As the world grapples with the pandemic, buyers and sellers find themselves in a drastically altered marketplace. The disruptions brought forth by COVID-19 have been unprecedented and will significantly alter how parties approach M&A transactions going forward. In this article, we share some of our insights on how deal dynamics can be expected to evolve as the economic downturn continues to take effect and governments cautiously attempt to ease some of the restrictions on our economies.
Gowling WLG Focus
The sheer magnitude of the disruptions caused by COVID-19 has temporarily frozen many deals. Uncertainty has led both buyers and sellers to delay or terminate many M&A transactions. Deals contingent upon financing are especially at risk, as lenders have grown hesitant to fund new transactions and have instead shifted their priorities to the day-to-day handling of existing loan portfolios and other complications arising out of the pandemic. Deal dynamics have changed considerably and will continue to evolve as the effects of the pandemic are felt across the economy.
What Might We Expect?
Muted M&A deal activity
The economic downturn that we are experiencing as a result of the unprecedented social distancing efforts imposed in many jurisdictions around the world is unique. It remains to be seen how it will impact M&A activity both in Canada and beyond. If past downturns are instructive, we can anticipate a decline in overall deal volume but not a precipitous one and we can still expect substantial transaction activity. For example, drawing upon data from the last recession brought on by the financial crisis in 2008, there were still over 170 reported M&A deals in Canada in the worst quarter following the start of that economic downturn. By the following year deal volumes had substantially recovered to pre-crisis levels (1,132 reported in 2008, 927 reported in 2009 and 1,130 reported in 2010).
According to Crosbie & Co., deal activity in Canada was up slightly in the first quarter of 2020 to 797 announced transactions. This included March, much of which transpired after the COVID-19 crisis started to take effect. If history teaches us, we can anticipate some challenging months ahead but we can also expect that M&A markets will be resilient.
There are other unique factors dampening activity in the near term. Social distancing protocols have challenged some deal activity, limiting the conduct of some due diligence activities and adding logistical constraints to matters such as court, shareholder and regulatory approvals. Deal professionals have already found creative ways to address these challenges. We anticipate well-positioned buyers are likely to push much of the additional deal risk posed by these challenges to the sellers.
A marketplace where "cash is king"
In the near term, buyers with significant reserves of cash will reign supreme. In this market, such buyers will be able to leverage their position to obtain more favourable deal terms. We expect cash rich buyers to use that leverage to impose greater deal risk on sellers. How this is addressed in a particular transaction will be deal specific and fact dependant. Regardless, we anticipate these buyers will flex their muscle to seek larger escrows and holdbacks, more aggressive price reduction mechanisms, broader representation and warranty coverage, more favourable indemnity arrangements and fewer earn-outs.
As lenders remain preoccupied, buyers typically dependent on leveraged financings will be challenged. They will need to be creative to compete with cash rich buyers. We expect private equity and other groups with deal strategies typically dependent on debt to seek other ways to bridge the gap. This may include deals with a much larger equity component with a goal to refinance at a future date when debt markets have stabilized. These buyers may also pursue larger vendor take-back arrangements with sellers.
From a seller's perspective, those with limited cash reserves are likely the most at risk. We anticipate that most sellers will attempt to delay or find ways to buy time. They will want to defer a sale transaction to a later date when economic conditions have stabilized and their business has a chance to recover. In the interim, many may seek co-investors or other equity or debt financing from a variety of sources. Historically low interest rates may help for some sellers with sufficient collateral. A range of government programs have also been announced to help businesses to weather the economic storm presented by the pandemic. We have consolidated details regarding federal and provincial assistance that is currently available here.
For those sellers without interim financing options nor sufficient cash to weather the downturn, a prompt sale, either in the ordinary course or as part of a restructuring proceeding, may be the only option.
Addressing valuation challenges
For most sectors, we anticipate a much more buyer-friendly world to emerge in this new economic environment. Going forward, deal valuations are expected to be muted in most sectors where the lockdown has materially impacted business. A number of factors are likely to have a negative impact on deal valuations for some time.
- While there has been some recovery, we have seen substantial declines in most public market indices in recent weeks. As a result, M&A deal valuations tied to metrics associated with listed company comparables will be negatively impacted as well.
- Another factor will be fewer buyers in the market. Less competition will mean less pressure to push up deal valuations, fewer auction-style M&A processes and a smaller pool of bidders in such processes.
- Probably the biggest drag on valuations will arise from the negative impact the shutdown has had on key financial metrics. Whether valuation is tied to revenue growth, profit, EBITDA or some other measure, in most cases the pandemic will have negatively impacted them. Some sellers will get creative and suggest metrics for adjustments to take into account the pandemic. Regardless, buyers will be reluctant to take on risks where it is not clear whether the pandemic has only had a short-term impact on the business or instead a more permanent adjustment is necessary. We can certainly expect more scrutiny regarding the financial status of a target's customers.
For sellers, the focus will be on re-establishing value to pre-pandemic levels – particularly for those disproportionately impacted by COVID-19. Sellers may be well served to delay transactions until they have a good handle on the impact that the pandemic and the impact the economic downturn has had on their business. Sellers who do transactions in the near term will want to negotiate for longer earn-out periods such that the company is able to recoup some of its lost value over time. Provided they have confidence in the buyer and the strength of its business, sellers may also consider accepting a purchase price partially paid by way of share consideration, so that they are able to recover some value after closing.
