The economic uncertainties and ongoing disruptions to economic conditions and business models stemming from the COVID-19 pandemic have resulted in numerous post-transaction disputes and have driven significant changes in due diligence and in how deals are structured and purchase agreements are drafted.
Due diligence for a COVID — and post-COVID — world
Uncertainty regarding economic conditions and the inability for many dealmakers to conduct deals in person caused a sharp slowdown in deal activity from March to June 2020. But deal activity rebounded to finish with record volume in 2021 and Q1 2022. Dealmakers were creative in structuring deals, the economy remained strong, and deal volumes and average deal size increased sharply, particularly in the middle market. The following conditions drove the market:
- Well before the pandemic, LPs and GPs began placing pressure on funds to deploy unspent capital. According to the 2022 Bain Global Private Equity Report, dry powder had arisen to record levels of $2.5 trillion by the end of 2021. Private equity was eager to put this money to work and sought new deals during the pandemic.
- Supplementing the record levels of dry powder, domestic and foreign governments stimulated the economy and shielded businesses from the economic impacts of COVID. Trillions of dollars were pumped into the US economy, boosting consumer and business spending.
- Change in control of both the White House and Senate in the 2020 elections raised the possibility of changing tax rates and structures and resulted in increased selling interest among U.S. middle-market business owners eager to divest before any potential tax increases.
These frothy market conditions were buoyed by historically low interest rates and high availability of debt capital to finance deals. These factors culminated in highly active M&A markets.
While M&A markets were extremely active, the pandemic necessitated changes in how M&A diligence is performed. The impacts of COVID were wide ranging, affecting different sectors and different businesses in unique ways. While dealmakers found creative new ways to structure deals, M&A advisors found creative new ways to understand historical financials and, in turn, understand the sustainability of near-term earnings:
- Technology-enabled deal processes that were traditionally performed in person. It became commonplace for buyers, sellers and management teams to hold management Q&A sessions via virtual platforms such as Microsoft Teams or Zoom. Virtual tours of facilities were held to verify and review.
- Evaluating the impact of the pandemic and management’s response to the initial shutdowns of the pandemic was paramount in anticipating how a target business would emerge from the pandemic. Buyers and sellers scrutinized recent results to forecast near-term performance.
- The pandemic drove a war for talent. Businesses that were quick to layoff and cut costs through personnel decisions often found themselves in a difficult position when labor markets tightened, resulting in capacity constraints and missing out on top-line revenue opportunities as demand strengthened. This ultimately led to stay bonuses, incremental recruitment costs, and higher average wages to mitigate the cost of higher attrition rates. Additional due diligence to understand recent payroll increases and near-term impacts to profitability were critical to assess the sustainability of EBITDA.
- Operating working capital levels fluctuated significantly, often out of line with prior operating levels. Working capital was especially impacted by supply chain constraints, which resulted in temporary buying pattern changes to minimize the impacts of stock-outs and material shortages. Additionally, many companies strategically focused on shortening DSO trends while elongating DPO ratios to strengthen the balance sheet during uncertain times. Due diligence focused increasingly on historical working capital levels, to negotiate and set working capital pegs.
In spring 2022, M&A activity remains healthy and strong. The market is ripe but faces the following new challenges in the near and medium terms:
- Dry powder continues to increase despite active M&A markets, rising to $3.4 trillion as of December 2021. As this dry powder ages out, there is added pressure from investors to put this money to work.
- Interest rate levels continue to hover near record lows, attracting debt and availability of debt. However, with the Fed committed to using rate increases to rein in inflation in 2022, it is uncertain how long these interest rate levels will last. Buyers and sellers need to consider the impact to enterprise valuations should debt service costs rise in the near term.
- Inflation is high, driven by the unusual combination of strong consumer demand while businesses continue to see significant labor shortages and supply chain constraints. Cost structures within all business are seeing increasing pressure. Buyers and sellers need to consider whether pricing pressures seen in expenses can be passed along through immediate and near-term price increases. Buyers should scrutinize recent cost changes and evaluate how these changes impact the sustainability of EBITDA.
- With the Russian invasion of Ukraine and the threat of broader conflict, buyers and sellers need to consider the impact of global revenue, additional supply chain disruption, and further impacts if globalization of business stalls in favor of protectionist foreign policy.
How the pandemic changed deals
Due diligence is one thing. Getting a deal documented, closed and through any post-closing disputes is another. The pandemic has changed M&A practices in these areas as well.
1. Rise in the use of earnouts
A 2021 Grant Thornton survey found a strong rise in the volume and value of earnouts. Nearly all survey respondents — a total of 94% — say they expect to use earnouts in at least 70% of their deals.
