April 3, 2020
By Colin Wittmer, US Deals Leader
As we weather this historic health crisis, keeping our communities safe remains the top priority. That means putting people first, with everyone using their expertise to address critical needs and protect livelihoods during this time.
With the coronavirus (COVID-19) pausing much of the economy, it’s no longer business as usual for deals. We’re clearly operating in a new M&A environment — one that will continue to evolve. Early trends, particularly around shorter-term deal tactics, are beginning to emerge, and soon there will be longer-term, more fundamental shifts in deal strategy, valuation and liquidity. Below are some initial impressions of what I’m seeing in the market, which we’ll continue to watch in the weeks ahead.
After a period of record M&A activity over the past decade, dealmakers now face unprecedented disruption. Some acquisitions and divestitures are still being completed, mostly between companies within the same sector and facing similar economic impacts. In some of these cases, the deals process has accelerated to get ahead of additional pandemic fallout. Other deals are on hold due to valuation and financing issues, as well as heightened uncertainty over business models. And, not surprisingly, some deals have been canceled outright.
It’s still early in what could be a significant downturn, but we’re quickly switching from a long-running seller’s market to one favoring buyers — especially those in relatively strong capital positions. For sellers, the tide is turning from contemplating broad auctions to prioritizing speed and certainty to get a deal signed.
Deals require capital and the right strategy
Companies considering M&A need to be able and willing to pursue a transaction. That requires adequate capital and the right deal strategy, and both will be challenging in the months ahead. COVID-19’s financial and operational impacts on companies affect many aspects of deals, from strategy and targeting to integration and value creation. Some impacts we expect:
- In the short term, companies will likely face issues with closing in-progress deals as they evaluate projected cost and revenue synergies and immediate liquidity needs in this environment.
- New options will arise, and previous options may dwindle. Resetting deal priorities to reflect the new competitive landscape — including revisiting deal funnels — will be essential.
- Fundamental principles on reducing uncertainty remain intact. Companies should focus on a robust and disciplined approach to forecast scenarios, with each probability assessed, to ensure they’re managing their value creation.
- Longer term, acquirers may need to rethink the cost of financing in a struggling market and consider alternative financing sources to get a deal done.
- Dealmakers should also adapt to a major shift in access to assets, with travel restrictions and shuttered facilities impeding the ability to assess and value targets.
In this landscape, where the impact of the outbreak is not yet fully understood, value creation in dealmaking is more important than ever. Here are a few critical areas in which companies are adjusting and putting themselves in a better position to consider acquisitions, divestitures and other deals — all through a value creation lens.
Finance and liquidity
Companies in various industries are facing significant declines in sales and revenue, so it’s likely that deals will compete with other corporate priorities for available cash — even though capital is still higher than in previous downturns. Government aid or insurance settlements will provide some help, and there will probably be more instances of companies drawing down credit lines to ensure access to cash. Increasingly, sellers are willing to offer financing to bridge capital needs that might not currently be available from third parties.
Other factors in this shifting liquidity environment include:
- Cost considerations: Beyond the obvious supply chain disruption, companies are facing multiple extraordinary, unusual or non-recurring expenses, such as sanitization, inventory loss, idle facilities or closed locations, tech infrastructure (especially to enable remote working), new employee training, and adjusted customer outreach and marketing campaigns. All of these expenses could affect a company’s position as either a potential buyer or seller, so they will need to be considered in deal modeling on all current transactions.
- Credit agreement provisions: Companies are assessing existing covenants and reporting deadlines and then determining where they may be able to adjust for COVID-19 impacts. This includes taking a fresh look at potential exclusions for items not previously considered and identifying where alternative interpretations might be possible, as well as anticipating potential areas of heightened scrutiny from lenders.
- Headroom analysis: As the current level of undrawn borrowing capacity becomes more critical, companies must closely examine headroom in covenants. Previous forecast scenarios are understandably more sensitive and may need to be recalculated. Identifying and tracking adjustments could lead to renegotiating covenants or signing new credit agreements, with the potential for future liquidity events, such as a sale.
COVID-19 is spurring companies to reassess recently signed deals, and the first question to evaluate is often whether to go through with the transaction. After a long economic expansion that generally boosted company valuations, more acquirers are weighing a decline in valuation against the cost of termination fees.
