Although deal volume has already started to decrease as a result of the impact of COVID-19, some sale processes remain ongoing (particularly those in certain sectors such as technology and which do not require any third party financing). As a result of the measures put in place globally to control the spread of the virus, it is important that Buyers are asking relevant questions of their targets (and Sellers of their portfolio companies) (“target companies” or “targets”) to fully understand how they are dealing with the current situation and their plans to mitigate any delayed impact that it could have.
We look at some of the most significant due diligence considerations that should be considered in light of the COVID-19 outbreak:
Commercial Contracts and Disruption
It is likely that some or all of a target company’s contract counterparties are experiencing their own disruption and therefore the force majeure, material disruption and similar provisions in key (upstream and downstream) agreements should be reviewed in order to anticipate the target’s exposure to non-performance or termination of those agreements. In general, the drafting of such clauses does not specifically provide for pandemics or health-related emergencies but may provide for other situations which could come into play as a result of COVID-19, such as state action or the declaration of a national emergency.
Other provisions in key agreements, such as exclusivity restrictions, may also impact target companies by not allowing them to, for example, switch to another supplier where its existing supplier is not performing. In addition, target companies may be party to agreements with hard or soft minimum purchase forecasts or commitments. In such cases, the terms on which the agreement can be terminated will need to be assessed.
We have seen a number of target companies respond to the COVID-19 outbreak by adjusting their governance procedures (for example to mitigate any travel restrictions that would not allow board meetings to take place as usual) or by setting-up specific committees to deal with COVID-19 issues. Whether this is required will depend on the target company and its industry, but will likely be helpful in resolving any knock-on governance issues (such as the potential inability to prepare financial statements or audits in time which could be a breach of any shareholders’ agreement that exists).
One way to judge such preparedness is to investigate whether the target has requested or received any guidance from its regulators as to its COVID-19 response and the extent to which it has acted on that guidance.
Insurance Coverage and Contingency Plans
A key area of focus for Buyers and Sellers will be the target’s existing insurance coverage and whether any business interruption insurance in place provides sufficient cover for the particular risks which could impact the target due to COVID-19 (e.g. government enforced lockdowns which prevent production or supply, employee health and safety, communication and internet access issues).
From a transaction viewpoint, our experience is that W&I insurance coverage in favour of the Buyer is very unlikely to be available in respect of any consequences of COVID-19 as this would be deemed a “known issue” and therefore excluded from coverage (though present indications are that the W&I insurance market remains operational more generally).
As we have seen in Europe and the United States with businesses requiring employees to work remotely, it is important that a Buyer gains a comprehensive understanding of: (i) to what extent sensible contingency plans are in place; and (ii) whether these have been robustly tested or, if already in operation, any deficiencies in the plans and their impact on the target’s productivity.
It will be important for portfolio companies to review and forecast their short-to-medium term liquidity needs and, if necessary, engage with their existing (or potential) finance providers at an early stage if additional liquidity is required, the terms of existing loans need to be amended or borrower covenants are likely to be breached.
For a more detailed consideration of how COVID-19 could impact financing arrangements, please refer to COVID-19 – what could it mean for your portfolio company’s compliance with its loan agreements?
To the extent that the target has given any guarantees or security, a Buyer may also wish to investigate the likelihood of that guarantee or security being called upon (particularly if it could be impacted by a downturn in hard-hit industries, such as travel and leisure) and the target’s ability to meet any such obligation.
Whilst issues impacting employees may be less important at the outset of negotiations (as generally these will not factor materially into earnings or ultimately, the purchase price) both the Seller and Buyer should be aware of issues that could become significant in due course.
Key factors to consider include the following:
(a) The remote working infrastructure which the target company has in place (including the remote working policy, access to adequate IT and conferencing equipment, privacy controls and cybersecurity);
(b) Employee travel restrictions that have been suggested or mandated (covering business and/or personal travel) and whether such travel is being actively monitored by the target company;
(c) Medical plan coverage and any cost sharing arrangements to which the target company has agreed;
(d) Employee pension plans and the potential adverse impact on funding that could occur, given the recent volatility of the equity and debt markets; and
(e) Availability of state grants or programmes to mitigate the economic impact of COVID-19 and the ease of/any restrictions on employee headcount reductions to address the impact of COVID-19.
Although it is impossible to determine the lasting effects of the outbreak, there remain opportunities for well-informed parties to proceed with transactions in the current climate. Accordingly, Buyers should seek to tailor their diligence in order to consider the consequences of COVID-19 and its potential to change both the short- and long-term operations of target companies.