Earnouts allow parties to hedge against the uncertainty of growth or future profitability by evaluating the performance of the business post-closing. Because earnouts are typically based on results from future periods, they require careful drafting and forecasting and must predict the accounting treatment of all foreseeable eventualities.
2. Specific accounting policies and treatments
Calculation of closing net working capital is highly subjective, so it must be carefully defined in a purchase agreement in order to minimize disputes. Buyers have, in some instances, used the working capital true-up following a deal, thus reducing the amount payable to the seller. While this trend has increased in the pandemic’s aftermath, as turbulent conditions have driven disparate views, it can cause more disputed deals and lost value.
This gap can be bridged through proactive consideration of the components of working capital and their basis of calculation. Traditionally, buyers and sellers drafted deals to rely on “GAAP, consistently applied” to determine closing net working capital. The problem? That left a number of issues open to interpretation. To minimize disputes, parties should instead define specific accounting policies and hierarchy of accounting principles to proactively consider how to calculate subjective, high-impact areas such as:
- Calculation of bad and doubtful debts: Should there be any increase in a reserve or a change in the level of prudence given the increase in uncertainty or a change in the profile of bad debts over the last two years?
- Inventory reserves: Whether through obsolescence, slow-moving inventory reserves, changed markets for goods, or distressed supply chains, COVID may have impacted inventory reserves to the extent a “GAAP consistently applied” approach is no longer relevant. For example, there may have been a significant build-up of inventories either to mitigate supply chain risk or due to a slowdown in sales. In either case, a historic approach to reserves may not apply at closing.
- Bonus accruals: Sellers may posit that no discretionary bonuses may be payable, as COVID has impacted performance and caused uncertainty. A buyer is more likely to suggest that a normal (or even excess) bonus will be payable and should be accrued ratably. Reference to past practice alone may not clarify the situation. Defining a specific policy regarding what bonuses will be included or pro-rated can definitively resolve this potentially contentious item before the deal is signed.
- Onerous leases: During the pandemic, many businesses decided to exit facilities and leases, resulting in onerous leases. GAAP may require a provision to exit or terminate the lease — a potentially “one-time event” for which there is no historical reference.
3. Working capital targets
Due to the impact of COVID on working capital during reference periods, parties have taken a number of approaches to set the Target Working Capital figure (the normal level to which the Closing Net Working Capital is compared to illustrate an excess or shortfall as of closing and yield a purchase price adjustment). Approaches include:
- Increased prevalence of forward-looking targets or the use of forecasts
- Substitution of periods — During 2020, we observed parties substituting 2019 months for 2020 months for a more “normalized” look (e.g., Jan–Feb 2020 + March–June 2019 + July–Dec 2020)
- Shorter periods (e.g., T3M/T6M rather than the most commonly used T12M)
- Overlaying of normalizations, derived through financial diligence
The appropriate approach to reflecting the impact of COVID on a working capital target should be driven by the nuances of each situation and thus should be negotiated between the parties based on the impact COVID had on the target company and the company’s industry. The further we get from the peak affected months of March through May 2020, and as these months no longer impact a trailing 12-month average, the necessity of applying bespoke reference periods or overlaying normalizations is reduced, though, for many businesses, the effects lingered far beyond those first few months.
As of May 2022, parties can use a trailing 12-month reference period indicating performance from late 2020 calendar year 2021 and Q1 2022, which may be unaffected by the most abnormal months of 2020. For many businesses, this may better indicate “new normal” levels, though this remains subject to diligence and an understanding of the unique nature of each business. For some industries, the supply chain impact on inventory levels still lingers on in 2022. While a trailing 12-month average remains most common, bespoke approaches are appropriate and careful consideration should be applied during negotiations on each deal.
4. PPP loans
For many, PPP loan forgiveness has already been secured, so treatment of PPP loans may not be an issue. However, in the months immediately following the initial COVID shutdowns, as deal activity restarted, there was a temporary trend, particularly within private equity, towards favoring Asset Purchase Agreements in lieu of Share Purchases. This approach allowed buyers to avoid acquiring PPP loans, given concerns over the associated regulatory or reputational risks, or over how an acquisition might impact future forgiveness decisions.
Where a PPP loan was to be acquired, parties needed to consider whether the item was considered indebtedness, whether forgiveness was assumed, or whether some escrow arrangement should be established. Careful drafting was necessary to preclude post-close disputes. Certain buyers will have benefitted from the debt approach, assuming no forgiveness and treating the entire balance as debt for borrowed monies. On the other hand, sellers typically preferred to treat the debt as non-recourse.
The approach to PPP loans has solidified, and an escrow arrangement — to the extent loans remain unforgiven — is commonplace. Buyers place funds into escrow, the seller makes certain representations and warranties over the loan, and upon forgiveness, the funds are ultimately dispersed to the seller’s account (or returned to the buyer if forgiveness isn’t achieved).
