By Lucinda Chen and Victor Yan
- General M&A Market Overview
- Material Adverse Changes (MAC) and Adapting Contracts
- Fundamental Changes In Deal Process
- Valuation Modelling During COVID-19
- Buyer vs Seller Leverage
- Regulatory Concerns
General M&A Market Overview
A decade-long boom in mergers and acquisitions has been brought to a halt amidst the far-reaching impact the coronavirus has had globally. This follows a strong year of global M&A in 2019, which remained resilient even with the threat of a global recession, trade disputes and growing national security and competition concerns. Many deals are being delayed or cancelled, with activity in 2020 being affected both by COVID-19’s impact on capital markets and the economy, as well as the logistical impacts physical restrictions and issues surrounding information transmission have caused. Underpinning this decline in M&A activity has been the major uncertainty businesses face regarding the depth/length of an anticipated downturn and concurrently the type of economic recovery ahead (V-, U-, W-, L-shaped).
Whilst major deals have been announced in the past few months, on the whole new M&A activity has slowed dramatically. Companies face difficulty in forecasting the potential of deals and obtaining reliable prices, with the more pressing need for cash causing a shift in focus from ambitious expansion plans to keeping current operations afloat. The overall value of deals in the first quarter fell 28% from a year ago, the weakest year-opening period since 2016, which was led by a major reduction in US activity.
Whilst sales processes have been put on hold for the time being, a large portion of these are likely to fall through, as evidenced by signed transactions which have fallen apart during these unprecedented times. Just recently, Sycamore Partners and the owner of Victoria’s Secret called off a $525 million sale which would have given US private equity group Sycamore a majority stake in the retailer – averting a legal battle over disagreements regarding operational decisions in current times. Other cancelled transactions include Xerox ending its $35 billion hostile bid for rival print maker HP due to the ‘macroeconomic and market turmoil having created an environment not conducive to continuing an acquisition’, and the termination of a multi billion-dollar merger between aerospace companies Woodward and Hexcel owing to the ‘inability to realise benefits’ as well as a need for both companies to ’focus on their respective businesses’.
As the saying goes, cash is king right now. Wilhelm Schulz, chairman EMEA M&A at Citigroup put this bluntly, stating “It’s all about liquidity, liquidity, liquidity”. With declining revenues, companies are currently prioritising liquidity to fuel operations in the face of supply chain issues, falling demand etc. The tightening of capital markets and debt financing, along with business closures and limitations, has prompted a surge in requests for lending and drawing down of credit lines. Rather than putting this increased available cash to use for growth opportunities, companies are preferring to sit on this in order to ride out the downturn and be prepared for whatever may come next. 63% of M&A deals terminated since the pandemic declaration were all-cash deals (as of April 7). It is likely there will be fewer cash deals to come, as companies focus on the safety of their businesses and employees.
Material Adverse Changes and Adapting Contracts
With the unpredictable and sudden effects of the pandemic disrupting transactions, parties may be seeking to invoke certain clauses within contracts – one such being the material adverse change (MAC) clause. A MAC clause enables a buyer of a transaction to back out of a deal in the event of a materially adverse effect on the business, financial performance or operations of the target during the post-signing and pre-closing period.
There has been much debate over whether the pandemic constitutes a MAC under existing contracts. These provisions have been generally interpreted quite narrowly and ultimately each case will differ based on the specific wording of the contract provision and the particular effects a company faces. For instance, a buyer could argue the disproportionate long-term impact on performance COVID-19 may have on a target business relative to other industry participants, thus triggering the MAC clause.
Whilst it is unclear whether the current outbreak satisfies this clause in differing contracts, what is certain is that contracts will continue to adapt to changing circumstances. Buyers are requiring greater security, and it is expected the inclusion of MAC clauses that address the risk of COVID-19 will become increasingly prevalent.
Fundamental Changes In Deal Process
Not only is the general M&A market poised to be impacted by COVID-19, but also the due diligence and process of deal-making. While these corporate financial activities are largely viewed as straight transactional decisions dictated by economic incentives, there still belies within a human process in which M&A deals materialize from.
For one, a heavy emphasis of understanding and maintaining interpersonal connection between key management from the involved companies is severely restricted, as compliance with safety guidelines will make it difficult to travel and meet, particularly if the bidder and target companies are internationally distanced. For example, travelling from Melbourne to meet with a bidder company in China will result in a mandatory quarantine and compliance with a new set of governmental safety regulations just to meet with management (as well as another strict-quarantine coming back into Australia, potentially resulting in a whole month of quarantine sacrificed for one face-to-face meeting).
Moreover, this same logic would apply towards physical on-site examinations that bidder companies often conduct towards a target company as part of their due diligence process. As these examinations are normally used to convey fundamental information about a company’s operations, as well as allow the bidder to verify the information provided by the target, their absence will likely hamper the deal process on grounds of reduced information and uncertainty as to the accuracy of present information.
Finally, a risk of contracting the virus from management on the other side of the table could easily turn a potential deal sour, as it can serve as a catalyst for social mistrust between stakeholders within these companies. After all, using the example of a merger, why would you want to work alongside someone who just gave you the coronavirus for the foreseeable future?
Of course, the obvious solution until life gets back to normal is to adopt technology as a viable substitute. With friends, universities and businesses using online services such as Zoom to virtually communicate, the same should apply towards the investment banking industry, who will need to grow comfortable with using such means to keep the deals flowing. Yet, in M&A where the ability to read management is critical, nuanced communication such as body language, eye contact and other non-verbal cues are much harder to interpret (not to mention under the constant threat of the internet connection imploding). As such, involved parties will likely have to hold more inefficient meetings in order to get a deal to close.
