This article was written together with Alberto Chocano.
Covid-19 is having a material impact on most economic sectors, including M&A, generating uncertainty and volatility in short- and medium-term economic expectations. Given that backdrop, it could prove challenging to align buyer and seller expectations, even if such a crisis brings significant opportunities to the market.
The banks, traditional financiers of M&A deals, have had to divert their attention from leveraged purchases to financing companies’ working capital needs. Investors have initially focused on managing their investment portfolio instead of pursuing new acquisitions. As a result, numerous deals have been delayed or canceled, while others are just sitting on the agenda.
However, the liquidity of the market has not disappeared, particularly in investment funds. It’s easy to foresee corporate operations gradually returning due to downward adjustments in asset valuations, companies needing to achieve liquidity through disposals and a more favorable market for buyers with resources.
In the coming months, the strongest assets – e.g. advanced technology or digital components – as well as businesses with barriers to entry will likely keep attracting interest from buyers, maintaining valuations near pre-Covid-19 levels. Nevertheless, mergers and acquisitions may move at different rates depending on sector and geography, as well as the severity of the crisis. The post-Covid-19 recovery will be much faster in sectors like retail food and healthcare, catching up with traditional M&A sooner. On the other hand, in other industries (e.g. travel and tourism and automotive) the number of operations in distress could continue to increase.
For transactions that are at the due diligence stage, an analysis of pandemic-related topics will play a critical role.
It’s important to carefully consider the impact of Covid-19 on business plan, budget and exposure to associated risks. Target companies are being forced to revisit pre-Covid-19 assumptions. The solvency of the target, its ability to service debt and the continuity of existing contracts with third parties (e.g. potential breaches) will determine the success of potential transaction.
Identification and assessment of pandemic-related risks through extensive due diligence will help ensure protection, specifically through representation and warranties in the purchase agreements.
When it comes to Covid-19’s impact on due diligence, the following questions should be addressed:
- What is the impact on the target’s revenues and profitability?
- Are the business plan assumptions reliable? How likely is it that the business plan will be achieved?
- Is there any impact on the working capital?
- What is the difference between the actual and potential liability exposure?
- What response plan is in place for the target’s employees?
- Is the target company able to deliver its financial statements and audits in a timely manner?
We will elaborate on the above areas in our next article.
Pricing mechanism and valuation
Covid-19 could also influence the choice of completion mechanism for the final purchase price. Pricing mechanisms were already heavily negotiated and subject to discussion before Covid-19.
It is unlikely that buyers will accept a locked-box mechanism with a date prior to the Covid-19 crisis as it will force them to absorb the risk of a possible decrease in value. Instead, buyers may prefer a completion accounts mechanism or, in case the locked-box mechanism was already agreed upon, a postponement of the locked-box date in order to reflect a more accurate picture of the company’s performance in the new environment.
In relation to the valuation, we can expect sellers to argue that their business fundamentals will be unaffected by the pandemic. On the other hand, buyers could opt to implement certain clauses in the purchase agreement to protect their positions. For example, buyers can propose deferring the payment of part of the purchase price with earn-outs. These earn-outs are contingent on the target business’s performance after closing and will split the business risk during the earn-out period.
For now, these are our general observations regarding Covid-19’s impact on M&A transactions. As the business and regulatory environment during this pandemic further evolve, additional concerns or issues may arise.
We will continue sharing insight to help make this complex environment more manageable. Stay tuned for specific information on key due diligence areas affected by Covid-19.
Get in touch:
If you have any questions or would like additional advice, please contact us.
At KPMG Luxembourg we have a dedicated due diligence team specializing in local and cross-border transactions. We have a substantive track record of assisting and advising boards, corporate development teams and private equity houses on transactions. We are also part of the Global KPMG Deal Advisory network and leverage its experts, market insights and tools. Visit our website for more information.