SRS Acquiom published a white paper in August 2020 and a 2020 review in December 2020, both discussing M&A trends that have emerged in these unprecedented times. Their observations confirm that parties need to be increasingly flexible and creative to adapt to the changes imposed by COVID-19. While some of their findings are limited to the U.S. context, others can be more broadly applied to the global M&A landscape. Below are our key takeaways from these publications.
Pandemic Taking Over MAE Clauses
Prior to the COVID-19 pandemic, as recently as March 2020, SRS Acquiom reported that almost no material adverse effect (“MAE”) clauses in transaction agreements made explicit mention of pandemics. By Q3 2020, over 75% of the transaction agreements contained a carveout related to the pandemic, over 60% provided for a COVID-19 specific carveout and over 20% explicitly included governmental responses to pandemics, such as lockdowns and quarantines. In almost all cases, this carveout is subject to the “disproportionate effects” exception to the MAE clause. This change is likely to have lasting effects beyond this specific pandemic, and is something that we would expect to see across the board.
Treatment of COVID-19 Related Loans and Subsidies
SRS Acquiom highlights specific challenges arising from Paycheck Protection Program (“PPP”) loans in the M&A context. Consent of both the lender and the Small Business Administration is required in order to effect a change of control, adding another closing condition, although SRS Acquiom notes that certain streamlined procedures have already been developed to address this issue. In purchase agreements, these loans have resulted in (i) the broadening of the definition of indebtedness for the purpose of the purchase price adjustment to include the amount of the PPP loan, (ii) the establishment of a post-closing payment of forgiven amounts, and - most frequently - (iii) the creation of an escrow which is based on the balance of the PPP loan.
Outside of the U.S., governments have been implementing a variety of financial assistance programs, loans and subsidies that need to be effectively dealt with in the M&A context. In Canada, the Canada Emergency Business Account (“CEBA”), which provides interest-free loans to small businesses and not-for profits that can be partially forgiven, needs to be taken into account in calculating and, in some cases, paying off, existing indebtedness in the transactional context. The Canada Emergency Wage Subsidy (“CEWS”) has also been made widely available to Canadian businesses, and parties should be careful in considering such subsidies and plan ahead as to who will be liable if the target be required post-closing to repay amounts to the government under the CEWS for a pre-closing period.
CARES Act: Who Gets the Benefit?
The Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) has allowed U.S. businesses to spread out losses incurred as a result of COVID-19 by temporarily permitting the carryback of certain net operating losses for up to five years from taxable years 2018, 2019 and 2020. The amendment of past tax returns by U.S. targets of recent acquisitions in order to benefit from the CARES Act has given rise to issues regarding the concept of tax benefits. U.S. transaction agreements are often silent on the question of which party is entitled to benefit from pre-closing tax benefits received in the post-closing period. SRS Acquiom proposed negotiating a split of these post-closing tax benefits, or allowing the buyer to benefit from the CARES Act benefits in exchange for some other benefit to the seller (for example, an earlier-than-expected escrow release).
This issue is not only CARES Act specific. It suggests a general need for more cautious drafting of tax clauses in merger and acquisition agreements. The parties should negotiate and plan for the allocation of benefit and risk with respect to potential pre-closing tax benefits that are, perhaps unexpectedly, received in a post-closing period. We note that this problem is unlikely to present itself in Canada, where merger and acquisition agreements more frequently plan for this issue as a result of the fact that the Income Tax Act (Canada) generally permits Canadian businesses to carry non-capital losses back three years.
Stock as Consideration
SRS Acquiom suggests that the market uncertainty and financial stress brought about by COVID-19 is responsible for the noticeable 3% increase (comparatively to 2019) in partial or all-stock transactions, and in post-closing amendments involving stock. While it is easy to focus on the negative impacts of the pandemic on the M&A market, this trend has also brought with it certain opportunities.
Earnouts: Mission Impossible?
One of the noticeable impacts of the pandemic in the M&A context has been to complicate the achievement and measurement of earnouts. Post-closing obligations and thresholds with respect to earnouts negotiated pre-pandemic have become difficult to meet in many cases due to safety issues, lockdowns, regulatory constraints, temporary changes to business plans and lack of available resources. Disputes have arisen between buyers and sellers, including as regards the scope and limits of the commercially reasonable effort standard and its application in these circumstances. SRS Acquiom suggests that parties have been surprisingly willing to adjust expectations in light of the pandemic, particularly where there is an emphasis on a continuing business relationship. Potential solutions include extending or renegotiating milestone thresholds or obligations that are no longer achievable, or even re-drafting the earnout structure completely in order to take account of changed circumstances.
Despite these complications, SRS Acquiom has seen a general rise in the number of earnouts across most industries. They also noted an increase in earnouts based on earnings or EBITDA measurements for those transactions (up from 16% in 2018 to 27% in 2020), and a corresponding decline in earnouts based on revenue measurements (down from 68% in 2019 to 58% in 2020).
Changes in Management Carveouts
SRS Acquiom observed a decrease in the volume of transactions included a management carveout plan (down from 9.7% in 2019 to 6.2% in 2020). Such plans carve out a portion of the proceeds of sale to pay certain members of the management in order to motivate them to remain with the company following the transaction. Perhaps counter-intuitively, this was accompanied by an increase in the median size of carveouts as a percentage of transaction value (up from 8.8% in 2017 to 12.8% in 2020), which is consistent with a pre-pandemic trend of increasingly significant management carveouts.
Looking for Alternatives
With respect to post-closing disputes, time delays and impracticalities associated with formal litigation in the context of the pandemic has prompted parties to turn increasingly towards alternative dispute resolution (“ADR”) processes, such as mediation. Once the dust has settled, it will be interesting to see whether this trend towards ADR as a means to resolve post-closing issues in the M&A context will continue. In Canada, some jurisdictions, including Alberta and Québec, are encouraging and on certain occasions even requiring to consider the use of ADR processes in order to reduce delays in resolving disputes and to reduce the backlog in the courts.
Some Things Never Change
Just as SRS Acquiom observed notable changes in the M&A landscape brought about by the COVID-19 pandemic, so too did they note that some things stayed the same:
- Representations and Warranties: While there has been a small shift towards more buyer-friendly representations and warranties, COVID-19 does not seem to have had significant impacts on representations and warranties. Trends appear to have been relatively consistent with pre-pandemic trends. In terms of what is looking more “buyer-friendly”, 2020 has seen more substantial representations with respect to undisclosed liabilities, more reps being qualified by knowledge, less “full disclosure” or “10b-5” representations, and more “no other representations” and “non-reliance” clauses are generally both more present in deals.
- Options: SRS Acquiom data reveals a continuation of a trend that has emerged since 2017 in which buyers are increasingly willing to assume options post-closing.
- Purchase Price Adjustment Escrows: The upward trend in dedicated purchase price adjustment escrows continued this year (the presence of such escrows increased by 15% in the last three years and are now observable in nearly 65% of transactions). However, even with these dedicated escrows, one can expect that the COVID-19 pandemic may complicate or prolong post-closing calculations.
- Post-Closing Matters: SRS Acquoim indicates that there has not been much change on this front, at least not directly as a result of the COVID-19 pandemic. That said, they have observed certain minor shifts, including a decrease in escrows or holdbacks as a percentage of transaction value, and a reduction of the use of individual claim thresholds.