COVID-19 Coronavirus: Strategies for Bridging Valuation Gaps in M&A in the COVID-19 Environment
- Earn-out mechanisms, while often complex and frequently subject to litigation, can be a useful tool to execute deals in an economic downturn.
- Toe-hold and other minority investments, if structured appropriately and with carefully crafted minority governance rights, can be effective deal-making strategies in constrained financial markets, allowing a seller or company to obtain access to capital without a full exit at a depressed valuation, on the one hand, and a sponsor to deploy capital and potentially craft a path to control at an attractive valuation, on the other hand.
- In the early days of the Coronavirus outbreak, Asian deal markets adopted various strategies to deal with valuation uncertainty, including negotiating for downside protections more often associated with venture capital or growth-stage investments, and the use of securities and instruments with enhanced down-side protection and other debt-like features; we would expect such trends to be deployed in U.S. and European deal markets in the coming weeks and months.
In the wake of the COVID-19 pandemic and its continuing impact on global financial markets, executing M&A deals at the right price has, almost overnight, become more challenging than ever. This OnPoint explores certain strategies to bridge valuation gaps in light of the ever changing economic landscape, including classic earn-out mechanisms, the increasing prevalence of toe-hold and minority positions, and other valuation trends observed in the Asian markets in the early days of the Coronavirus outbreak.
As asset valuation-uncertainty increases, earn-out structures are the quintessential deferred-consideration mechanic used to bridge valuation uncertainty. While they come in many shapes and forms, the typical earn-out obligates a buyer to make additional consideration payments to a seller following the closing of a deal, with such obligation based on the achievement by the business of certain performance metrics post closing. In downturn economies, earn-outs are one of the key M&A valuation tools that enable parties to execute deals. However, in periods where valuations are strong, their use tends to decline, as has been the case since 2010. One reason for this is that earn-outs are notoriously difficult to implement and rightfully have a reputation as a structure that invites the parties to litigate. In a strong market, a seller does not need to take the practical risk the earn-out structure presents, as upfront valuations tend to be well supported. Yet, as we move into unchartered territory in this COVID-19 era, the deal-making lessons of 2008-09 all point to earn-outs re-emerging with increasing frequency, at least in the short term.
From a seller’s perspective, earn-outs can provide upside benefits in the current environment when valuations are likely to be suppressed and, especially in the event of a quick economic recovery, can help the seller avoid ceding value due to “selling in the dip.” Further, where an earn-out is self-funding (i.e., the consideration is paid from proceeds from operations), sellers will have additional comfort given their familiarity with the operations of the target business and its ability to recover from an event that significantly disrupts the global markets. However, earn outs can be challenging for sellers in that sellers will relinquish operational control of the business to the buyer during the relevant measurement period. Therefore, sellers should consider negotiating for express contractual protections with respect to the operation of the business post-closing, such as:
- requiring that the buyer operate the business in accordance with the seller’s past practices;
- providing the seller with specific voting rights over certain corporate actions (e.g., transfers of assets to related parties) to gain increased control over actions that could impact the target asset’s ability to achieve the earn-out targets;
- structuring the earn-out as a waterfall of potential payments as opposed to a single all-or-nothing payment, or using weighted averages of the agreed-upon parameters over a number of periods as opposed to a single test period; and
- providing that the calculation of the earn-out parameters will carve out financial results impacted by adverse extraordinary events, such as pandemics or, more generally, force majeure events.
A seller’s success in negotiating for the above contractual protections will of course depend on the strength of its negotiating position and other deal dynamics. Sellers should be aware that, in the event of a dispute over the buyer’s failure to hit the earn-out targets, relying on Delaware courts to regulate the financial impact of the buyer’s conduct through the implied covenant of good faith and fair dealing would face significant obstacles. Delaware courts generally apply the implied covenant of good faith only as a gap-filling measure to address an issue that arises after the contract is signed that the contractual parties could not have reasonably anticipated when they negotiated the agreement. On that basis, a court might find a violation of the implied covenant if the agreement is silent as to the buyer’s obligations for satisfying the earn-out and the buyer takes affirmative steps designed to avoid achieving the earn-out metrics in ways that the seller could not have anticipated when negotiating the transaction agreement. However, if the transaction agreement contains covenants that obligate the buyer to operate the business in a certain way, or even if the record shows that the parties considered such covenants in their negotiation of the agreement, Delaware courts will typically enforce the explicit terms of the transaction agreement and hold the parties to their negotiated bargain.
While New York law with respect to the enforcement of earn-out provisions is not a robust as Delaware law, New York courts may be more inclined to apply the implied covenant of good faith and fair dealing to a buyer’s conduct and operation of the business and its impact on the earn-out provision unless the specific post-closing actions taken by the business are expressly permitted by the agreement (i.e., general language allowing the buyer to operate the business is its sole and unfettered discretion would not suffice to relieve the buyer from the obligations of an implied covenant of good faith and fair dealing). As a matter of English law, parties are not generally under any obligation to act in good faith or to balance their interests with those of a contract counterparty unless the transaction documentation imposes an obligation on them to do so.
