COVID-19: What might it mean for public M&A in the UK?

Introduction

The COVID-19 pandemic has resulted in unprecedented challenges for businesses in all sectors, coupled with market upheaval and volatile share prices. This briefing considers the likely impact of this backdrop on public M&A activity in the UK, both in the immediate future and in the longer term, as well as some key practical considerations for bidder and target companies.¹

Barriers to activity

There have been considerable barriers to deal activity in the last few months, with the de-prioritisation of M&A attributable to a number of factors, including:

• Operational/inward focus on both sides of the deal – for corporates, accessing liquidity, addressing operational performance and taking mitigating actions have been at the top of the agenda; for private equity and financial sponsors, the areas of immediate focus have been portfolio management and managing investee companies’ liquidity requirements. 
• Lack of a clear roadmap as to when/if business performance will start to return to pre-COVID-19 levels has made assessing potential M&A opportunities difficult. 
• Valuation dislocation and bridging the gap between the “bid” and “ask” by bidders and targets, compounded by volatile share prices and a complete shift in base case valuations, has made price discovery extremely challenging.
• Lack of acquisition financing available from traditional lenders – in a period of extreme volatility, the focus on assessing the covenant strength of existing borrowers (including dealing with borrower waiver and amendment requests) together with the pressure on capital/lending capacity (with outstanding bridge loans yet to be refinanced and borrowers maximising liquidity through drawing down existing facilities) have limited the availability of finance.
• Hostile target management teams who are unlikely to be receptive to opportunistic approaches made on the basis of volatile or depressed share prices or to have the bandwidth to focus on M&A (other than in those cases where “distressed” M&A may be the only way forward). Identifying the right time to re-start discussions against this backdrop is a delicate balance.
• Logistical difficulties of holding face-to-face meetings with teams on both sides of the deal and conducting a thorough diligence exercise in the current environment.

Potential green shoots?

Notwithstanding the challenging landscape, we have seen some public M&A deals launched and, more generally, there has been a tangible shift in focus to greater M&A readiness, if not yet full blown M&A execution, with many expecting the second half of 2020 to be characterised by a marked uptick in activity. This can be attributed to a number of factors, including:

• Valuation opportunities which are arguably too good to ignore, particularly for private equity bidders who can see a route to ownership of listed assets (which in some cases, given the challenges facing many corporates, may give rise to potentially unprecedented opportunities) but also for other corporates, where a combination of scope for opportunistic M&A and the potential for scaling up and risk sharing through consolidation is forcing the topic up the agenda.
• Capital needs to be deployed by private equity and financial sponsors – after initial portfolio company re-capitalisation, looking outward and putting money to work acquiring listed assets (which have historically often provided better value opportunities than the private sector) is, to an extent, inevitable.
• First mover advantage – the need to be ready when the market stabilises and opportunities can properly be assessed means that initial valuation and structuring work needs to be undertaken and the crucial assumptions underpinning any pricing propositions, which will need to be tested in diligence, identified.
• Challenges in accessing liquidity, whether through traditional equity raising, funding from cornerstone investors, or debt financing from existing lenders, mean some target companies are being forced to look at M&A as a potential route out of the challenges posed by COVID-19, whether that be “forced” M&A as a result of liquidity issues or scaling up through consolidation.

“Rolling the dice” – getting the deal done and managing risk

Where there is a potential deal to be done, bidders will need to think about the impact of COVID-19 on the usual public M&A process, including some of the areas discussed below.

Due diligence

On a practical level, although restrictions are easing, consideration will still need to be given as to how the due diligence process will be conducted in light of social distancing and other restrictions that could be in place for some time. This may well limit the ability to conduct site visits, and alternative solutions will need to be sought – perhaps ranging from the use of emerging bespoke/specialist providers of diligence services to virtual reviews of tangible assets.

While virtual data rooms are obviously already integral to the public M&A process, underlying source information still needs to be collated, which could pose practical and logistical challenges. The effective conduct of virtual diligence meetings, and appropriate interrogation of management teams, will clearly be key – with the absence of typical ad hoc/“break out” sessions that often characterise such exercises and the broader opportunities to build rapport with target management posing other challenges.