Other potential issues in purchase agreements include:
- Material adverse change (MAC) clauses: There have been questions about existing MAC clauses in which COVID-19 isn’t specifically mentioned. Meanwhile, sellers are beginning to add exclusions for the virus in new MAC clauses — even though such exclusions may not make a difference in deals. To trigger the clause, a material adverse effect must be specific to a company, and a global pandemic may not qualify. Typically, the impact also must span years. That “durational test” may be questionable, but the unknowns of COVID-19 have opened the door for more MAC clause conversations.
- Earnout mechanisms: With increased uncertainty, buyers are looking harder at contingent considerations. We previously saw this in certain sectors, such as a tech startup without a proven track record or a pharma company waiting for federal approval of a drug. Because of COVID-19, an acquirer will likely be less confident in a target’s projected fiscal-year earnings. There may be more offers in which part of the purchase price is paid up front, with the rest deferred and based on the acquired business hitting certain targets. And there could be a rise in disputes over closed deals with earnouts that are still being settled.
- More aggressive stance overall: In response to the market shifts discussed above, buyers are likely to become more assertive in agreements and negotiations. They could try to include more favorable language in the purchase agreement — for example, pushing for wide-open GAAP (generally accepted accounting principles) language versus a detailed accounting hierarchy. During closing, acquirers may look at where they can claw back value to compensate for possibly overpaying in the previous seller’s market.
Accounting and reporting
As noted previously, companies struggling with their capital structure are considering making changes to existing debt agreements. From an accounting perspective, this could mean assessing whether debt modifications or settlement represent a troubled debt restructuring, debt modification or extinguishment. It might also mean reviewing covenants to determine their impact on the business, liquidity and cash management.
Other accounting and reporting considerations include:
- Workforce disruption: With COVID-19 resulting in workforce reductions in multiple sectors, companies may need to record a restructuring liability when an occurrence creates a present obligation. Typically, a commitment to a plan doesn’t create a present obligation. Many costs, including relocation, can’t be accrued before they’re actually incurred. For example, the accrual of employee severance and contract termination costs is complex and should be based on the specific facts and circumstances.
- Goodwill and intangible impairments: Decreased demand for products or services, supplier and customer disruption, closed stores and idle facilities — all can affect financial performance and future earnings estimates. Companies are determining whether these disruptions are a “triggering event” that results in a decline in value for assets, such as goodwill and other intangibles. If an impairment assessment is warranted, the assumptions and cash flow forecasts used to test for impairment should be updated to reflect the potential impact of current market events. Budgets, forecasts and other assumptions should reflect the increased risk and uncertainty in the current environment.
- Equity and related incentive plans: Given the negative financial impacts of a declining market, companies are likely to reassess executive bonus payouts and equity incentive awards. Changing targets for equity plans or other terms for similar compensation arrangements may be considered a modification of an award. Companies that make such changes should assess whether they need to adjust related compensation expenses.
Companies need to consider tax implications of the market factors and business decisions related to COVID-19, as they can impact cash flows. For example, debt modifications may provide additional cash flow and headroom, but, in certain circumstances, such modifications may generate taxable income that would reduce the intended cash flow benefits. In addition, both sellers and buyers should consider the many tax-related provisions of the new federal Coronavirus Aid, Relief, and Economic Security (CARES) Act. Such benefits include the following:
- The ability to carry net operating losses from 2018 to 2020 back for five years. Before the CARES Act, those losses could not be carried back.
- The ability to calculate the interest limitation for 2019 and 2020 based on 50% of EBITDA instead of 30% of EBITDA.
- For signed deals that are working toward closing, these tax benefits should be quantified. It should be determined whether the seller or the buyer is entitled to those benefits under the transaction documents.
- For deals that are still being negotiated, these tax benefits should be quantified. The seller and buyer should negotiate to determine which party is entitled to the economics of the tax benefits.
For most of us, COVID-19’s impact is one of the most complicated and concerning situations we’ve ever faced, and it is likely to continue evolving. As companies navigate this uncharted landscape, we’ll continue sharing insights and guidance that hopefully will help make this incredibly complex environment more manageable.