DealMakers - Q2 2020
Dealmaking opportunities in a time of crisis
by Elnalene Cornelius and Tessa Brewis
The pandemic has forced many businesses into survival mode. For some, acquisitions and expansion plans have been shelved, the emphasis shifting to mitigating risks and maintaining the status quo. Others find themselves in distress, requiring urgent cash injections to avoid going out of business. Such distressed businesses may not have access to debt funding in the current environment, and finding equity partners could be their only means to sustain themselves. How can cash-rich investors and private equity funds, in particular, seize the opportunity to invest in private companies that present a good value proposition, despite the constraints of the current situation?
Businesses looking for cash injections
Businesses in sectors such as hospitality, entertainment and tourism watched their revenues disappear overnight due to the COVID-19 restrictions. Many of these businesses now require urgent cash boosts to resume or reshape their operations and to stave off business rescue or liquidation. Seemingly immune, longstanding household brands fall among these cash-strapped businesses, despite recently boasting stable and attractive balance sheets. Closely-held family businesses that may not have been open to private equity investors pre-COVID-19 are now having to rethink their position. Private equity investors bring advantages other than their obvious cash: their business management expertise can also help such target companies navigate crises.
From an investor’s perspective, loan funding to these businesses would be too risky, and a subscription for equity by the investor would be a more viable mechanism to provide the business with the cashflows required.
The investor exposes itself to shared risk but the benefits for the investor include:
an investment opportunity at a lower consideration; and
bargaining power to negotiate more favourable transaction agreements.
Investors can further manage their risks by negotiating put options and drag-along rights to facilitate their exit. Robust minority protection provisions would also be critical, giving the investor the opportunity to influence the business strategy to steer the company back to a profitable income stream, securing returns on its investment.
Given the looming uncertainty of the next few years, staggered investments through call options can also be considered, so that the investor can start with a smaller stake, with the option to obtain more equity once the target company demonstrates its improved performance.
Time is of the essence for many struggling companies. Regulatory approvals, including Competition Commission approval, exchange control approval, the approval of governmental departments, and waivers or approvals required from the Takeover Regulation Panel, to name a few, threaten to delay the implementation of such transactions. Legal advice on the optimal transaction structure should therefore be sought to avoid such pitfalls.
Investors can also consider loan funding with the option to convert a loan into equity at the appropriate time. Investors need to carefully strategise their exits, especially since successful IPOs are unlikely in the current climate. When negotiating put options, the investor should consider how the other shareholder/s would pay the consideration, so that it is guaranteed a full or substantial return should it exit through this mechanism.
Companies Act 71 of 2008 considerations
From a Companies Act perspective, the board may, in terms of section 40(1)(a), only issue authorised shares for adequate consideration to the target company as determined by the board. The subscription consideration payable by the investor at a potentially lower value should therefore still constitute adequate consideration to the target company for the equity, in order for the target company to comply with s40(1)(a) of the Companies Act. Should the transaction be structured in a way that the target company provides financial assistance to the investor, as contemplated in s44 or s45 of the Companies Act, the target company must further be able to satisfy the solvency and liquidity test.
The directors of the investor and target company must also ensure that they comply with s76 of the Companies Act by exercising their powers and performing their functions in the best interests of the company and with the necessary degree of care and diligence expected of a director during this time of concentrated risk. This is especially important for the deal principals of private equity funds that are directors. Such directors need to protect themselves from potential liability if something goes wrong with the investment, or if it results in a loss for the fund.
As Winston Churchill famously said, when working to form the United Nations after the Second World War, “Never let a good crisis go to waste”. A liquidity crisis for some could mean an investment opportunity for others. The benefits don’t stop at the investor: the investment could save a business, and owners’ and employees’ livelihoods, in the current economy when such lifelines are hard to find. From an investor’s perspective, pursuing business opportunities during an unusual time should, however, be carefully managed to maximise the potential upside and limit the additional risk that comes with it.
Cornelius is a Senior Associate and Brewis a Director in Corporate & Commercial practice, Cliffe Dekker Hofmeyr.