COVID hasn’t changed the overall purpose of legal due diligence– a well-run diligence exercise should enable a prospective buyer to understand the target’s legal obligations and liabilities and help determine at what price and on what terms the proposed acquisition represents a sensible investment. What has been affected by the pandemic is both the focus and practicalities of that exercise.
Buyers need to understand how the pandemic (and resulting general economic stress) is impacting the target and its business so as to ensure this is accurately factored into both valuation and risk allocation. Whilst diligence always needs to be tailored to the particular target company (taking into account, for example, its industry and geography) this article considers some of the general areas we are seeing as being of particular interest to prospective purchasers as well as flagging some of those practical considerations.
Diligence findings are based on information derived from a variety of sources including (i) data room documentation (ii) management meetings (iii) site visits and (iv) publicly available information (for example filings at Companies House and the Land Registry).
COVID has presented challenges to accessing these sources in the normal way. Lock-down restrictions have resulted in physical meetings and on-site inspections all but disappearing. Whilst virtual data rooms and zoom calls have generally functioned well they have their limitations and in certain instances key documents and employees have not been accessible due to furloughing or office closures. In addition, search results (particularly from local authorities) have sometimes taken longer to be processed than usual.
Deal teams should consider local circumstances when scoping and timetabling the diligence workstream. It is prudent too to proactively ‘game plan’ likely implications for deal terms if findings indicate a target has been adversely impacted by the pandemic – whether through enhanced warranties and indemnities, tailored insurance coverage or alternative consideration provisions.
Areas of Focus
The areas highlighted below are intended to give an indicative rather than exhaustive flavour of how diligence needs to be scoped with an eye to the impact of COVID:
- Material Contracts – the pandemic has affected the ability of many contracting parties to perform their obligations. Diligence will need to identify where this has already triggered an event of default or where there are indications that a future breach is likely. In particular, an assessment will need to be made of any force majeure, material adverse change clauses and other termination rights – specifically applying the pandemic context – so as to understand whether the target can invoke such provisions if it wished to and, on the flip side, the impact on the business if a counterparty was entitled to.
- Supply Chain – the force majeure and termination provisions mentioned above are likely to be of critical importance in key supplier and customer contracts. The pandemic is having a disruptive impact on supply chains where suppliers are experiencing issues with cash-flow, sourcing and, in some instances, insolvency. As well as identifying where this has happened, or is likely to happen, it is also vital to trace through the impact of such supplier issues to the target’s own customers in terms of financial and relationship consequences. A related point to test will be the exclusivity of that aspect of the supply chain – is
the target permitted, or indeed able, to source elsewhere if their existing supplier, distributor or manufacturer experiences difficulties?
- Government assistance – many targets will have benefited from one or more of the schemes offered by the UK government or equivalent domestic arrangements. It will be necessary to diligence both the target’s compliance with the requirements of such schemes (in terms of eligibility and implementation criteria) as well as the implications for the target if such assistance is withdrawn including any repayment obligations.
- Insurance – the ability (or inability) of the target to claim for the effects of COVID – including under business interruption and key man policies - should be ascertained. It may be prudent to assess the impact of the pandemic on the target more broadly including its likely impact on cost and coverage and whether lock-down consequences (employees working remotely, empty premises) have had an adverse impact on policy terms.
- Financing arrangements – the cost of COVID has meant that many companies would have breached their borrowing covenants if they had not obtained waivers. Such waivers, and the terms of any other debt variations, need to be fully understood as well as the target’s ongoing ability to comply with its obligations without triggering an event of default.
- Employees – one of the areas which has attracted a lot of attention is furloughing (or, more formally, the Coronavirus Job Retention Scheme) which is currently due to apply until the end of March 2021. Buyers will need to understand how the target chose to implement the scheme as well as, or instead of, redundancy programmes or changes to contractual employment terms. Other employment issues that will need to be diligenced include how COVID has impacted the buyer’s workforce in terms of absence (sickness, self-isolation, shielding), annual leave, health and safety (homeworking and returning to the workplace) and visa status.
Whilst the hope is that the world will begin a return to normality in 2021, it will remain crucial for acquirers to adequately assess the impact of COVID as part of their diligence on potential targets. That assessment will inform both the current value and future viability of the business. Care should be taken when using pre-pandemic diligence templates and processes that this COVID dimension is appropriately covered always taking into account the nature of the business as well as the sector and geography in which it is operating.