Doing deals – Some thoughts for fund managers in the midst and aftermath of COVID-19

By John Bellew, Head of Private Equity, Bowmans

The first article in this series looked at how managers should look after their portfolio companies, especially as regards their financing arrangements and the injection of follow-on equity. However, although fund managers have their hands full in preserving value in their existing portfolio companies that does not mean that deal-making should be put entirely on hold.

The fall-out from the Corona crisis is going to lead to exciting buying opportunities as solid but potentially over-geared or otherwise cash-strapped companies look for fresh equity injections to put themselves back on a stable financial footing. Also, some deals may be far advanced and buyers and sellers may wish to finalise their negotiations and move to completion. In this article, the second of two, I will focus on some key commercial issues to consider when doing deals during and in the immediate aftermath of COVID 19. The list is by no means exhaustive or of universal application, but hopefully provides useful pointers and a possible toolkit of solutions.

Why continue with a deal?

This is possibly the most fundamental question a manager should ask itself right now. If there are not compelling reasons to proceed it is wise to put the process on hold and see how things pan out. There is an enormous amount of ‘dry powder’ sitting in private equity funds across the continent now, and many funds still have a number of years in their commitment period within which to invest. Limited partners may also be amenable to extending commitment periods given that transacting is difficult in the current environment.

So why go ahead? Factors that would suggest that the show should go on could include one or more of the following:

– The degree to which the target company is insulated from the direct or indirect effects of the virus. As in any crisis there will be winners and losers – some businesses will thrive but others will be heavily knocked back. If your target is rendering an essential service, or the demand for its products is inelastic, there may be no need to press the pause button

– The extent to which the economic impact on the target is likely to be limited. So, for example, if the sale of alcohol is prohibited for 30 days, the impact is likely to be temporary as underlying demand is unlikely to change fundamentally (yes this is a bad example given many funds investment restrictions, but it illustrates the point)

– The perceived potential for a rapid recovery with the injection of capital and skills

– Whether the company is a leader in its sector

– The extent to which the real driver for the acquisition is the attainment of a long term strategic objective. This could apply in the context of a platform play where the acquisition fills an essential gap in the platform, or where it is essential to a backward or forward integration strategy. In these cases the acquisition has a ripple effect through the platform and if the target is a solid business the risks of losing the deal may outweigh short term considerations

– The ability to mitigate risk by adjusting pricing, by staggering the acquisition, by introducing co-investors into the deal or other creative solutions

– The extent to which the seller is a forced seller. These situations could potentially include end of fund disposals or sales of business divisions to raise cash to repay debt.

Areas of focus in uncertain times

There are a few key areas of additional focus and negotiation in a time of crisis. Clearly buyers and sellers are likely to have opposing outlooks on these issues and an ability to find middle ground will be key.

Firstly, in an uncertain environment due diligence assumes even greater importance than normal, and may need to extend to an analysis of the financial health of key customers and suppliers, whose collapse would have a serious impact on the business, and on key contracts.

Secondly, pricing expectations on the buyer side will have moved downwards. Sellers may acknowledge that their businesses are worth less, but the potential for growing pricing gaps is real.

Deals are typically priced either on a locked box basis or on the basis of completion accounts to be prepared in the future and which adjust an initial price recorded in the agreement.

In a locked box the parties determine price by reference to an agreed historic set of financial statements. The purchaser assumes risk and benefit and is contractually entitled to profits and losses, from that date. The seller receives interest (or a similar purchase price adjustment) from the locked box date to closing, but may not extract any dividends or other amounts (defined typically as ‘leakage’) from that date. It goes without saying that locking the box at a date preceding the pandemic is highly risky from a purchaser’s perspective, as historic financial performance may not seriously affected.

Where pricing is determined by reference to completion accounts, a base price is included in the sale agreement but the final price is determined by completion accounts to be prepared. The intention is to verify that the actual financial position of the target company at completion is in fact what the parties expected when, on the basis of historic financial information, they signed the deal. Completion accounts are more risky from a seller perspective if the business is likely to be adversely affected by the pandemic.

Given the pricing risk for both buyer and seller, particular attention should be given to those clauses of the sale agreement governing interim conduct of the business between signing and completion. Having due regard to anti-trust concerns, the buyer should have as much insight into the running of the business as possible, especially as urgent interventions that are not strictly ‘ordinary course’ may be required to mitigate the effects of the crisis.

Close consideration also needs to be given to material adverse change (or MAC) provisions. These provisions typically entitle a buyer to either renegotiate price or walk away in the event of a material adverse change happening between signature and completion. MACs are a topic on their own, but typically there is a lot of negotiation over whether the MAC is business specific or whether it encompasses general changes in the economy. The impact of COVID-19 on the ability of a buyer to call a MAC is a key negotiating point and buyers and sellers would do well to define carefully the financial impacts that would constitute a MAC in their deal. Excluding a MAC is unlikely in the current environment.

Whilst a MAC can mitigate risk for a purchaser, creative pricing solutions could also be employed to help bridge the pricing gap. These could include splitting the deal into a number of tranches, each priced off the same multiple but hopefully, from a seller perspective, increased earnings. Provision could also be made for a so-called ‘agterskot’ if earnings exceed a base number, thus rewarding the sellers for a quick bounce back. The seller could also offer profit warranties which, if not met, would lead to a price reduction.

Thirdly, from a buyer’s point of view, there needs to be much more focus on business warranties. Key warranties to consider reinforcing and requiring to be given on an unqualified basis include the enforceability of key contracts, no breaches of key contracts, no changes to ordinary course of business (for example accelerating debtors through early settlement discounts whilst delaying creditors), deduction and payment of taxes and contributions to medical aid or retirement funds and the maintenance of insurance policies. These are all areas where a company in distress may seek short-cuts. Although in many deals a lot of these warranties will be insured via warranty and indemnity insurance, there is merit in making sure that the sellers place some of their price at risk in addition to the warranty insurance. This could be by filling the gap between an unqualified warranty and one that an insurer is only prepared to insure on a knowledge basis, by having the sellers be liable for retention amounts or for warranty claims above the limit insured.

Finally, consideration should be given in these times to an ‘anti-embarrassment clause’. This clause provides that if the buyer flips the business within a short period at a higher price, a top-up is payable to the sellers.

Bowmans is a leading corporate law firm with a highly skilled team, track record and geographical footprint to provide both upstream and downstream services to the private equity sector in Africa. www.bowmanslaw.com/service/private-equity