Advances in Mergers and Acquisitions

Cary L. Cooper, Sydney Finkelstein, Cary L. Cooper, Sydney Finkelstein

• Publisher: Emerald Publishing Limited
• Year: 2021
• ISBN:
  9781800717213
• Topic: Commerce
• Subtopic: Fusions & acquisitions

Advances in Mergers and Acquisitions stands out from the competition due to its focus on three key characteristics: studies from scholars in different countries, with different research questions, relying on different theoretical perspective. Such a broad and inclusive approach to mergers and acquisitions is not easily replicated in academic journals, with much narrower mandates and metrics. The chapters published in this volume provide cutting edge ideas by leading scholars and help to inform mergers and acquisitions research around the world.

Volume 20 of this annual series explores a range of issues relevant to a post-Covid world and the ensuing recession. These include creative ways to bridge the gaps between buyers and sellers, mitigating cross border acquisition uncertainties, M & A investment decision-making, as well as how customers experience an acquisition and whether merging firms perceive their customers as assets to trade or as stakeholders to engage.

This book is of interest to scholars in strategic management, organization theory, and organizational behaviour who are studying questions around mergers and acquisitions. Doctoral students in particular will benefit from access to the diversity of research that can trigger new research questions and expanded research agendas.

CHAPTER 1

AN M&A GUIDEBOOK FOR A POST-PANDEMIC WORLD: CREATIVE WAYS TO BRIDGE THE GAPS BETWEEN BUYERS AND SELLERS AFTER THE COVID-19 PANDEMIC

Andrew J. Sherman and Paul Pryzant

ABSTRACT

In this chapter, the authors explore current trends in M&A deal structure, due diligence and post-closing challenges. The global pandemic has had a direct and indirect impact on the capital markets, transactions and market conditions, some short-lived and likely to return to normal as the global economy slowly re-opens and some more permanent as to how buyers and sellers and their advisors are likely to perceive, allocate and mitigate transactional risks.

Keywords: Capital market trends; mergers & acquisitions; deal structuring; due diligence; post-closing integration; allocation of risk

• The COVID-19 pandemic has caused a shift from a seller’s market to a buyer’s market in the space of a few months and has potentially forever changed the M&A deal process.
• How should deals can be structured to allocate the risks between buyers and sellers in a post-COVID-19 world?

The COVID-19 pandemic (COVID-19) throughout the course of 2020 and spilling into 2021 has created unparalleled uncertainty for nearly all businesses in that companies are unable to predict when and how businesses and consumers will resume buying their goods and services. This unpredictability has made it more difficult for dealmakers to use historical earnings to predict a company’s future earnings, and accordingly their valuation, which has severely curtailed the number of M&A transactions at the present time. Somehow, however, a trickle of deals are getting done and others are being pursued, although at a much slower pace than in 2019 but many predict that M&A at all levels and most industries will come roaring back by Q2 of 2021.

WHY WOULD BUYERS AND SELLERS WANT TO DO A DEAL IN THIS ENVIRONMENT?

Buyers with available funds may find that the current environment provides opportunities that would not have existed before the pandemic. In particular, strategic buyers with deep industry expertise will look for transactions that will allow them to add a new product or service, acquire new technology or a set of skilled employees or some combination thereof. Private equity buyers have a lot of available funds to invest and will need to deploy capital, especially if they perceive this to be a buyer’s market. One of the pandemic’s principle effects for M&A transactions has been to lower seller valuation expectations, motivating sellers to be more flexible than they were only a few short months ago. As a result, valuation expectations are materially lower for sellers, making it easier to structure a transaction that makes sense for both parties. In certain industries, such as hospitality, travel, tourism and restaurants, opportunities in troubled, turnaround and even bankrupt companies have led to very attractive valuations.

Throughout this chapter, reference to “private equity” generally means platform acquisitions by a private equity fund, which are acquired to be a standalone portfolio company, as opposed to a “tuck-in” acquisition by a portfolio company. “Strategic buyer” generally means an existing company already operating in an industry, which can include both public and private companies and can include a private equity portfolio company looking for a tuck-in acquisition.