Treatment of deferrals — Payroll and rent
Two of the more frequent balance sheet items COVID has impacted have been payroll and rent deferrals. Typically, payroll taxes are considered a component of net working capital (unlike income taxes). Some sellers have suggested payroll deferrals related to COVID as a normal component of net working capital, offset by other COVID impacts. However, a general consensus has been reached within diligence providers to exclude these items from net working capital and treat them as debt-like items.
Another significantly impacted balance sheet item is deferred rent. Some businesses have received significant rent abatements as their retail operations have been shut down or temporarily closed. This can have a significant impact on working capital or indebtedness depending on if parties treat this as a debt-like item.
Parties should pay special attention to deferrals and their impact on indebtedness or working capital at the closing of a transaction.
Post-acquisition disputes: Representative cases
It was quickly apparent that COVID would present significant risks to buyers and sellers in the process of negotiating deals, including agreeing on how to structure purchase price adjustments. Two years in, working capital and earnout disputes have unsurprisingly spiked. The following are two key areas of disagreements between buyers and sellers:
1. Accounting estimates and subsequent events
COVID’s severe economic disruption presented a new risk to in-process transactions. Transactions that use U.S. GAAP as the basis for calculating net working capital typically result in consideration of subsequent events occurring after the closing date. During a time of unprecedented economic upheaval, the lack of clear contractual language related to subsequent events led to disputes. Key questions raised included:
- Should parties consider only information that was known or knowable up to a certain point (perhaps prior to the emergence of COVID in the U.S. or prior to any shutdown of operations)?
- To what extent are a seller’s past practices relevant in calculating net working capital when the business environment has so radically changed?
With the benefit of hindsight, we can ask these questions and agree upon a response prior to signing an agreement. However, for many deals signed prior to Q1 2020 and with true-ups or earnouts occurring beyond such date, this was not possible.
We have seen examples of what happens when the consideration of accounting estimates and subsequent events is not effectively defined in purchase agreements. In one situation, a dispute arose around the calculation of the reserve for accounts receivable as of the closing date. While the purchase agreement specified that a full reserve was to be taken based on the seller’s past practice to reserve for receivables outstanding more than 180 days, the application of this calculation at closing (which occurred during the pandemic) resulted in a reserve that was more than double the historical reserve and actual write-offs over the past year. In this case, COVID had severely delayed payments, but many were ultimately collectable. While the buyer argued that the company’s past practice should be followed, the seller argued that their past practice was no longer in accordance with U.S. GAAP and needed to reflect the delay in collections.
In this case, the parties could have drafted specific accounting policies within the agreement to reduce their risk of a post-acquisition dispute. For example:
- Rather than a reliance on GAAP, consistently applied, the parties could have detailed the bad and doubtful debt policy to be applied at closing. Additionally, the parties could have added language specifying which methodology shall prevail in the case of a discrepancy — U.S. GAAP or the company’s past practice.
- The parties could have supplemented the reserve policy with a floor and/or a cap (which often exists in the form of an agreement that the calculation shall not exceed a certain percentage of accounts receivable, or a specific amount).
- The parties could have detailed how post-closing events, such as the receipt of debtor balances, would impact the calculation — in this case, no reserve would have been included for monies ultimately recovered by the buyer prior to a certain date.
2. Earnout provisions and the calculation of target financial metrics
Earnout provisions (which are often based on achieving revenue, EBITDA, or net income targets) have also presented challenges in the COVID environment. The inability to reach earnout targets due to the pandemic is now a common threat, especially for businesses impacted by shutdowns. In order to reduce the risk related to the calculation of earnout provisions, it is critical to specify how one-time events will be handled.
Failure to specify such contractual language has resulted in disputes. In one example, a retailer forced to close due to the government shutdown in the spring of 2020 experienced a sharp decrease in net income (the metric by which the earnout payment was to be calculated). While the buyer argued that the earnout payment should be zero (based on the net income earned during the earnout period), the seller argued that an adjustment should be made to exclude losses during the shutdown period and add back lost profits.
While the purchase agreement did allow for certain adjustments to be made to the earnout payment, what constituted acceptable adjustments were not clearly defined. Had the contract specifically provided for the effects of a government-imposed shutdown, there would have been no question regarding how the effects of COVID should be considered in the earnout payment. In order to prevent similar disputes, parties should consider upfront how such events should be treated concerning earnout payments.
From due diligence to documentation to closing and beyond, COVID has had a profound impact on how deals get done. Whether you’re a buyer, seller or an advisor, understanding the issues the pandemic gave rise to, and the solutions used to address them, will help your deal go more smoothly and minimize the chances of disputes.
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