DealMakers - Q1 2021 (May 2021)
Put your money where your mask is
by Tracy van Wyk and Cheván Daniels
COVID-19 pulled the rug out from underneath us and, overnight, we had to change the way in which we operate. Governments declared national states of emergency, borders were closed and sectors of the world’s economy came to a grinding halt.
Through our legal window to the economy, we have seen a significant decline in M&A activity and a rise in financially distressed businesses.
Sectors hardest hit include construc-tion, manufacturing, air travel, road and rail freight, wholesale, motor vehicle trade, financial services, personal services, tourism and hospitality.
Not all businesses have been negatively affected, however. In fact, certain sectors have stood out as champions during this time. For example, agricul-ture, online retail, manufacture and supply of food and other essential items, virtual streaming and education, health and technology businesses, and services generally.
Echoing the general uncertainty of this time, a question that we have had to grapple with is: What does the future of M&A look like?
Tracy van Wyk
In South Africa, our lockdown restrictions have eased significantly, and the general feeling is that everyone is coming out of hibernation and starting to look for opportunities. However, with parts of the world still significantly under strain, the future is still uncertain. The trend is certainly for businesses and investors alike to reflect on what the markets and products of the future will be and what opportunities are available. Like never before, we are seeing businesses rethink the way that they operate and find ways to adapt and innovate to stay relevant.
From an M&A perspective, there is no doubt that opportunities exist. However, investors will need to be even more discerning.
There are two important aspects to bear in mind here. The first is that the significantly increased revenues of the COVID-19 champions will not necessarily be sustained into the future. The second is that certain of the businesses that have been negatively affected by the pandemic will recover. In identifying promising targets, investors will have to test viability and sustainability and perform careful projections in anomalistic conditions, and the impact of COVID-19 and similar pandemics will need to be taken into account.
Even more so in the current climate, and having learnt from the corporate scandals and failures of the past, investors will find value in businesses that have focused on managing financial risks, quality and sustainability of earnings, and return on capital, as opposed to simply growth in earnings (off the back of debt). Ultimately, businesses will be assessed more holistically, and those that are good quality, offering deep value, with strong management teams and low business and financial risks, clear strategy, good governance and deployment of capital and long-term prospects will stand out. Here, the spotlight will be placed on careful and focused commercial, legal and financial due diligence.
Even where opportunities are identified through this process, investors are likely to face an additional hurdle: price.
Sellers of financially stressed but viable and salvageable businesses are unlikely to be willing to give them away, and they shouldn’t! Owners shouldn’t be too hasty to dispose in this market and would be advised to look at other options, such as partnering with equity investors or negotiating with their funders. On the other hand, investors are unlikely to be willing to pay inflated prices in circumstances where their projections may not materialise.
Closing this pricing gap may require the parties to consider alternative deal structures that achieve the appropriate value for the seller, but also satisfy the investor that it is not overpaying. For this, the parties may consider delayed valuation dates, deferred payments, retentions, “earn-outs” or other price adjustment mechanisms. This may be coupled, for example, with incentive schemes for key management and potentially other employees, in order to ensure that all parties’ interests are aligned in reaching the business’ fullest potential.
An investor may also want to build in conditionality, walk away rights or “material adverse change” clauses to add additional protection.
Of course, these are not new concepts, but we anticipate that the spotlight will be placed on these mechanisms in deal-structuring in the current climate. There is no “one-size fits all”, and the nuances of each transaction and each target will dictate the appropriate structure and balance.
In addition to, and in spite of, the negative impact that COVID-19 has had on certain aspects of the world’s economy, and the livelihood and psychology of the world’s population, it has also brought opportunities for improvement, positive change and innovation. The world’s axis has shifted and people are rethinking the way in which they do things. While in the M&A space, the opportunities may be more challenging to identify, they will be there. It may just require some innovative thinking to get deals across the line. We are already seeing an uptick in M&A activity during the first quarter of 2021, even if, at this stage, most of it is exploratory.
Van Wyk and Daniels are Executives | Corporate Commercial | ENSafrica.