Despite the downturn in M&A activity during the COVID-19 pandemic, there are already signs that businesses are starting to identify opportunities for growth. However, buyers and sellers alike need to ensure that the people-related impact that the pandemic has had on a target business is the key focus in evaluating transactions.
In this blog, we consider how the employment aspects of a M&A transaction might change in this new environment, focusing in particular on predicted trends, transaction structure, due diligence and drafting protection.
In upcoming months, we expect to see M&A activity pick up in sectors that have not been as adversely affected by the COVID-19 pandemic, such as the technology, biotech, and supermarket sectors. We can also expect an increase in distressed M&A for businesses that have been the worst hit, such as in the travel, event, entertainment and restaurant industries.
Employment considerations are likely to be key for this latter category, as businesses that have experienced a downturn in activity throughout the pandemic are those most likely to have made changes to their employment structures, whether through redundancies or use of government support schemes, for example the UK government’s Coronavirus Job Retention Scheme ('the JRS').
In the Asia-Pacific region, M&A was severely disrupted in the first quarter of 2020. However, signs of recovery in deal flow started to emerge in the second quarter, with many of the key markets in Asia (eg China, Singapore and India) seeing a positive trend in activity. Initial trends in the Asia-Pacific region point towards a likely increase in divestitures, allowing companies to generate cash and re-focus on their core businesses. Companies are also increasingly exploring joint-venture models in the wake of COVID-19, allowing them to use strategic alliances to move into new areas or consolidate existing business operations.
In the US, there is currently a meaningful increase in M&A activity levels, reflecting a number of different strategies and considerations, such as transactions:
- among corporates that still make strategic sense to gain scale, acquire new technology or enter adjacent spaces;
- to purchase that one competitor a buyer has always eyed;
- to shore up liquidity or financing considerations; and
- involving strategies looking to manage a company’s portfolio by divesting low growth or unattractive businesses.
As we emerge from the lockdown period, there will likely be uncertainty around predicting a business’ value and analysing its past performance, as neither historic financial information nor more recent management accounts may be reflective of future performance and potential.
The same can be said about a business’ employee needs and expenses, as its future requirements, at least initially, will likely depend on how well it has fared during the lockdown period.
We anticipate there will be large fluctuations in headcount, and increased use of temporary staff, contractors and agency workers. Prospective buyers must bear this in mind when conducting their due diligence, as discussed below.
Buyers often wish to structure their purchase as a share acquisition, despite taking on more liabilities and risks, perhaps to benefit from tax relief or for reasons of simplicity.
From an employment perspective such structures are more straightforward, as they largely allow employees to remain with their existing employer and avoid complicated transfer exercises. However, it may now be the case that buyers will want to ring-fence liabilities to attempt to avoid inheriting risks that have arisen due to COVID-19.
Deals that are structured as the sale of a business and its assets, rather than a share sale, can create doubts over which employees transfer automatically under applicable legislation and in some jurisdictions where there is no such legislation, such as the US, employees that need to transfer will be rehired by the buyer. This is also largely the position in many of the key Asia-Pacific jurisdictions.
Information and consultation obligations may apply on the transfer of employees. This creates risk, which can be mitigated to some extent in the transaction documents.
However, in some jurisdictions employees that transfer as part of an asset sale have enhanced rights, for example in relation to changing their terms and conditions, that may impact on the buyer’s ability to integrate the new employees into the buyer’s workforce or may delay or complicate the buyer’s initial plans for the business.
Both parties will want to mitigate the risks that have arisen due to the pandemic in their transaction documentation. Effective and targeted due diligence will be key to maximising the protections that are available, although buyers are currently facing practical difficulties in carrying out entirely remote due diligence exercises. Sellers may be expected to undertake more extensive vendor due diligence before the sale process begins. Buyers may be inclined to focus detailed due diligence in specific areas that have been impacted by COVID-19 to fully assess how the target business has been affected and how it is positioned to face future disruption.
Of increased importance is the need to ensure a good understanding of any cultural alignment challenges that the buyer may face once the deal has closed. Increasingly the due diligence questions as they relate to people are critical to ensure that the buyer knows that the cultures of the two merging businesses are aligned from both a performance and risk perspective. To the extent that cultural alignment issues have not been considered prior to closing, parties should prioritise this as soon as possible after signing or closing.