From the outset, bidders will also need to give thought to the scope of the diligence exercise and identification of those areas which are likely to be particularly complex and require an even greater degree of focus than may normally be the case. In particular, the level of uncertainty created by the pandemic (and associated public policy responses) makes modelling and testing the base case, and formulating associated sensitivities and assumptions, uniquely challenging. Even in the short-term, making reliable forecasts as to performance is likely to be problematic in many cases given the current lack of certainty about when, or if, “business as usual” will resume – a range of scenarios, including a reasonable worst case, will therefore likely need to be modelled. Desktop diligence may have its limitations as publicly available information will potentially not be sufficiently robust or granular. The resilience of the target business to crisis and disruption, its reliance on key contracts (including its supply chain) and any geographical dependencies will all need thorough testing.

These issues are thrown into sharper focus on public M&A deals, given a bidder’s only real remedy is to ensure it prices in these risks while at the same time pitching its offer at a sufficiently attractive level to secure a target board recommendation. Target companies will also have to balance their desire to keep the diligence exercise as focused and efficient as possible against bidders’ and their financiers’ reduced appetite for risk in the current environment.

Forward looking statements

Under the Takeover Code, bidders are required to make a range of forward looking statements concerning their plans and intentions for the target business post-acquisition. Although, technically, these statements are not binding on the bidder (in the strict legal sense), they are taken very seriously by the market and the Takeover Code requires them to be an accurate statement of the bidder’s intentions and to be made on reasonable grounds. Whilst forward looking statements of this nature have always been an area of focus, bidders will need to give even more careful consideration to their formulation in the current uncertain environment. While we have seen examples of COVID-19 caveats and qualifications included in forward looking statements for deals launched in the earlier stages of the pandemic, whether this approach will continue to be appropriate and acceptable to the Takeover Panel remains to be seen.

From a financial adviser’s perspective, the basis on which intention statements are made will need to be thoroughly tested – in particular, what is reasonable against an unpredictable and rapidly changing background? As a related point, given the uncertainty of the current environment there is an increased likelihood that deviations from intention statements may be necessary in the 12 months post-acquisition – it would therefore be prudent for financial advisers to ensure that their clients fully understand the requirement to consult the Takeover Panel and update the market should this occur.

Cash confirmations

Given the potential financial and reputational risk, cash confirmation exercises are, of course, undertaken with rigour at all times. In the current climate, however, bidders can perhaps expect an even greater degree of scrutiny from financial advisers (and their risk committees) around financing arrangements for a proposed offer.

For example, in the context of leveraged deals, the scope of the certain funds regime will continue to be closely scrutinised. In terms of offers financed from a bidder’s own existing resources, there may be a greater focus on formally ring-fencing or placing cash in escrow for the duration of the offer period, rather than reliance being placed on funds being available at the relevant time (which may well only be a route available to the most well capitalised corporates). Working capital and cash flows during the offer, as well as ordinary course treasury management functions, will likely be scrutinised more closely than ever.

In the context of take privates, we are likely to see increased emphasis being placed on the visibility, and assessment of the covenant strength, of those investors standing behind private equity and similar bidders. Financial advisers will want certainty on the availability of funding, with no prospect of redemptions or withdrawals by underlying investors. For financing structures which involve leverage, if traditional lenders have reduced appetite to provide acquisition finance on previously acceptable debt/equity ratios we may well see third party (non-traditional) providers of debt, whether credit funds or co-investors, coming into the transaction to bridge that gap. Where this is the case, additional diligence and related work streams will be required to assess the covenant strength of these lenders, all of which will need to be factored into the overall timetable. In a similar vein, with indications we might see more consortium or “club” deals as a strategy to spread deal risk, diligence on each of the relevant private equity funds will need to be factored into the cash confirmation process and timetable. Refinancing and co-investment during the offer period may also not be unusual. 

Strategies to mitigate currency risk during the offer period have also been top of the agenda for financial advisers for some time and this will no doubt remain a key area of focus in the current market. Notwithstanding the associated cost, hedging products may well be considered preferable (by both bidders and their financial advisers) to protections derived from setting aside a “buffer” of excess cash or capital – in particular given the potential uncertainty as to the level of buffer that may be required in light of market volatility.

Timetable

For those offers where regulatory approvals are key to a successful outcome, decisions have inevitably taken longer during the pandemic. With social distancing restrictions likely to remain in place for some time (and varying across different jurisdictions), this will doubtless continue to impact on regulatory timelines, particularly in more complex cases.