To bridge valuation differences between buyers and sellers, negotiations may turn to a number of options. Assuming the seller will remain engaged with the business post closing, perhaps a buyer is prepared to agree to a longer-term earn-out to give a seller or its principals the chance to participate in the future growth of the business as it recovers post pandemic. A buyer may be prepared to offer some sort of equity participation rights to the seller as a means of giving the seller an opportunity to gain some further upside.
Cross border considerations
The vast majority of Canadian M&A deals have some cross border component. This may include a foreign seller or buyer, a group of non-Canadian investors or a lending syndicate based outside of Canada. Most cross border deals in Canada will involve the United States. As of the middle of April, the Canadian dollar exchange rate is at more than a three year low as compared to the US dollar. In past experiences involving a material currency exchange rate correction we have seen a significant inflow of US and other foreign buyers seeking out Canadian target businesses at a discount. We can anticipate a similar experience in the near term while the Canadian dollar remains low as compared to the US dollar.
Foreign buyers must be mindful of regulatory issues. The Canadian government recently announced that it will apply enhanced scrutiny to foreign direct investments in certain businesses, and to all foreign investments by state-owned investors. Enhanced scrutiny may involve Investment Review Division staff "requesting additional information or extensions of timelines for review" under the Investment Canada Act. This approach will continue to apply until "the economy recovers from the effects of the COVID-19 pandemic." For further details, see our MarketCaps article here.
Distressed M&A deals
Sellers may not control their own destiny in the current environment. We expect there will be a number of "walking wounded" resulting from the pandemic. Some creditors may show patience with defaulting borrowers but others may not. If impatient creditors do not see swift action in the form of an M&A deal on the part of the target business or otherwise, we expect creditors will be quick to consider their own options to force some combination of a sale or repayment. This anticipated crunch on sellers will be an additional challenge in the sale process as buyers will also have options by way of distressed deals.
Sellers can use the current economic "pause" to prepare for a potential M&A transaction. See our article here for many of the steps that can be taken now to prepare a business for future sale. Being prepared for that transaction gives a seller the best chance to maximize the transaction for the seller and other stakeholders (in particular creditors) in the business. Not being prepared can risk losing control of the process when a creditor or other stakeholder forces matters.
The use of formal insolvency and restructuring proceedings, such as a Bankruptcy and Insolvency Act proposal, Companies' Creditors Arrangement Act proceedings, or receivership provide additional opportunities and challenges for buyers and sellers. Broad representations and warranties for buyers are often unavailable in such proceedings, and there is often a limited time to conduct due diligence. There may also be less deal certainty. On the other hand, vesting orders may be available from the court to provide buyers with assurance that the purchased assets are free and clear of all claims.
Whether distressed M&A commences due to formal restructuring processes or by negotiation, cash rich buyers will likely have opportunities to pursue M&A transactions on favourable terms and in an environment that likely involves more limited competition. However, cash rich buyers need to be aware that having ample "dry powder" is not enough to be the successful bidder in a distressed M&A process, whether that process is consensually started by the seller or forced on the seller by other stakeholders in the target business.
The exercise of finding deals and developing a strategic approach to the target business can make the difference between failure and success. Knowing the relevant players (in the target's industry, the target's management, the target's equity holders and among the restructuring community) and considering strategies such as whether or not a buyer should be a "stalking horse" bidder, can give a buyer a distinct advantage. Each strategy needs to be "bespoke" depending on the circumstances of the seller and the urgency of the sale. The assessment of these circumstances with the assistance of restructuring professionals familiar with the unique distressed M&A process is a first critical step to advancing a winning bid.
Current trends and developments
We are carefully monitoring all reported M&A deal documentation in Canada that is publicly available for trends and unique deal features arising as a result of the COVID-19 pandemic. Here are some of the developments we have noted:
- Revised definitions of "Material Adverse Effect" and "Material Adverse Change" that include express carve outs for pandemics and/or epidemics (including without limitation COVID-19 and the impacts thereof).
- Extensions of "Outside Dates" for closing transactions to account for delays due to COVID-19.
- In the case of public company transactions, amendments to the timing for "Interim Order" or "Final Order" requirements, particularly where it is challenging or not possible to obtain such orders due to suspension of regular court operations.
- Interim period covenants on the part of target companies in respect of various actions, modified from customary provisions (such as timely filing of documents required by law and seeking third party or court approval) to take into account extensions for additional time and other accommodations arising due to the effect of COVID-19.
These provide some insight into how buyers and sellers are negotiating during the COVID-19 crisis, and inform our views on how negotiations may evolve over time. Additional changes are expected into the future as the long-term impacts of the pandemic are felt. Buyers and sellers are likely to negotiate and develop representations, warranties and covenants related to specific impacts arising from the crisis such as those related to cash flow, insurance coverage and changes in law. Other areas of focus may be assessing ways to minimize risks to supply chains, and developing continuity and succession plans.
Deal dynamics will keep evolving as the pandemic continues to pose unprecedented challenges. It is unrealistic to assume that the market will be back to pre-pandemic levels overnight – rather, it is more likely that a transitionary phase will remain for some time. Smart buyers and sellers will be prepared to address this market efficiently and effectively so they are well positioned to act on opportunities into the future.
 Source: Crosbie & Co.