A claim by the seller that it was fraudulently induced by the buyer to enter into the transaction agreement based on promises made by the buyer to operate the business in a way that will maximize the earn-out is likely to run into similar challenges if litigated. If the seller claims that the buyer induced it with promises not captured in the agreement, then the issue will likely be settled on the basis of a provision in the transaction agreement known as a disclaimer of reliance. A party making a disclaimer of reliance waives the right to assert a fraud claim based on statements not made in the contract. Though usually a negotiated protection in favor of the seller to limit its fraud exposure based on extra-contractual statements, these disclaimers are increasingly given mutually by buyers and sellers. Therefore, in light of the difficulty of obtaining relief on either a theory of fraud or breach of the implied covenant of good faith and fair dealing, a buyer will have broad discretion to operate the business during the earn-out measurement period in the absence of any express contractual protections for the seller.
From a buyer’s perspective, an earn-out can be an equally useful tool in the current environment of valuation uncertainty that allows it to reach an agreement when a seller may otherwise take the position that an asset is undervalued. By relying on an earn-out, a buyer has the obvious benefits of reducing the amount of cash that it is obligated to fund at closing and having any marginal consideration payable only in the event that the target business performs in accordance with the parties’ expectations. However, earn-outs can be challenging for buyers in the event that the seller is successful in negotiating for any of the contractual protections discussed above. In that case, a buyer would be subject to contractual restrictions on its ability to operate the target business for some period of time. Particularly in the current period of ongoing financial disruption, buyers should carefully consider the operational implications of any contractual protections they may be willing to grant to sellers. When earn-out payments are not made in full to a seller because the target business has not achieved the post-closing performance metrics, in whole or in part, litigation often ensues over the post-closing conduct of the business by the buyer and whether the buyer has complied with any pre-agreed obligations with respect to the operation of the business post-closing. To avoid potentially costly litigation, buyers should also consider whether other deferred consideration strategies, such as seller financing, or more atypical earn out concepts, such as an early buy-out option or liquidated damages in the event of a breach of the conduct of business standard, are more appropriate given the deal dynamics of a particular transaction.
Over recent years as valuations and competition for quality assets have steadily increased, private equity sponsors have been more willing to deploy capital in minority positions further down the capital structure in order to gain a toe-hold in target businesses at attractive valuations. We expect to see this trend continue and potentially accelerate as investors deal with the implications of COVID-19 on the financial markets, as a lack of liquidity and the more limited availability of debt financing means that private equity sponsors will continue to seek more innovative structures to deploy capital at attractive valuations. From a seller’s or company’s perspective, this continued trend will be beneficial as sellers will be able to access capital and liquidity but will not necessarily be required to cede full control of attractive assets at suppressed valuations.
For investors, toe-hold or other minority positions can allow for the prospect of the investor gaining a control position in the future. Additionally, investors may be able to structure a toe-hold or minority investment in the form of preferred equity or debt securities that are convertible to equity, or other similar instruments, which would provide the investor with down-side protection as compared to a typical equity investment. However, in the short term, sellers will maintain operational control of the business, subject to a negotiated suite of minority governance rights.
As we saw in 2008 through 2010, in this current environment we expect investors will try to negotiate more expansive governance rights, including additional board seats, a more extensive set of operational controls (which may be enforced in the form of put and/or call rights in the event of a default) and a path to controlling the ultimate exit event for all investors. Successful partnerships will be those that seek to align the interests of the majority owner, management and the minority investor around liquidity (e.g., through tools such as demand rights, drag-along and tag-along rights and an appropriate exit-proceeds waterfall, among other provisions). We would also expect to see minority investors increasingly focused on negotiating liquidity or control protections, such as redemption rights or put options, that allow them to exit the investment after a certain period of time if a change of control event has not occurred, or a right of first offer or right of first refusal, which would allow the minority investor an opportunity to increase its stake in the business in the event other investors seek to sell. As you would expect in periods of uncertainty, minority investors will be interested in more closely monitoring their investments during the hold period and will likely negotiate for more extensive information and access rights.
The balance between the need for liquidity, on the one hand, and the need to deploy capital, on the other hand, creates for many mutually beneficial opportunities in financial markets like this. Any such rights should be carefully negotiated as to ensure that all parties maintains the necessary flexibility to achieve their respective operational or financial priorities in uncertain market conditions.
Early Covid-19 Valuation Trends in Asia
Given that the Asian financial markets have been dealing with the effects of the COVID-19 pandemic longer than the U.S. or European markets, and have also had experience dealing with SARS and other similar market volatilities in recent times, it is worthwhile to consider the evolution of recent valuation-related trends in the Asian markets. Some of these, which may be duplicated in the U.S. and European deal markets in the coming weeks and months, include:
- The use by sponsors of downside protections typically incorporated in venture capital transactions, given the similarities between the current environment of valuation uncertainty and the valuation uncertainties inherent in venture capital investments. These measures include negotiating for most favored nation clauses, down-round protections and enhanced liquidity and dividend preferences.
- Investors increasingly structuring their investment as a hybrid debt/equity instrument to ensure there is down-side protection, with the prospect of equity upside in the future.
- Investors providing convertible bridge loans with an agreed-upon conversion discount triggered by a subsequent equity investment, which provides initial capital to the target business and also provides the investor with more time to conduct diligence and determine the appropriate equity valuation.