While the On Target editing desk has been quiet in the last few months, our clients haven’t been, and the M&A market has bounced back remarkably since autumn 2020. In this edition, as we look ahead to a year of resumed activity, we share a few COVID-19 triggered transaction issues, M&A trends and legal developments, arising in the last twelve months.
1. Return of the MAC
Material Adverse Change (MAC) clauses in sale and purchase agreements (SPAs) allocate risk between a buyer and the seller(s) between signing and closing. In essence, if the target business suffers a MAC during this period, then the buyer can terminate the agreement and walk away from the deal.
MAC clauses have long been a feature of US deals, but the exception to the rule in the UK (and even then, rarely seen outside of large cap transactions). The number of MACs that are invoked is even smaller. However last spring and summer many institutions and corporates on both sides of the pond questioned if they could invoke existing MACs to reduce their exposure to vulnerable sectors, and whether to demand them more frequently in the future.
One of the M&A trends in the small and mid-cap markets we saw was an increased number of MACs demanded by buyers, with the COVID shock lending credibility to requests that would otherwise have been rejected as disproportionate or contrary to market “norms”. MACs remained hotly debated in negotiations, and were often ultimately watered down or traded for other points. However, in the short to medium term the appearance of a MAC clause in a non-US SPA is, after COVID-19, unlikely to be dismissed out of hand in smaller transactions.
It is perhaps not surprising that autumn 2020 also saw a rare, and therefore notable, test of a MAC clause in the English High Court. In Travelport Ltd & Ors v WEX Inc., a buyer (WEX Inc) sought to exercise a MAC clause as a result of the COVID-19 pandemic. The judgment, in favour of Travelport due to ambiguities in the drafting, emphasised the importance of clear and objective criteria for determining when an event qualifies as a MAC. Key take-aways are:
(1) A MAC must define clearly the “effect” or “change” on the target business. In Travelport, the clause referenced the effect on “competitors” within the same “industry”. But at trial, what constituted “competitors” and the relevant “industry” were both argued extensively.
(2) The courts will favour a literal interpretation rather than implying words or meanings that might at the time have reflected “market standards”. So, a claim that cannot be evidenced of “everyone knew at the time what it meant” will fall on deaf ears.
(3) The decision continued the tradition that the courts are reluctant to undo a valid bargain freely made by contract, so even the slightest ambiguity can defeat a MAC.
2. Bigger pricing gaps
Significant pricing gaps are a common characteristic of either the beginning, or an end, of an economic downturn, when buyers’ and sellers’ projections for future financial performance, magnified by different assessments of (and appetites for) risk, result in diverging valuations. Rarely, though, is the economic shock as sudden as that caused by COVID-19, and never in living memory have entire industries been switched on or off so abruptly.
In the last year we have seen this translate as (i) increased focus on earn-outs, and (ii) a return to post-completion price adjustments (sometimes accompanied by an escrow or quasi-escrow.
Earn-outs have been a staple of small and lower mid-market deals since the last financial crisis, but in the last 12 months they have represented a much greater percentage (some over 30%) of overall purchase price. Where COVID-19 has caused atypical cash/debt fluctuations, or a “locked box” purchase price structure appears risky due to exceptional financial results, we have also seen a flight to the relative certainty of post-completion adjustments. A number of these transactions have also featured either use of an escrow account for post-completion adjustments, or a withholding of purchase price/use of deferred consideration with set-off rights, to provide a buyer with added security.
3. Focus on due diligence
COVID-19 has created new legal due diligence topics, and increased focus on traditional ones and areas. One new topic has been the accuracy and completeness of applications made for government financial support such as the furlough scheme, and the adherence of the target business to government guidance.
Other areas warranting increased focus are employee relations (have there been redundancies, pay cuts, changes in working conditions and patterns?), commercial contracts (have suppliers been paid? Have customers cancelled contracts?), insurance (have claims been made for business interruption?) and debt finance (is the business still complying with borrowing covenants?).
In the last 12 months financial due diligence has taken on even greater significance; producing and projecting normalised financial metrics is no easy task against the backdrop of such economic turbulence. This is having, and we predict will have, an impact on transaction timetables and M&A trends.
4. Devil in the detail
For many businesses, trading has been anything but normal in the last 12 months, so beware of standard drafting such as “in the ordinary course of business” or “in a manner consistent with the last 12 months”. These phrases, which typically find their way into non-competes and other restrictive covenants, accounting policies, business warranties, earn-out protections and restrictions between signing and closing, might not mean quite what the parties intended if tested against trading patterns and M&A trends in the last 12 months. Linking back to the Travelport judgment, in the absence of evidence to the contrary the courts will presume that the parties intended precisely what was written. Time to call a lawyer!
Is this brief too brief? Expert legal advice is on hand from MJ Hudson’s M&A and corporate law team.