Valuation Modelling During COVID-19
With the crisis impacting a multitude of business factors, this creates major implications for
the mechanisms used within deal making. Valuation gaps between buyers and sellers may be exacerbated due to the uncertainty associated with the short and long-term impact COVID-19. As such, businesses face key challenges in establishing the value of a target and will need to consider what factors may be temporary or what could potentially become permanent in future growth prospects. Whilst fundamental principles regarding uncertainty still apply (in terms of a disciplined approach to forecast scenarios), traditional valuation methods may be ineffective in the current environment and models will need to be more fluid and adaptive than ever before.
Valuations based on historical financial information may not accurately reflect current business circumstances as companies face disrupted supply chains and distorted accounts receivables. Determining a working capital reference point will therefore be challenging as there are many unknowns which impact the timing of revenue normalisation and collectability of receivables.
Alternatively, for valuations based on projected free cash flows and earnings of a business, there will be difficulties around accurately assessing earnings generation capability and the expected timing of a recovery. Dealmakers will need to consider the revenue and solvency impacts within certain industries, as these will have key effects on cash reserves and costs of financing. Whilst it is evidently difficult to forecast the effects COVID-19 will continue to have, cash flow risks will need to be carefully evaluated when determining an appropriate discount rate.
Buyer vs Seller Leverage
Overall, it seems that the COVID-19 impacted M&A market is fairly bearish with investment banks retreating into hibernation, not to mention added complexities due the need to acclimatise to new deal processes and procedures, as well as a new revision towards valuation methodology.
Despite this, the perpetual seesaw of the M&A universe between buyers and sellers has seen leverage shifted towards the buyer-side due to this COVID-19 episode. Following valuation logic, the general fall in market capitalizations across companies should see those with high reserves being able to acquire potential targets on the cheap. Fundamentally, the idea of M&A activity is to generate synergies that see the consolidated entity achieve strategic agendas beyond the reach of their individual parts. Simple math will dictate that generating comparable synergies for a cheaper cost will equate to higher returns once the economy emerges from its recession.
Moreover, buyers are likely able to flex their negotiating muscle to whittle down the acquisition premiums typically paid for a target. This should come as particularly exciting news for private equity firms who are often called upon to pay enormous premiums above base value due to their debt-fuelled acquisitions. After all, shareholders of a struggling target company would likely rather have a lower premium received for being acquired, then their company reject a bid offer and eventually file for bankruptcy – causing their held shares to drop to zero.
As backdated analysis by EY entails, activist acquirers during a weak economy have outperformed those who do not with a median growth of 6.6% over 3 years for the former, compared with 1.7% for the latter.
However, this does not simply mean having a war chest of “dry-powder” during COVID-19 gets you easy results in the M&A market. As mentioned previously with M&A valuation model changes, the present environment of changing data and unknown future cash flows has led to immense difficulty in a reliable target company valuation. Thus, while everything is seemingly on the cheap, there is a tradeoff of higher uncertainty such that buyers need to make sure that they have doubled down on a strong acquisition thesis and due diligence before signing off their names at the bottom of the page. Borrowing from an apt Warren Buffet analogy, “There are no called strikes on Wall Street. You don’t have to swing at everything – you can wait for your pitch”.
On top of any sort of merger or acquisition thesis comes needed considerations for the current regulatory landscape. As stressed by anti-monopoly regulators, the present circumstances dictate that few well positioned buyers are in prime position to merge/acquire other entities to improve their strategic position in the market – overall endowing themselves with a higher degree of monopoly power. As one example, Uber’s recent offer to horizontally acquire U.S online delivery service Grubhub could potentially see a higher power concentration for Uber in the food-delivery market.
Policy makers and competition regulators have taken notice of these risks and have made efforts to protect consumer interests. In the U.S. where large tech companies could use the current climate to eat up their smaller competition, senators Alexandria Ocasio-Cortez (AOC) and Elizabeth Warren propose the “Pandemic Anti-Monopoly Act” to freeze large mergers and acquisitions during COVID-19.
Similarly in Australia, the ACCC body has stated that potential acquirers shouldn’t expect a “free pass” on merger clearance during the pandemic, as they place emphasis on the “longer term impact on competition of any change in the structure of markets”. As such, M&A players should consider an early and coordinated engagement with organizations such as ACCC and FIRB to reduce the risk of triggering delays and opposition.
The crisis has not only caused deal activity to dramatically slowdown, but it has also fundamentally changed the way M&A processes and valuation is, and will continue to be conducted in the foreseeable future. The current corporate focus is on building up cash reserves and strengthening balance sheets, rather than expansion and growth plans. However, companies which have corrected their immediate debt and liquidity issues with a good stash of cash reserves can see the COVID-19 episode as a fruitful opportunity to strategically acquire assets, and emerge out of the crisis stronger than ever before.
Whilst market dynamics have shifted in favour of buyers through falling market capitalisations and potentially cheaper acquisition opportunities, buyers will be requiring more information to bridge data gaps and manage risks of transactions in this current environment – which will consequently feed back into MAC clauses. The global economic decline is causing companies to change strategies and approaches, implying a change in M&A valuation models to adjust towards “the new normal”.
Zoom Conversation with Tomas Kemptys of Contrarian Ventures
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Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a professional before making investment decisions based off of this article.