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Article - A guide to managing your M&A pipeline during COVID-19 for global industrials - Global

Article - A guide to managing your M&A pipeline during COVID-19 for global industrials - Global
  • United Kingdom
  • USA
  • Coronavirus - M and A issues
  • Distressed - Distressed M and A and reorganizations
  • Industrials - Industrial engineering

09-04-2020

The COVID-19 pandemic has taken global industrials around the world largely by surprise with wide-ranging consequences for their M&A pipelines. Coming on the back of a period of high valuations, political uncertainty and slowing deal activity, COVID-19 can be expected to bring not only lessons learned, but also opportunities for companies with access to capital and a longer-term strategic view.

Global industrials face continued downward pressure on demand, production and revenues in the short term as the COVID-19 pandemic intensifies. The industry is especially vulnerable given that the bulk of its workforce is employed in on-site jobs that cannot be done remotely and global supply chains are disrupted.  These challenges are driving M&A and management teams to consider divesting non-core or underperforming assets — or assessing M&A prospects, to ease cash-flow liquidity and mitigate long-term risk.

Below we set out three key themes and some key considerations that boards and M&A teams need to consider during the COVID-19 pandemic, when it comes to (re)calibrating your M&A pipeline and strategy:

Short Term - Hitting the pause button on M&A

 

  • Market sentiment: We are seeing a varied picture with earlier stage deals more likely to pause and mature deals generally continuing to completion. In the short term, businesses are focusing resources on firefighting immediate issues such as furloughing employees, cutting production and troubleshooting supply chain issues which are drawing their attention away from M&A. In particular, the automotive industry is being hit hard with plants shutting down and employees being furloughed. However, newer deals are generally only hitting the pause button rather than entirely falling down, and so businesses may wish to keep their M&A ‘war-chest’ to hand.

 

  • Supply chain/regulatory: Globalised supply chains, especially those leveraged to China, are experiencing severe stress causing both immediate operational issues but also potential long-term changes regarding future-proofing. Restrictions and travel bans are causing numerous logistical and demand issues, and also the ability of governmental bodies to operate is having a knock-on effect on the ability to transfer shares in several jurisdictions. Both factors are presenting immediate priority issues for boards and we can expect this to significantly drag on M&A activity in the short term.

 

  • Capital constraints: Higher operational costs and lower demand is leading to cuts in capex and the preservation of cash across the sector. We would expect a short-term knock-on effect to deal flow as companies take stock and look to be reactive by building up reserves in the case of any further negative shocks.

 

  • Falling valuations: Following years of increasing multiples and a “seller’s market”, indications are that valuations are stagnating (if not falling) and we can expect potentially sharp corrections. COVID-19 has the potential to spark a move back towards “buyer’s market” terms with valuations forming a key re-negotiation issue in ongoing deals, as downside risk and concerns around due diligence have moved to the forefront.

 

  • Protecting downside: Certainly, it is hard to imagine that aggressive seller-driven processes will continue in the short-term. Buyers are much more likely to require downside protection, whether through immediate price reduction or the use of earn-out type structures or through forward looking warranty & indemnity protection (which have been almost unheard of in recent times).

 

Short / Medium - Opportunities and distressed assets

 

  • Cash is king: Companies with strong balance sheets and the ability to raise capital on the equity/debt markets will likely be presented with both value-add and strategic opportunities as weaker balance-sheet businesses seek to divest to shore up working capital reserves as detailed below. With private equity war-chests remaining at record highs, we expect this capital to be deployed as valuations correct. There may be an immediate pause, but once the dust settles there will be some real opportunities out there for those able to take advantage. Potentially, as with the 2008 crash, those strategic buyers with big balance sheets can snap-up well priced assets, alongside those private equity houses who are able to do all-equity transactions.

