The outlook for M&A after the US elections

Global Publication janvier 2021

The Chinese word for crisis is composed of the character for danger and for opportunity. In terms of the dangers associated with the pandemic, they will endure for some time to come, but the uncertainties relating to the pandemic will continue to diminish significantly. As they decline, opportunity will grow. Indeed, as some financial analysts are quick to point out, recovery in China shows the potential for this trend.

In particular, there will be opportunity for those able to insightfully understand and take advantage of pervasive market dislocations. And mergers and acquisitions will be one of the most rapid and significant ways to do so. This article discusses M&A opportunities after exploring the pandemic-related challenges to be overcome in M&A dealmaking.

Challenges

COVID-19

Obviously, COVID-19 is a major challenge to be overcome in the current M&A environment. It may be, as some have argued in some form or other, that the fight against the disease should not have restricted economic activity as much as it has. However, when considering what has in fact occurred, it appears likely that we will continue to see economic activity increasing when COVID-19 is under control and decreasing when it is not. The up's and down's in the struggle against COVID-19 and in economic activity are likely to remain a significant threat for at least the next six months, but are also likely to become a phenomenon of the past within 15 months, as a result of some combination of vaccines, improved treatment and effective public health measures.

Prospective buyers could, conceivably, wait until COVID-19 is vanquished before they engage in M&A. The problem with this approach is these buyers could find themselves to be latecomers, with few compelling acquisition prospects, because enterprising competitors and investors will have taken some COVID-19 risk and acted earlier to make good acquisitions on attractive terms.

When we look at M&A activity since the start of the pandemic, we see a sharp decline for the first three months, but a resumption since then. Dealmaking rose significantly to a limited, no longer extraordinarily low, level in the third quarter of 2020 and now appears to be back within the normal range of activity. The initial increase in M&A seems to be attributable to a "backlog" or "inventory" of deals from the pre-pandemic period and distressed situations, though we are increasingly seeing acquisitions contemplating an altered, post-pandemic, world.

As shown by post-pandemic M&A deals and the recent performance of the US stock market, COVID-19 uncertainties are no longer a showstopper to M&A activity and investment. Much is now known about the disease, as well as the related restrictions, adaptations and shifts in economic activity.

Investors now recognize that COVID-19 can be brought under control or even suppressed by public health measures, for example as shown by the varied experiences of New York (prior to a second wave in New York and a surge in the rest of the US), Australia, New Zealand, Finland, Taiwan, Japan and China. Many places have experienced failures in controlling the disease, but they can be expected to learn from their mistakes and from the success of others. Moreover, the widespread deployment of a reasonably effective vaccine is likely within the next 15 months, allowing a full resumption of economic activity.

However, if economic victory over COVID-19 seems to be preordained, it is uncertain what battles may be lost in the war against the disease during the next 15 months. Setbacks in control over the virus, like the second wave of cases in Europe and the third peak of cases in the US, can have a material adverse effect on economies, M&A target companies and M&A buyers.

A key question for M&A buyers, including under Delaware case law, is whether a material adverse effect of this sort will be consequential for long term earnings power over a commercially reasonable period, measured in years rather than months. In the case of a given M&A target, its prospects may still appear to be good if it can weather a downturn until COVID-19 is under control; that is, until, at the latest, the first quarter of 2022 when vaccination is widespread. From a legal perspective, the buyer may not be entitled to abandon the acquisition on the grounds of a material adverse effect, because the downturn in the target company's business may not qualify as such under Delaware, or other applicable, law. Indeed, the buyer may also not have such grounds if, as would be typical, the MAE definition in the acquisition agreement excludes general changes in economic conditions or the effects of the pandemic.

Stimulus

In contrast, from a business perspective, general changes in economic conditions could be at the heart of an M&A buyer's risk analysis. In the wake of the pandemic, a major worry of the US Federal Reserve, economists and financial analysts was a general downward spiral in the economy resulting from the restrictions on economic activity associated with COVID-19. For example, massive layoffs and small business failures in some sectors of the economy could cause a significant reduction in consumption or financing affecting all sectors of the economy and generate a negative feedback loop of additional unemployment, business distress and financial difficulty dragging down the economy. A general adverse effect of this sort could destroy the value that a buyer hoped to gain from an acquisition.

Fortunately, the large magnitude, systemic risk of a downward economic spiral was, for a time, satisfactorily avoided by the huge stimulus programs in the US and Europe. Stimulus meant that investors could, and as the US stock market demonstrates, did "look through" the bad times of the pandemic to the better times after its demise. With the end of the pandemic in sight as a result of widespread vaccination (perhaps in combination with public health measures), setbacks in control over the virus could be regarded as temporary and their adverse effects on the economy as largely reversible as a whole. Understood in M&A terms, buyers could get comfortable accepting general economic and pandemic risk and excluding them from the termination right for an MAE, since they could count on governments to mostly mitigate them.

Unfortunately, beginning in August, the imponderables of systemic risk started to become an issue again, as the timely provision of additional fiscal stimulus became doubtful in the US in the near term. Despite strong statements by the US Federal Reserve about the need for additional fiscal stimulus, stimulus legislation was not enacted before the US elections.

