, among other things, carefully prepare disclosure schedules to address all ramifications of the crisis, particularly with respect to human resources and benefits matters for alternative home based work arrangements and covenant defaults for supply chain businesses. Deal participants will need to balance this exercise with the goal of minimizing exclusions from representation and warranty insurance coverage of COVID-19 related matters, as known issues are unlikely to be covered by these policies. Moreover, specific representations (for example as to contingency planning, protocols and the like) regarding the crisis may become part of the purchase agreement lexicon and more standard practice.
- Outside Date/Termination Rights – The time between execution and consummation of a transaction requiring governmental approvals is likely to elongate. Consequently, it is possible that the outside date for transactions may be longer than traditional levels to accommodate the length of time to obtain approvals or permit increased deal certainty. Ironically, extended interim periods, while allowing more time to fulfill closing conditions, will, perhaps, give buyers a greater opportunity to terminate a deal due to a material adverse effect. It is also important to ensure, now more than ever that the termination rights under financing commitments are fully in line with the termination rights under the acquisition agreement.
- Governmental and Other Approvals – Covenants specifying the level of efforts to be utilized to obtain necessary approvals should be carefully tailored given the need for extra steps to interact with displaced counterparties, including, homebound government officials or contractual counterparties, and prolonged periods to obtain consents.
- Conditions – While sellers will resist diminished deal certainty arising from specific crisis related conditions, if M&A activity slows, leverage of buyers is likely to increase. If so, specific conditions tailored to the expectations of the crisis may become a part of purchase agreements.
- Representations and Warranty Insurance – These policies are unlikely to provide a solution to a crisis. The expectation is that impacts of a crisis, since they are in part known, will be excluded from coverage and a form exclusion has already been deployed by some insurers. We may also see a rise in key man insurance policies.
- Material Adverse Change or Effect – It is common to carve-out from this definition known events that are impacting a business. Therefore, we are seeing specific references to COVID-19, epidemics and pandemics as a carve-out from the circumstances which would cause or have a material adverse effect. However, deal participants should seek to tailor this definition in the context of COVID-19 and other situations, to take into account the worsening of existing conditions due to the crisis in geographic areas in which the target operates or the world in general.
- Interim Covenants – Given the challenges discussed for travel and meetings, boilerplate access provisions will need to be reviewed to allow for “virtual” visitation rights and other solutions. In addition, sellers will need an exemption from these covenants to be able to take “emergency” measures to preserve the business to be sold without seeking purchaser consent.
- Locked Box – Given uncertainties around performance and receivables, we may see deals which initially contemplated locked box mechanics revert to the traditional working capital adjustment provision to limit risks in declining working capital for buyers.
- Financing Terms – We expect to see continued scrutiny of financial covenants as borrowers may face unexpected working capital needs and un-forecasted testing of springing covenants. For cov-lite deals we expect that lenders shall focus increasingly on strengthening protections around financial reporting and notice requirements. We are already seeing a tightening of terms around incremental debt provisions, including with respect to MFN sunsets and reductions in the free-and-clear tranche. In the middle market PE direct lending space, we expect that PE sponsors and portfolio companies shall be proactive in seeking covenant waivers where a default of their financial maintenance covenants is anticipated. As syndicated loans trade at significant discounts on the secondary market, PE sponsors can be expected to take potential advantage of their existing debt buyback provisions; accordingly, that is another area of loan documentation that should be subject to increased scrutiny by lenders and borrowers in the months to come.
The COVID-19 epidemic is a hopefully short-lived tragedy. However, the markets, from time to time, face different and perhaps less severe crises but with similar effect. Strategic M&A and private equity market participants can deploy some or all of the curative measures identified to improve their planning and mitigate risks. In that vein, from a commercial perspective, a beneficial consequence of this time may be that our clients augment their planning around deal certainty and valuation.