 

  • Distressed assets/market consolidation: We expect harder hit industries, such as the automotive and oil & gas sectors and those sectors particularly sensitive to consumer demand (e.g. travel), to see a rise in distressed transactions. We expect that COVID-19 could also be the trigger for non-core asset disposals and other sales that have been under consideration to be accelerated (in an attempt to shore-up balance sheets). Such dynamics could throw open opportunities for market consolidation and companies looking to make strategic acquisitions and also bolt-ons to fill gaps in technology and their supply chains that may have been exposed by the outbreak.

 

  • Pragmatic approach to due diligence: Given the practical issues thrown wide by an inability to diligence assets (e.g. site visits) and increased concerns about potential impacts of COVID-19, a pragmatic approach will need to be taken where full-scale due diligence is not possible. This could be reflected in further reductions in price, particularly where sellers are forced to quickly sell non-core assets to shore up balance sheets, or escrow and price deferral mechanisms coming to the fore. That said, the scope of diligence is only likely to increase in the medium-term, unless there is a truly compelling price reason to take a view – most buyers will be wanting to turn every stone in this environment.

 

Medium/Long-term - M&A strategy and deal terms going forward

 

  • Material Adverse Change/Force Majeure: Material Adverse Change clauses remain fairly unusual in certain jurisdictions and true force majeure provisions are rarely seen in a modern M&A transaction. We can expect to see a renewal of interest and negotiation in these areas and their inclusion in acquisition documents, as well as specific carve outs for COVID-19-type events, epidemics and government action. As a seller one should approach with caution as carve-outs relating to general market conditions and market events, and restrictive interpretations, could significantly shift the dial in terms of deal uncertainty.  Sale & purchase agreements are likely to come under even more intense negotiation.

 

  • Financial due diligence: Business plans and performance against plan including run-rates both before and after the outbreak of the COVID-19 pandemic will be paramount. More than ever, buyers will demand visibility on the sensitivity to material swings in customer demand, for example.  What that means for price or other deal terms, in terms of down-side protection, remains to be seen.  Certainly earn-outs and similar constructs could gain traction.

 

  • Legal due diligence: The practical ability to carry out full-scale due diligence (such as site visits) will be limited. Questions concerning COVID-19 such as business continuity, insurance, and health & safety may well become common-place as buyers look to understand the scale of risk. An increased focus will be placed on whether disruption could result in the inability of performance of key contractual obligations resulting in breach and counterparty enforcement risk. Expect buyers to either be required to take pragmatic approaches by sellers in positions of strength, or to push for discounts or other measures to balance this risk.

 

  • Locked box/completion accounts: We could expect the market to shift risks in declining working capital onto the seller, with completion mechanics in Europe moving from the seller friendly locked box towards completion accounts and earn-outs which take a working capital adjustment into account. Sellers can also consider deposits, termination fees and security/guarantees in relation to a buyer’s obligations. In the US market we can expect to see renewed focus on closing account procedures and potentially increases in related escrow deposits.

 

  • Warranties: Given the measures being taken by businesses to mitigate the impact of COVID-19, employee and contractual disputes seem likely to rise in the near future. Buyers should seek specific COVID-19 related warranties to ensure full disclosure, particularly in respect of employment, supplier contracts, covenant defaults. Deals featuring split exchange & completion should consider looking at conditions precedent and termination rights allowing the buyer to walk away or renegotiate valuations. Buyers should seek the repetitions of warranties to flush out an intervening issues and sellers should look to bring down disclosures at completion and carve out COVID-19 related issues.

 

  • W&I/R&W insurance: We must wait and see to understand the full ramifications on the buoyant M&A insurance market, but it is likely that known events and pandemics may well be excluded from policies as a matter of course (particularly where governments implement a phased return to public life).

 

  • Alternative financing: If external financing costs increase due to debt and liquidity constraints, we would see a move towards alternative financing mechanisms. Option mechanisms, last popular in the 2007-8 recession (where the parties enter into a financing agreement allowing the buyer to take control of shares with an option to convert into equity at a later date) could come back into fashion.