Government support has helped many businesses stay afloat during the peak of the pandemic, and buyers will want to ensure that the target business has complied with the government guidance and legislation at each stage. In the US, target businesses may have elected to defer certain pension plan contributions under the Coronavirus Aid, Relief, and Economic Security Act ('the CARES Act') and those accepting financial assistance under the CARES Act may be subject to certain limits on executive compensation, as well as the obligation to remain neutral in any union organising effort during the term of any loan provided under the CARES Act.
Prospective sellers who have made use of government support should ensure they have kept careful records of all decisions made so that potential buyers can review their process in detail. In the UK, reasons for placing employees on furlough and compliance with the tax authority rules and processes will be key areas of scrutiny. If there are employees who remain on furlough, it will be important to assess the target business’ plans for transitioning out of the JRS and any intended redundancies after the JRS ends on 31 October 2020. In the US, potential buyers will want to assess whether the target business has taken loans under the CARES Act since the transaction may cause the buyer or its affiliates to become ineligible for certain tax credits.
Where changes to the target’s employment arrangements have been made during the lockdown period, whether through furlough, redundancy or otherwise, sellers should be alert to potential liabilities arising out of claims for unfair dismissal, discrimination or breach of contract.
The current and future remote-working arrangements of the business will also need to be kept in mind during due diligence. It is important to understand whether and when the company intends to move back to ‘normal’ working arrangements (or, indeed, whether they plan to return to pre-pandemic practices at all), and if employment policies have been updated to reflect any new arrangements.
Moreover, the buyer should be aware of employees’ expectations around working arrangements, particularly if there have been communications from current management on this topic. The risk of constructive dismissal claims, particularly where there has been a transfer of employment as part of an asset sale in Europe, should be at the forefront of buyers’ minds when making decisions about changes to working conditions post-transaction.
Similarly, if restructuring decisions are envisaged, it will be important to understand the seller’s approach to such decisions, including ensuring that, for example, selection criteria have been adapted to discount any criteria that, following the pandemic, could be discriminatory (eg absence due to shielding or linked to other medical conditions).
In M&A activity going forward, we will likely see more buyer-friendly deal protection with a wider coverage of warranties and indemnities, as sellers prepare themselves for higher levels of scrutiny and a competitive buyer-friendly market.
In the US, we are likely to see buyers continue to negotiate for flexibility in their commitments to provide continuing employees of a target business compensation and benefits in any particular form, level or for any material period of time following closing.
Between signing and closing, undertakings or covenants limiting the seller’s flexibility with the target business might be appealing, particularly where the pre-closing period may become longer to accommodate extensive regulatory reviews or delays in regulatory clearances. For instance, buyers may wish the seller to undertake that there will be no changes regarding employees, specifically around engaging in redundancy processes or changes to furlough arrangements, or that the buyer’s consent is sought on these decisions.
However, care should be taken in drafting these pre-closing covenants, particularly any involving commitments to operating the business 'in the ordinary course' where in the previous months the seller has had to implement redundancies or lay-offs at the target. This may inform what is now the 'ordinary course' especially in a post-COVID-19 environment.
For longer-term protection, buyers may want to consider adding specific provisions that relate to the COVID-19 pandemic. This may include changes to health and safety compliance requirements, material adverse change clauses that accommodate COVID-19 related impacts or indemnities for identified risks.
At present, buyers may be more sensitive to even short-term adverse impacts on a business due to the uncertainty. If the potential liability is significant, the buyer could consider requiring the seller to put funds in escrow to cover the potential liability and negotiating for a higher indemnification cap.
Sellers should also be mindful of their ability to obtain warranty and indemnity insurance for such risks, as the insurance industry may adapt their coverage to exclude such unpredictable issues.
There remains uncertainty as to how M&A will proceed in the post-COVID-19 world, and how the new risks associated with M&A activity will be managed in the foreseeable future.
Sellers should ensure that they are prepared for a deal process that will scrutinise the decisions that they have made during the pandemic, and employee-related decisions may be at the forefront of that analysis.
Buyers who plan to use M&A as part of their growth strategy may be more selective about which businesses to target.
Both parties should be prepared to adapt their approach to, and expectations of, the M&A process to take into account the impact of the pandemic for a considerable time to come.