Many young start-ups and technology companies may lack sufficient cash resources to weather the COVID-19 storm and may be unable to find additional funding quickly enough. This predicament may increase the attractiveness of a larger strategic buyer capable of providing stability and added resources that the seller and its employees sorely need. Sellers may have other reasons to seek a sale, including the death or divorce of a founder, the need for liquidity to provide some diversification for the owners or a management team that has reached its limits for moving the company forward. In some cases, COVID-19 has “expedited” the retirement plans of baby-boomer business owners who have re-prioritized their life goals. Such sellers may have been trying to find a buyer before COVID-19 and do not have the luxury of waiting a year or longer for a more favorable selling environment. There are also distressed situations in which a company may face insolvency and bankruptcy, but transactions involving bankruptcy have very different rules and considerations which are beyond the scope of this chapter.

What Trends Have Influenced M&A During the Pandemic

If there is anything that is certain for M&A in 2021 and beyond, it is uncertainty. In a Fall of 2020 McKinsey survey of global leaders, 80% of CEO’s said that they do not believe that their current business models were sustainable, due to the impact of COVID-19, digitization, shifting work place trends and the overall impact of technology. How will M&A be impacted? How will M&A be part of the solution and not just make the problem worse? Many experts predicted that COVID-19 expedited the path to digitization by as much as five to seven years and most companies were just not ready.

In addition, the impact of the new Biden Administration on capital gains/estate/income taxes, health care, immigration, trade and foreign relations, environmental policy is all uncertain. As the submission of this chapter to the publisher, the balance of power in the US Senate was still unclear.

HOW HAS DUE DILIGENCE AND THE M&A PROCESS CHANGED IN THE POST-COVID-19 ENVIRONMENT?

Acquisitions typically are the start of a long-term relationship between the seller’s management team and the buyer, the success of which depends heavily on the seller’s key employees. For buyers, face-to-face meetings with the seller’s management team remain a critical component of deal-making and due diligence, and few buyers will be willing to close a transaction without several opportunities to interact in person with the management team. Most deals that eventually closed in 2020 were likely underway before the pandemic, so the buyer already had spent time with the seller and the seller’s management team. Due to the challenges posed on travel by COVID-19, the nature of due diligence on the management team is likely to change. For new transactions in which the buyer has no prior relationship with the seller, video conferences will allow the sale process to get started between motivated parties. For now, however, buyers will likely insist on meeting the management team in person before they are willing to close the deal.

Travel has been constrained for an extended period which together with immigration restrictions affecting cross-border transactions, buyers may need to rethink their dependence on face-to-face meetings. Similar to hiring decisions, buyers will become more comfortable sooner or later with video conferencing, both for getting to know the management team during due diligence and for interacting with them post-closing. Buyers may also increase their use of personality tests and similar assessment tools to better understand the management teams of the seller during due diligence. You can also expect to see buyers becoming more structured in their due diligence discussions on video conferences, similar to the hiring methodology Geoff Smart and Randy Street recommend in their book, Who—The A Method for Hiring. Although right now partners at private equity funds and strategic buyers may say that they would never buy a company without extensive meetings with the management team in person, this attitude could change if the effects of the pandemic persist.

The inability to meet with the seller’s management in person is one of several reasons to extend the due diligence time period. An extended due diligence period allows the buyer more time to assess more accurately COVID-19’s impact on the seller and to find any needed financing for the deal. As a result, look for the exclusivity period in letters of intent to be extended from the typical period of 60 days pre-COVID-19 to 90 or 120 days, if not longer.

Due Diligence and the Nature of the Seller’s Assets

A few short decades ago, most of the assets conveyed especially in middle-market M&A deals were tangible in nature, such as equipment, inventory, real estate, vehicles, etc., but most transactions in 2021 and beyond will be the exact opposite. Today’s most critical strategic assets include brands, relationship, channels, culture, reputation, systems, processes and social media and digital assets.

The skill sets and experts needed to satisfy due diligence best practices in the 2020s, together with the impact on allocation of risk that R&W insurance policies have created, will permanently change the nature, scope, depth and breadth of due diligence.

The exact nature of due diligence will strongly depend on whether the key assets of the seller are intellectual property, such as for a software company, or whether the key assets are physical, such as inventory or a factory or distribution facility. The more the key assets are physical, the more likely the buyer (and the buyer’s lenders) will require physical inspections that will lengthen the closing timetable.

