Distressed M&A Dealmaking during the Covid-19 Crisis

Image by Frans Ruiter

by Jerome Fogel

There are deals to be made during the COVID-19 crisis. Doing this well requires a tailored approach, shaped by current forces and trends. What follows is a brief overview of them, followed by a call to redemptive action.

The Market Impact 

The hardest-hit areas include energy, retail, restaurants, traditional entertainment, hospitality, travel, auto manufacturing, and home construction. 

That said, opportunities include telemedicine, direct to consumer/distribution, commercial cleaning technology, software applications, entertainment (online gaming, esports, animation), remote working technology, community-based platforms, and online learning.

The Market Response

Analysts predict an estimated 20-30% drop in GDP (and some higher) for Q2, and the stock market has priced that into its models. That said, the market going forward will continue to attempt to accurately price the disruption of COVID-19. Volatility will continue. This creates more action in the small and middle-market as money moves from the volatility of public markets to private markets. 

Business Response

Businesses are focused on workforce and supply chain stability, customer engagement, ongoing working capital requirements, business retooling, workplace and customer safety, innovation, and strategy. 

Mergers and Acquisitions Dealmaking

Here are some of the trends to expect in mergers and acquisitions:

Deal Flow Will Be Slow – Social distancing has two effects: it slows the relational dynamics that kickstart deals and throws a wrench into on site due diligence plans. However, where states and counties begin reopening, M&A activity will return. There are also tightening credit markets for M&A financing. So, expect at least 1 or 2 quarters of holding patterns for many transactions. 

Reduced Seller Expectations - On the other hand, the market is reining in seller expectations, which now fall more in line with buyer expectations. And opportunistic buyers are actively canvassing for value-based targets that are looking for a life preserver. 

Preference for Cash vs. Stock Deals - Targets likely will want cash vs. stock in an uncertain environment. Typical backend restricted stock offers are less appealing for sellers seeking the certainty of upfront cash. Earn-outs will continue to be a hot topic.

Negotiations 

What’s “market” is more fluid as businesses adjust and adapt to the new environment. Some deal terms will be heavily negotiated that include:

Explicit Language for COVID-19 Risk Allocation – Sellers will push for COVID-19 risk to fall on buyers, and vice versa – but parties will need to come to a meeting of the minds tailored to each transaction. The solution is thoughtful, fair, and explicit language for COVID-19 risk allocation.

Reps & Warranties – Expect discussion around emergency planning and business continuity (employee and labor, occupational safety, internal financial and disclosure controls, regulatory compliance, SEC reporting, business interruption insurance, IT, inventory, customer and supply chain, material contracts, undisclosed liabilities). And by the time parties get to signing, the seller may already have experienced multiple material changes to the business.  The seller’s business may be moving target that is hard to pin down.

Reverse Break-Up Fee - Expect sellers to protect themselves with significant reverse break-up fees if the buyer’s financing falls through.

Increased Due Diligence - Expect slowdown of the due diligence process and increased scrutiny of 2020 financials.

Interim Operating Covenants – Expect spirited discussions over such items as liquidity, debt levels, working capital, and human capital. 

Termination Rights – Expect lively debate on what triggers buyer’s termination right to the deal. The action will center around pre-closing key performance indicators.  

Insurance – Buyers should examine coverage very closely as well as the target’s business interruption insurance. 

Lenders/Financing – Review credit agreements and other loan documents to avoid “foot faults,” minor violations which nonetheless require a waiver from the bank. Credit agreements require notification of material adverse effect, material casualty events, material litigation, or loss/breach of material contracts. Examples include borrower receives a notice that a material customer is terminating its contract; borrower makes a claim on business interruption insurance; or borrower receives service of process in connection with a lawsuit. 

Material Contracts – Companies who are the subject of a potential acquisition should evaluate credit agreements before waiving material terms.

Force Majeure – Expect new normal of additional negotiations of force majeure clauses in deal terms, executive employment agreements, and other material agreements. 

Savvy buyers who are making a strategic acquisition have an opportunity to create long-term value from and for companies in distress. And sellers of privately held companies who are looking to hedge their position by cashing out all or some of their interest can expect lucrative returns in areas where there is market growth and tempered returns where there is market contraction. This presents a great opportunity. God is the great Redeemer, and thus the goal can be more than simply maximizing deal value.  Parties can look for the greater good of all stakeholders – employees, shareholders, vendors, sellers, buyers, and the cities where these companies reside. And so, the distressed dealmaker can also become the redemptive one.

FOR MORE INFORMATION ON COVID-19, PLEASE SEE OUR PAGE HIGHLIGHTING SOME OF THE BEST RESOURCES OUT THERE FOR FAITH DRIVEN INVESTORS & ENTREPRENEURS IN THIS SEASON.