While protracted timetables can potentially lead to incremental costs arising in respect of certain funds, from the bidder’s perspective, extended timelines will of course also prolong exposure to the performance (and any potential decline) in the target’s business over the offer period, making assessment of the impact of COVID-19 all the more important in the diligence phase. While an ideal strategy for a bidder might be to use an extended possible offer period as a way of obtaining clearances without being committed to proceed with a firm offer, this is unlikely to be palatable to a target as it will want to ensure that the bidder is locked in. Where there is regulatory uncertainty around a transaction, target companies will also be very much focussed on deal protection (as discussed below in Bidder shareholder approval and other potential “outs”).  

The nature of the crisis means that in some cases failing firm arguments may be helpful in the overall competitive assessment of the deal, but these will not provide a free pass on antitrust issues. To make a strong failing firm case parties will need to provide compelling evidence not just of the difficulties the target faces but also of the likely impact of the deal on competition – and there has been a consistent message from the antitrust authorities of the importance of not letting their standards of assessment slip during the crisis. For deals that do not involve protracted regulatory clearances, shortening the transaction timetable has always been a key means of mitigating against interloper risk. Against the background of COVID-19, the ability to move quickly will also have the benefit of minimising the period until the target is under bidder control, something that is likely to be particularly relevant in certain sectors. Planning and preparation is therefore key – and being in a position to publish offering documentation and prosecute the transaction without delay could well be an important consideration.

National security and government intervention

For a number of years, overseas bidders looking at target companies which form a significant part of the UK industrial landscape have had to react to a shifting governmental industrial policy. This has been  manifested, to a degree, by a potential greater willingness to intervene in public M&A than has been the case in the past. Short-term measures were also introduced in the UK to enable transactions which posed national security concerns to be more easily called in for regulatory scrutiny, and the types of transaction falling within this approach have been expanded over time, with recently announced plans to include additional strategically valuable sectors (such as AI) in the list of activities which will be subject to a lower threshold for review. In addition, the Government has recently added the capability to deal with public health emergencies (including activities such as PPE production) to the existing list of public interest grounds on which the Government can intervene in a transaction (having added maintaining the stability of the financial system to the list in 2008 during the global financial crisis).

COVID-19 concerns have seen a widespread trend internationally toward more protectionism and a readiness by local government and regulators to intervene in M&A transactions which raise national interest or security concerns and/or to protect companies vulnerable to bids from overseas predators.  The UK appears, to a degree, to be following suit, with more far reaching national security legislation than previously anticipated potentially coming down the track in addition to the short term measures mentioned above. This may include introducing a mandatory requirement to notify those transactions which constitute a threat to national security, backed up by significant regulatory sanctions, with a wide range of transactions being in scope. For more information on these topics, see our separate briefing Global rules on foreign direct investment.

Consequently, bidders may need to be prepared for a greater degree of regulatory intervention in deals in certain sectors and, particularly in high profile cases, for the Government to seek to extract public commitments (including, in all likelihood, by way of ‘post-offer undertakings’ under the Takeover Code) regarding areas of strategic concern or perceived public interest. Finalising and negotiating post-offer undertakings with the Takeover Panel can have potentially significant timing implications which need to be factored into the offer process. Strategies to engage with government departments to address these concerns may therefore be expected to move higher up the agenda for bidders when planning public M&A.

Stakebuilding

In the UK environment, where deal protection measures are so heavily restricted, stakebuilding has often been a key strategic tool for bidders seeking to mitigate costs and manage interloper risk.

In volatile markets, the potential benefits of stakebuilding mean that it may well be attractive to potential bidders. However, any potential upside needs to be weighed against the risk of being left with a material shareholding in the target in the event the offer fails to close – an increased possibility in circumstances where the outlook for many target businesses post-COVID-19 remains unpredictable and where the diligence process may be more likely than usual to throw up issues that might militate against taking the bid forward. As a separate point, regard should also be had to the potential price setting implications under the Takeover Code of any share purchases, which are typically manageable but may be more relevant given greater potential market volatility than might usually be the case.

