Distressed M&A and ''new'' types of transactions

By Luiz Fleury, HLB Brazil

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The COVID-19 crisis has most dealmakers put a hold on deals activities. Current market volatility has caused a steep decline in investor confidence and has strategic acquirers lay low as M&A risks increase. Their priorities are with their companies’ portfolios and own operations, focusing on liquidity, cancelling or postponing acquire decisions. But distressed M&A also creates room for opportunistic transactions. In this article, we review what potential deal issues to look out for and alternatives for raising capital.

The impact of this scenario in M&A data is still incipient because the virus reached Europe and the Americas in the end of Q1. However it is already possible to see global M&A activity declining in 1Q20 39.1% by value versus 1Q19 reaching USD 563.7bn. We believe the decline in numbers is related due to pre-pandemic uncertainties with COVID-19 accelerating the decline further. This will become clearer in the coming quarters.

In comparison to other crisis in the past , it seems that the fast governments support, low interest rates, investors solid position, financial market strength and liquidity in balance sheets of global companies might make the recovery less traumatic for some sectors, depending on the duration of the situation. For sectors which are taking the harder hits, the entire value chain may never be the same post COVID-19 crisis. Some are expecting economic recovery in a U-shaped curve after a longer slowdown, while others foresee a V-shaped recovery. Regardless the speed of recovery, the evaluation in unemployment rates, low consumer spending and variance of capital structure between companies, it is inevitable that both businesses and individuals will find themselves in distressed situations in the foreseeable future.

Therefore, in the current business environment, opportunistic transactions are expected to emerge in key sectors and in special situations. But dealmakers on both seller and buyer side must be prepared and aware of the types of deals, new risks, process limitations and different forms of negotiation now at play to be able to take advantage of the opportunities that might arise. A short list with possible issues and alternatives was prepared to help you in deal discussions:

Potential issues to look out for

Anti-trust clearance: in a market with several business failures a buyer and a target position might be different than when negotiation began.

Closing: there are risks between signing and closing stronger in a fast-changing environment that can be mitigated using the signing price as a reference, but with adjustments in certain conditions in the closing.

Data rooms: populating data rooms could be an issue due to lockdowns and difficulty in accessing some documents in a remote mode can delay a deal. Sometimes it is not possible to gather all information, but an organised virtual data room can minimise this risk.

Due diligence: during crisis and specially in distressed transaction, buyers may be required to undertake limited due diligence in a shortened timeframe. Retention payment or scrow accounts can minimise it.

Key executives / employees: illness or quarantine can create issue to access key individuals.

Operational risk: Buyers should try to measure the impact of COVID-19 on supply chains, closer review of insurance policies, which could impact the discontinuation or renegotiation of contracts after the end of the coronavirus crisis or cause them to take more time than expected, risks related to the location of potential buyers or supply chain, as well as employee health measure procedures.

Post-merger integration: border closures, internal country mobility and team personal engagement actions have to be considered

Termination rights: Material Adverse Change (MAC) clause has to be clear, including possible unexpected situations related to coronavirus

Valuation: due to uncertain situations, earn-out can be an alternative with or without equity adjustments. Another way is to establish valuation caps and floors in the contracts.

Types of Capital Raising and Deals

Different types of deals usually increase in times of crisis, especially for distressed targets as follow:

Asset Backed Securities, Credit Assignment and Covered Bonds: it is not an equity instrument but depending on the situation, these structures can be an interesting funding source in difficult times which can be an option before any share sale.

Buy of Debt to gain control: in distressed situations some investors can buy a debt with a discount related to face value to negotiate with lenders and take control for a turnaround.

Buy inside formal insolvency: depending on the size of the target liabilities and legislation of each country, buyers of companies in distress may prefer to buy companies with a “protection” by the law related to succession of claims and encumbrances.

Cash Generating Unit Sales, Business Unit or Asset Sales: in distress, depending on the situation, buyers could be interested in a specific part of the firm to try to minimise potential liabilities or due to the fact that it could be faster in terms of due diligence and take the final decision.

Convertible Bonds / Loans: this instrument can be used with conversion terms in the beginning, giving protection to the buyer in terms of minimal interest rates and at the same time can be used to try to balance expectations between valuation. Also, there could be a clause to convert only if there is a liquidity event in the future such as an IPO or an expecting sale of the target.

Stake transactions: instead of the buyer acquiring 100% of the target, some players could prefer to buy just a stake to incur in less risk in this moment.

Strategic partnerships: considering the lack of certainty about the future before any equity transaction, a commercial agreement can be a first step.

Short-term bridge financing: some aggressive buyers can lend a short-term bridge finance to support the target and keep the target alive until the full closing of the deal.

While economic uncertainty endures, focus shifts to liquidity preservation, finding funding alternatives and development of a model with size of COVID-19 impact. Economic scenario analysis, industry forecasting to simulate stress test P&L and staying close to costumers and supply chain to understand their position in terms of liquidity. Be prepared for any type of capital raising organising information for transparency and develop a plan to achieve goals in the ‘’new normal’’. The one certainty we have about the current crisis is that it too shall pass.

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