Certain physical assets, such as a factory or distribution facility, will require more rigid due diligence on new health and safety measures put into place to protect workers at the facility. Similar to having Phase I environmental reports for real property, third-party health and safety inspections must be added to due diligence checklists for physical facilities.

The pandemic provides new lines of questions to ask the management team to better assess its capabilities and the operations of the target business.

• What decisions did you make to cope with the pandemic and why? How did they turn out? How did you treat your employees and vendors? What did you learn, and what would you do differently? How has work place and work space shifts affected leadership, governance, teamwork, collaboration and innovation? New product development pipelines? How has it affected culture or exacerbated already alarming levels of disengagement? (See Gallup Study on the State of the American Workplace.)
• What is the seller’s supply chain vulnerability, especially to China and other overseas sources? What plans does management have to change the supply chain in a post-COVID-19 world?
• What additional operating costs are required to operate in a post-COVID-19 world?
• How has management adjusted to the Fall 2020 spikes in the spread of the pandemic?

A common area of due diligence in 2020 was targeted at a loan under the Paycheck Protection Program (PPP) and Economic Injury Disaster Loans (EIDL) programs, especially if the loan was for more than $2.0 million so that it is subject to the automatic audit promised by the Small Business Administration (SBA). Buyers should ask about the seller’s eligibility for a PPP loan under the SBA’s affiliation rules. Buyers will be leery about buying a company subject to an SBA audit when the seller’s eligibility was questionable, or there are questions regarding the seller’s good-faith certification regarding the “necessity” of the loan and its eligibility for loan forgiveness.

Due to the shift from a seller’s market to a buyer’s market, sellers must find ways to distinguish themselves in a chaotic marketplace. One way to do that is to make due diligence easier and more transparent for the buyer. In this new environment, sellers should make the up-front investment in pre-sale due diligence. This will include investing in a more thorough quality of earnings (Q of E) review before starting the sale process. The Q of E will provide the buyer with better visibility into the seller’s pre-COVID-19 financial performance and how the seller will manage through the disruptions caused by the pandemic. A seller will also want to prepare a “stress test” analysis for its business under different possible scenarios in a post-COVID-19 world. Buyers will find sellers with more transparent financial data and a plan for an uncertain future to be much more attractive. These types of “stress test” analyses are critical to help develop more creative deal structures required under the current environment, as discussed below.

How ESG and CSR Priorities Have Crept into the Due Diligence Process

As corporate strategy and the capital markets embrace Environmental/Social/Governance (ESG), Corporate Social Responsibility (CSR) and impact investing priorities, ESG-driven issues have crept their way into M&A and that trend is likely to continue in 2021 and beyond. Our recent political, social and economic unrest and divisiveness have lead buyers to make ESG priorities a critical screen and filter in due diligence, provisions in definitive documents and post-closing conditions and covenants. An increased emphasis on environmental compliance and carbon footprint, worker safety and hygiene, child labor and supply chain, diversity and inclusion, governance best practices, digital asset brand and reputation are all likely to affect M&A transactions and definitive documents.

What Are Ways to Bridge the Valuation Gap, Given the Uncertainty in the Seller’s Future Financial Performance?

Setting the Stage – Valuation Methodologies and Changing Expectations

Three common ways to value target companies are:

• Multiple of prior 12 months of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), which is used for companies with earnings. This is the most common valuation methodology.
• Multiple of revenues, most commonly used for software and other technology companies that have been able to build significant sales but are not at the stage of having earnings.
• A “build versus buy” analysis, in which the buyer assesses the cost to duplicate the functionality of the seller’s product or technology from scratch, versus the cost to buy the seller and its employee team. This measure is most commonly used for early-stage software and other technology companies prior to them having significant sales revenues. Acquisitions of these types of companies are especially attractive if they have a skilled set of employees who can jump-start the buyer’s efforts to add a new product or service or technology. This valuation methodology generally leads to lower valuations, but not always, depending on the immediate needs of the buyer. When Facebook paid $1 billion for Instagram in 2012 for a one-year-old company with 13 employees, it sounded insanely high at the time, but in retrospect, it has turned out to be a bargain and has been recently valued int...