Using equity financing for a cash offer

With the equity capital markets being supportive to many issuers during the pandemic, there have been discussions on the scope to raise equity to finance cash offers, particularly where there is strong, strategic merit and potential business resilience for corporates that could be achieved by scaling up through bolt-on M&A. Equity financing often proves challenging in the context of public M&A given the need for certainty of funding and the restrictions on conditions and termination rights in underwriting agreements as set out in Practice Statement 10. These issues may be more manageable where the fundraising can be structured as an accelerated bookbuilt placing which is not conditional on the takeover completing and so can be launched and closed in short order following announcement, with the funds being used for other means if the offer subsequently fails to become unconditional. However, this may not be feasible due to the size or nature of the fundraising required – for example a pre-emptive offering (with a prospectus and a longer timetable) may be necessary – or as a result of concerns around the ability to deploy the proceeds elsewhere in the business which may mean the company does not want the fundraising to become unconditional unless and until the offer completes. Given these issues, a structure that has been seen in the past is a “certain funds” debt financing coupled with a standby underwriting, as this affords the issuer some flexibility – and we are seeing this approach re-emerging in initial structuring discussions as a potential option.

What if it all goes wrong?

Invoking a condition and lapsing the offer

The certainty that, once announced, takeover offers become unconditional and go on to complete has long been a central principle of public M&A in the UK. Offers are not permitted to lapse without the consent of the Takeover Panel, and consent will only be forthcoming if the material significance test in Rule 13.5(a) of the Takeover Code is satisfied.² Obtaining this consent has long been considered to be extremely difficult (if not impossible).

The impact of COVID-19, and the potentially far reaching implications for target businesses, led to some considerable debate in the market as to whether there was likely to be increased scope to invoke conditions in the current climate, particularly those relating to material adverse change. The Takeover Panel’s decision in Moss Bros Group plc has, to a large degree, put paid to that speculation. It has always been extremely difficult for a bidder to invoke a condition where the circumstances giving rise to its breach were, or could have been, reasonably foreseeable by a bidder at the time of the announcement of an offer and/or the damage suffered by the target is not permanent or long lasting. In the context of Moss Bros, the timing of the Rule 2.7 announcement and the potential impact of lockdown measures easing would both be likely to have been key factors in the Takeover Panel’s determination that the bidder was not entitled to lapse its offer.

The Takeover Panel’s decision on Moss Bros suggests it is very much “business as usual” so far as invoking conditions is concerned. Any bidder launching an offer against the current backdrop will have to accept that any adverse implications arising from COVID-19 (including a material deterioration of a target’s business) would in most cases be unlikely to constitute a material adverse change satisfying the test for lapsing a condition set out in Rule 13.5(a) of the Takeover Code.

In the context of the Moss Bros decision, it is notable that the bidder was seeking to rely on a number of general, “boiler plate” conditions to its offer. By contrast, there is, and has always been, scope for bespoke/specific conditions to be negotiated into an offer and a bidder is arguably in a stronger position when seeking to invoke this type of condition (as opposed to a more generic condition), provided the other criteria discussed in Practice Statement 5 have been met, including the condition being specifically drawn to the attention of target shareholders with a clear explanation of the circumstances which might give rise to the right on the part of the bidder to invoke it. Scope remains, therefore, for bidders to seek to include specific conditions to address perceived issues relating to COVID-19. However, whether these will materialise on offers, and whether they are capable of being constructed in accordance with the requirements of the Takeover Code and reflected in the offer documentation in a way that would be acceptable to a target, remains to be seen.

Bidder shareholder approval and other potential “outs”

There are a number of conditions to an offer which fall outside the scope of the materiality test set out in the Takeover Code discussed above. Aside from conditions relating to achieving the requisite offer or scheme approval thresholds, two other areas are conditions that relate to bidder shareholder approval and those that relate to certain regulatory conditions. 

A bidder may need approval from its own shareholders to proceed with an offer for various reasons – for example, to approve the transaction itself as a result of regulatory obligations in its own jurisdiction (similar to Class 1 approval under the UK Listing Rules) or to issue securities in connection with the offer. Where a condition of this nature is included, in circumstances where the offer becomes materially less attractive to the bidder (whether as a result of a deterioration in the target’s business or otherwise) such that it is no longer in its interests to proceed, the bidder is generally free to recommend that its shareholders vote against the relevant resolution(s) and invoke the condition to lapse the bid.