The environment for M&A is now much improved, because of the recent passage of stimulus legislation. If more stimulus appears to be necessary or advisable, then Democratic control of the presidency, Senate and House of Representatives means it will likely be made available.

Additional fiscal stimulus will not only go far towards reducing the risks relating to COVID-19, but will probably lead to a substantial increase, if not boom, in economic growth. Acquisitions, in an early stage of a growth cycle when the business world is still in the process of changing in response to the pandemic, could be quite rewarding.

Key effects of the pandemic on M&A deals

Valuation

As the foregoing discussion suggests, seller and buyer valuation is more challenging to do and agree than before the pandemic.

In arriving at the valuation underlying the purchase price, the difficulty can be that the historical financial results prior to, and during, the pandemic are not indicative of future performance. The result can be valuation gaps between sellers and buyers. In public and private M&A deals, stock consideration, as well as or instead of a cash purchase price, can be used to help bridge these valuation gaps. Earn-outs are, in private deals, another option for this purpose, though they can be difficult to craft and negotiate. The devil is in the details, but the conundrum is, in essence, finding an acceptable balance between (i) the freedom of the buyer to do with the acquired business as it sees fit and (ii) the protection of the seller to prevent buyer actions detrimental to the achievement of the earn out, including the potential for the buyer to "game the numbers" by deferring strong results until after the end of the earn-out period.

The definition of a Material Adverse Effect is another area in which the issue of valuation is played out. Essentially, this MAE definition in the acquisition agreement determines when a buyer can terminate, or "walk away," from a deal because a change in circumstances had made the agreed valuation non-sensical. A seller is unlikely to concede to the buyer a termination right for the effects of the pandemic, but the potential size, unpredictability and variability of these effects on the target business could make it difficult for the buyer to satisfactorily account for them in the purchase price or bear the full risk relating to them. To address this dilemma, buyers may be more inclined today than in the past to seek to agree with the seller a quantitative definition of MAE. Lawyers have long recommended this explicit risk allocation among the parties as a superior alternative, in theory, to the vagaries of recourse to the courts and the general case law on MAEs. Buyers have, in practice, often preferred to avoid potentially contentious negotiation over the quantitative terms of the MAE.

Deal certainty

The broader question of deal certainty is posed by the issue of a material adverse effect, since the target business may suffer from one that does not fall within the definition of MAE and related termination right in the acquisition agreement.

Specifically, the pandemic has increased the chance of unexpected negative circumstances that emerge after the signing of a legally binding acquisition agreement but before the buyer's payment of the purchase price at the closing of the transaction. On the one hand, these circumstances may be partly or fully outside of the seller's control, even if the seller is well insured, has engaged in good contingency planning and has robust capability for risk mitigation. On the other hand, the buyer's purchase price may be too high because it does not fully account for these circumstances, which arise before it owns the target business.

Faced with this problem posed by the pandemic, a number of buyers and their legal counsel explored possibilities for reneging on signed deals and some buyers sought to actually do so. For example, a private equity fund refused to consummate the acquisition of Victoria's Secret, claiming not only that an MAE had occurred but that Victoria's Secret's actions in response to the pandemic were in breach of the covenant to conduct its business in the ordinary course during the interim period between the signing and closing of the deal. Or, to take another example, LVMH initially refused to proceed with the acquisition of Tiffany by claiming that the French government was halting it. Subsequently, after this claim was called into question, LVMH also asserted that an MAE had occurred.

The private equity fund succeeded in backing out of the Victoria's Secret deal, probably because the fund's equity commitment letter for the deal was flawed from the perspective of a seller. However, LVMH is proceeding with its acquisition of Tiffany after it was sued by Tiffany and negotiated a purchase price reduction of approximately 2.6 percent. More generally, we have not seen the rash of litigation and broken deals that occurred during the great financial crisis. Sellers seemed to have learned lessons from it and to have achieved a relatively high level of deal certainty.

In acquisitions of private companies, buyers may be willing to grant sellers a high degree of deal certainty in exchange for seller indemnification covering material adverse effects after signing.

In both public and private deals, sellers and buyers may try to manage the risk of material adverse effects by using reasonable best efforts to limit the length of the "gap" period between signing and closing. However, timing will usually depend on regulators, as well as the parties. Antitrust review and foreign investment screenings can be slower than usual because of COVID-19. Moreover, they have been getting stricter, both in terms of the relevant rules and their implementation by regulators.

Due diligence

In addition to lengthening the time required to execute signed deals, the pandemic has tended to increase the duration of due diligence investigations in preparation for signing.

As compared to the pre-pandemic past, due diligence has been taking longer for substantive and process reasons. In terms of substance, a buyer will usually need to do an especially thorough and extensive due diligence investigation when historical financial statements of the target company have limited utility. As noted above, this is often the case because of the pandemic. In terms of process, experience thus far has been that a remote due diligence approach takes longer than one in which some in-person meetings are possible (within the buyer and seller teams as well as between them). Improvement may be seen as people become better at remote working.

