Coming into 2020, the U.S. M&A market was robust and the general consensus was that 2020 would be another year of significant M&A activity. Half-way through the year, it is clear that the market uncertainties caused by the Covid-19 pandemic have resulted in a noticeable downturn in M&A activity, whether measured by volume or by number of transactions. When and how the market will recover to its pre-Covid levels is anyone’s guess, but in the meantime, we expect to see more distressed M&A transactions.
The far-reaching economic impacts of the Covid-19 pandemic have left many companies unable to withstand the coming recession without taking unanticipated actions, such as drastic cost slashing (e.g., closing a plant or laying off employees) or seeking an infusion of cash (e.g., carving out businesses or assets to sell). While the phrase “distressed deals” typically brings to mind Section 363 bankruptcy sales, distressed deals come in all shapes and sizes. For purposes of this article, we define distressed deals as any out-of-court deal where a seller is motivated to sell quickly and at a price less than what the seller would have preferred given normal market conditions.
How closely these deals resemble “traditional” M&A deals between willing sellers and willing buyers will depend in large part on what is driving the seller to sell. A seller facing an immediate loan covenant default may be forced to accept more onerous terms than a seller choosing to proactively divest underperforming assets. In either case, a buyer may see this as an opportunity acquire and turn around a struggling business, or as a chance to pick up trained employees or useful assets.
Impact on deal process and deal terms
While Covid-19 has impacted nearly all industries, some industries are struggling more than others. Deal terms will likely vary depending on the industry, emphasizing the importance of having an experienced and savvy deal team familiar with the industry and the target’s business (including industry-specific impacts and operational changes, and the target’s general compliance with rapidly-changing laws, executive orders, and regulations). Deal teams will need to focus on a varied array of Covid-19 impacts, including employee disruption and lowered morale, supply chain impacts, ability to comply with physical-distancing mandates, immediate capital requirements, and forecasted future impacts on the target’s industry.
Given the importance of cash and “certainty of closing” to sellers, cash-rich buyers are well positioned to complete a distressed deal and may even be able to use the promise of an immediate cash infusion as leverage to negotiate a lower purchase price or more favorable deal terms or structure. In exchange, a buyer may need to move quickly in order to meet a seller’s (or its creditor’s) timeline. The buyer may not have time to implement its standard diligence process or perform an in-depth diligence review and will need to keep its team flexible and focused and take advance of deal structures that may insulate the buyer against unforeseen liabilities. For that reason, distressed deals are often structured as asset deals, which may have negative tax consequences for the seller and may require significant third-party consents.
Sellers are likely to focus on limiting closing conditions where possible and will prefer buyers with available cash and those that would not trigger a CFIUS or contentious antitrust review. Where a simultaneous sign and close is not possible, the parties will need to be strategic and flexible in terms of interim operating covenants, and tailor such covenants to the industry and circumstances at hand. In addition, the parties will need to ensure that the target business has sufficient capital to operate during the interim period.
2. Contingent consideration
With uncertain or unfavorable valuations and forecasts, buyers and sellers may agree to purchase price structures that involve earnouts or other forms of contingent consideration. Sellers typically resist contingent consideration because they have limited control over the target business’ ability to achieve the earn-out metrics and would prefer to maximize up-front cash; however, given the choice between a lower purchase price or the possibility of deferred consideration, sellers may be willing to accept an earn-out structure.
3. Indemnities and risk allocation
In some cases, particularly those where the seller will not continue as a going-concern or will have limited capital post-closing, distressed deals may involve little to no post-closing protection for buyers. The result is substantial pressure on buyers to complete a thorough due diligence process, which may not be possible as discussed above. However, buyers may still seek indemnification from sellers, including special indemnities for any losses related to identified liabilities or risk areas that were not thoroughly investigated. A buyer will want to have an escrow or a holdback to fund any seller indemnity obligations.
If there is time to complete the underwriting diligence process, Buyers can also purchase representations and warranties insurance (RWI), which can serve either as the sole source of recovery or as an additional layer of protection above whatever indemnification a seller may be able or willing to offer. In some cases, an RWI policy may include “synthetic representations,” which are representations that are not otherwise included in the purchase agreement. Successor liability, fraudulent conveyance, and other contingent risk insurance may also be available.
4. Integration and post-closing operations
The success of a deal depends on the ability of the buyer to integrate the acquired business into its existing operations and recognize the expected synergies. Distressed assets are generally harder to integrate; and the pandemic is complicating this already complicated task. Buyers need to consider integration issues throughout the process. For example, if the target business is a products business, the buyer should carefully consider what resources (including transition services from the seller, if the seller is in a position to offer them) are needed to continue the manufacturing and sale of products immediately after closing. This is especially important given Covid-19-related delays and supply chain interruptions. Likewise, if a business’ relationships with its customers and/or suppliers have been negatively impacted as a result of payment or performance defaults or other issues, the buyer will need to be prepared to win back customers and smooth over any issues with suppliers.
Similarly, remote work and back-to-work policies and procedures will hamper integration efforts and restrict traditional all-hands meetings, happy hours, and water-cooler mingling. Buyers will need to consider the impact of forced physical separation on integration and adaptation of the acquired employees to the buyer’s culture and may need to find creative ways to incentivize key employees to remain with the business post-closing.
1. The economic uncertainty caused by Covid-19 is likely to result in an uptick in the number of distressed deals.
2. Sellers will want to expedite the sale process to obtain quick access to cash, but buyers should take the time to complete a thorough diligence process and consider whether RWI or other transaction risk insurance is available.
3. The impact of the pandemic on M&A activity is likely to lead to a “buyer’s market” for the first time in years. Motivated sellers will likely need to agree to contingent consideration, offer higher escrows, or agree to other “buyer-friendly” deal terms.
— Karen Hermann and Scott Rissmiller, a partner and senior associate, respectively, in Venable’s corporate group, contributed to this article.