Similarly, some regulatory conditions are binary under the Takeover Code. For certain others, where relevant consents are not obtained on satisfactory terms, the bidder’s ability to invoke the condition will either be excluded from, or at least subject to a potentially more nuanced application of, the materiality test referred to above.
Clearly, any conditions that are not subject to the usual materiality threshold introduce an element of optionality for the bidder in terms of its ability to lapse its offer, sometimes referred to in the market as a “backdoor MAC”. The scope and inclusion of such conditions will, as always, depend on the relative bargaining power of the respective parties and the background to the offer (including whether it falls into the category of distressed or forced M&A). In the current climate, the scope of any such conditions will be a particular area of focus for target companies, given their potential impact on deal certainty, and we expect to continue to see an insistence on reverse break fees and other penalties should such conditions be invoked by bidders.

Distressed M&A – target in difficulty during the offer period

Notwithstanding the above, the potential for material deterioration in a target’s business during the offer period such that its solvency could be threatened may be a real concern for a bidder, particularly in the context of distressed M&A.

Actual insolvency of a target company during the offer period would, in most circumstances, release a bidder from its obligation to proceed with the offer. The more difficult issue for bidders will arise where the position of the target business deteriorates significantly but falls short of actual insolvency. In these circumstances, a bidder may want to take action to mitigate the risk of insolvency and protect the deal (for example, by way of providing financing or through other ancillary transactions). Where this is proposed, the restrictions on frustrating action and offer related agreements in Rule 21 of the Takeover Code are likely to be engaged. However, in circumstances where the very existence of the target is under threat, we would expect the Takeover Panel to be willing to adopt a pragmatic approach and potentially dispense with full compliance with the requirements of Rule 21, although early consultation by the bidder and its advisers will be key.

It’s all too challenging – alternatives to P2Ps?

In weighing up the various risks associated with public M&A, it is conceivable that bidders may look to enter into alternative transactions with a target company, particularly where private equity or financial sponsors are concerned. Similarly, a valuation gap between bidder and target which is not capable of being bridged may drive discussions down a different path.

There has been much discussion since the early stages of the COVID-19 crisis about whether private investment in public equity or “PIPE” transactions, typically involving a private equity investor, may gain traction in the UK (the recently announced fundraising by SIG plc involving a significant private equity investment is notable in that context). Whether a PIPE style transaction is an option will depend on the circumstances, including whether a potential private equity investor has the ability or appetite to hold a minority stake in a target company (which retains its listing and all of the associated governance restrictions). From a target’s perspective, equity capital markets have shown themselves to be very much open for business during the pandemic, with a number of companies raising significant funds. The availability of traditional equity financing has arguably mitigated against the need for PIPE deals with a cornerstone or strategic investor to date, but it will be interesting to see whether the position evolves over the coming months, particularly in the event of any prolonged economic downturn.

Where there is a real appetite on the bidder’s side for part of a target’s business, and a corresponding need on the target’s side to raise capital and improve its liquidity position, a private M&A disposal of the relevant assets may be a more desirable outcome for both parties than a full-blown bid. Similarly, particularly between corporates, combining forces in a joint venture relating to certain parts of the business may be an alternative way forward, allowing risk sharing as well as retaining value exposure and potential upside for both sets of shareholders. For more information on these topics, see our separate briefings, COVID-19: Private M&A transactions: Issues and emerging trends and COVID-19: Joint ventures in a distressed environment.

The target’s perspective – battening down the hatches?

While the implications of COVID-19 provide some real challenges to executing public M&A, the uncertainty will inevitably also create significant opportunities for bidders. Potential targets should therefore be mindful that they could find themselves on the receiving end of an unsolicited, and potentially unwelcome, approach. We are discussing with clients the need to be prepared and our separate briefing Responding to an approach: Some key considerations for potential target companies considers some of the practical issues in this context.

Conclusion

While there is little doubt that the immediate impact of COVID-19 has suppressed public M&A activity, the opportunities for investment in listed assets and the potential benefits of corporate consolidation and/or bolt on M&A arising from the uncertainty will likely drive takeover activity in the second half of 2020. Although the impact of COVID-19 will not dramatically re-shape the structure of takeovers, it will certainly throw into acute focus some of the execution concerns that are often a feature of the public M&A landscape. In a stabilising market, those best prepared and able to move quickly could well emerge with the advantage as deal activity resumes.

How we can help

• Extensive experience of advising bidder, target companies and financial advisers on public M&A – since 2015 we have advised on over 50 takeover offers worth over £40 billion in aggregate.
• Our public M&A team includes ex-secondees from the Takeover Panel, and so is fully up to date with its regulatory outlook and best practice.
• We regularly provide training to boards and financial advisers on the Takeover Code.