Deals done during the pandemic have highlighted that legal, financial and certain other due diligence can be remotely performed. In contrast, business due diligence can benefit significantly from site visits by the buyer's managers and technical experts, and in-person meetings between them and their counterparts at the target company. This need may be in conflict with pandemic-related restrictions limiting or precluding site visits.

Strategic buyers, who know well the target company and its industry, and private equity investors, who own portfolio companies with this knowledge, may be able to learn a lot from site visits and be uncomfortable doing deals without them, especially when the target companies are in manufacturing. Nonetheless, they may be better positioned to do satisfactory due diligence than financial buyers and may take advantage of this comparative strength in an auction process for a target company. The playing field may be more level when the target company is in the technology sector and predominately has intangible instead of physical assets.

Outside of the US, sellers may find it to be in their interest to facilitate due diligence by preparing vendor due diligence reports. This practice has not, in general, been followed in the US, but US sellers and their legal counsel may wish to reconsider its pros and cons for the US in light of the constraints on due diligence during the pandemic.

Because of the challenges of due diligence and valuation related to the pandemic, buyers may be more inclined to pursue listed target companies than private companies. The public disclosure of listed companies should provide transparency and lessen the burden of due diligence for a buyer. Markets, as opposed to private sellers, may be more realistic in their valuations of target companies. Indeed, unsolicited bids for target companies may become more prevalent than before the pandemic.

Opportunities

The pandemic is dramatically altering the business world. M&A is an opportunity for investors to respond to, and benefit from, the market dislocations caused by the pandemic, since adaptation through M&A is bigger and faster than most "organic" development. Indeed, many have already engaged in M&A since the pandemic began.

In the new post pandemic world, strategic and financial buyers should be on the lookout for the following kinds of M&A opportunities.

New areas of growth

The growth of some companies, especially in the technology sector, has increased because of the pandemic. In some cases, it seems pretty clear that this increase indicates a long term development. For instance, the pandemic has accelerated trends towards remote working, online shopping and online financial services.

During the pandemic, the most active sector for M&A has been technology. Reinforcing their positions in growing technology sectors, tech companies have been acquiring other tech companies. For instance, in May 2020, Zoom Video Communications, Inc. announced its plan to acquire Keybase, a provider of secured messaging and encryption services.

Investing in technology-related trends, non-tech companies have been acquiring tech companies. For example, in May 2020, Verizon acquired BlueJeans Network, a video conferencing and vent platform that is one of Zoom's key rivals. In June 2020, Mastercard announced that it is acquiring Finicity, an open-banking platform.

In some cases, it may not have been obvious how the pandemic would affect a company in the short term or long term, but the company may have become an attractive target because it's performance during the pandemic has been strong or its response to the pandemic is making it a leader with respect to nascent trends. For instance, in June 2020, lululemon, an athletic wear company, announced its acquisition of Mirror, a seller of a tech enabled mirror for the streaming of home fitness classes.

Value and distressed investment

Some companies, especially in the travel, hotel, restaurant, entertainment and retail store sectors, have suffered from the pandemic-related restrictions on economic activity or the general downturn in the economy. Some of these companies may be well positioned to profit from pent-up demand or a boom in certain activities after the pandemic, especially if business failures have lessened competition for them. Others may simply have current valuations that are overly low, especially if they are restructured or stimulus generally creates an economic boom. For example, restaurant brands Krystal, Logan's Roadhouse, Bar Louie and the US division of Le Pain Quotidien were sold after filing for bankruptcy, as was the luxury department store Neiman Marcus.

Synergistic combinations

Some companies may, in combination with other companies benefit from economies of scale and other synergies, especially if they are in industries that should be, or already are, consolidating. The pandemic may be the impetus for combining companies to allow them to better survive during it and prosper after it. For example, in the semiconductor industry, Analog Devices, Inc., agreed in July 2020 to acquire its rival Maxim Integrated Products, Inc. and Advanced Micro Devices announced in October 2020 its acquisition of Xilinx.

The food delivery industry, which benefitted largely from the COVID-19 pandemic, is undergoing major consolidation. In June 2020, Amsterdam-based Just Eat Takeaway.com agreed to acquire Grubhub. In July 2020, Uber Eats, agreed to acquire its competitor, Postmates, after losing in its bid to acquire Grubhub.

The pandemic caused a major downturn in the oil and gas industry, as demand for its products fell sharply. The result has been a trend towards consolidation in the industry. Chevron announced its acquisition of Noble Energy in July 2020 and closed the deal in October 2020. In September 2020, Devon Energy agreed to buy WPX Energy and, in October 2020, ConocoPhilips announced it was acquiring Concho Resources.

Developing industries irrespective of the pandemic

Some companies are not, positively or negatively, experiencing large direct effects relating to the pandemic, but are in industries that continue to develop rapidly, such as renewable energy. For example, in July 2020, Kansai Electric Power Co., Inc., a Japan-based utility holding company, purchased a 48.5 percent interest in the 525 MW Aviator Wind Project in Texas, the largest single phase wind farm in the US.

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