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Freshfields Transactions

| 6 minutes read

After the fact: the actual impact of COVID-19 on M&A

Almost 10 months after the first lockdown restrictions were introduced in Europe, we find ourselves at the end of an unprecedented year with most of the world still battling a ferocious 'second wave' of the pandemic. Many are clinging to the hope that vaccines will help restore a sense of normalcy in 2021, but our futures remain uncertain. This post will look at M&A in 2020, and assess how some of the predictions made in the spring and summer stack up against the current market practice.

When we zoom out and look at where the market was this time last year, prior to the outbreak of COVID-19, we can see how the global M&A market was bullish and characterised by a very seller-friendly environment, where quality targets were few and valuations were high. 

Two key themes of pre-COVID-19 M&A were:

  1. the volume of funding (such as PE and sovereign wealth funds' dry powder) looking for investment opportunities as available targets were limited; and 
  2. cash-rich corporates looking to do transformative deals.

Already around Q2 of 2019, many started to ask whether we were going to see the end of the M&A bull market. All the indicators were there: geopolitical tension, protectionist governments increasing foreign investment restrictions (along with the resulting decline in cross-border deals) and inverted yield curves. 

However, it was also the era of cheap money. Despite predictions of a downturn, the bond markets remained buoyant and we saw a continued flurry of M&A activity. CEOs remarked that it was an easier decision to do deals because fewer synergies were required to make a success of the acquisition.

We ended 2019 with renewed concerns around a potential downturn in M&A. Even though the S&P 500 closed at a record high on 19 February 2020, M&A deals were on a downward trend and the M&A market was bracing for turbulent waters – yet no one could have predicted what would happen next.

Q1 2020 saw the M&A bull market of previous years effectively grind to a halt. Overall M&A activity was down 31 per cent by value on the previous three months, the biggest quarterly fall in seven years. Latest figures show the economic contraction this year has been somewhere between the Great Depression of 1929 and the Second World War.

While the crisis has impacted some sectors (such as aviation, leisure and retail) more than others (tech, and financial and support services), it is clearly a crisis that plays out across all sectors to varying degrees. Seen from a macroeconomic perspective, COVID-19 has simultaneously triggered a consumer crisis (less consumer spending and less consumer confidence), a market crisis (the stock market rally has been labelled 'truly crazy' by more than a few experts) and a liquidity crisis (cash-strapped companies looking for alternative sources of funding). Government stimulus programmes work to alleviate some of these pressures but of course cannot guarantee solvency in the long term.

Crystal-ball gazing is hardly an exact science and predictions have their limitations but generally, trend forecasts were (mostly) right on the money.

1. A rise in distressed M&A

Not yet. Governments responded by introducing a range of measures, including suspending the obligation to file for insolvency, direct grants, subsidised lending, tax breaks and capital/equity injections. Such measures have staved off the expected rush of insolvencies and restructurings (including distressed M&A) for the time being, but one should expect the floodgates to open once the measures are lifted.

The increase in distressed M&A may also coincide with an uptick in consolidation in sectors hard hit by the pandemic, such as aviation and leisure. In sectors where consolidation is long overdue (such as banking), the crisis may speed up efforts.

The record-breaking boom in SPACs has been a key feature of the 2020 M&A market. Once consolidation picks up, SPACs may offer an attractive structuring alternative to combine multiple players under one roof.  

2. M&A activity uptick in H2 2020 and H1 2021

True. We have seen a definite increase in M&A activity in H2 from both financial sponsors and strategic clients. As news regarding the availability of vaccines spread, M&A actors increasingly returned to the stage in a big way. Companies are looking to secure their supply chains – not only due to weaknesses exposed by the crisis but also to:

  • increase transparency demanded by ESG-driven activists (activists briefly pressed pause on campaigns during the crisis but have recently regained momentum); and 
  • speed up the digitisation of weak links in the chain. 

A proliferation of domestic legislation encouraging companies to localise supply chains has also significantly contributed to the rise in this trend. Unsurprisingly, critical industries such as tech, pharma, healthcare and life sciences remain most active and that trend will almost certainly continue into H1 2021 and beyond.

3. A move away from 'cookie-cutter' deals

Yes. The focus on more strategic alliances was especially pronounced in a time where cookie-cutter deals and neatly orchestrated competitive pressure on M&A auctions fell away. There are far fewer auctions than pre-crisis as bilateral forms of M&A draw more acceptance than the straightforward acquisition processes. Companies are exploring more creative and innovative forms of M&A such as joint ventures or strategic alliances, close M&A and option deals. Carve-outs have become increasingly popular for large corporates put under pressure by the crisis, as they allow the companies to quickly generate cash and/or reduce costs while managing their overall portfolios. 

2020 also saw a significant rise in growth equity, particularly in corporate venture capital. Industrials large and small are increasingly looking to invest in disruptive and innovative technologies to better position themselves in a post-pandemic market where exponential growth in technologies and the speed of digitisation has dwarfed all other market trends.

4. Protectionist governments to tighten regulations

They certainly have. Already a prevalent trend pre-pandemic, changes in the foreign direct investment (FDI) review space in response to COVID-19 have occurred at a dizzying pace in recent months and regulations continue to be tightened by legislators. 

This follows a recent period of unprecedented international focus on FDI issues and geopolitical change, leading to major legislative changes or proposals in most major economies. As a result, governments were already sensitive to the risks (security risks, industrial policy risks and economic risks more generally) related to FDI, making it easier for them to enhance FDI controls quickly in response to COVID-19. 

5. Valuation will be the biggest challenge

The difficulty in valuing targets has possibly proven to be the biggest challenge for M&A in 2020. Traditionally, there has always been significant reliance on historical financials in determining the value of a business. However, this year, a buyer was primarily interested in the financial impact of COVID-19 on the business both in the immediate and the long term. 

Historical financial information did not provide an adequate basis upon which to make such a determination. Similarly, financial projections and their underlying assumptions were equally challenging as the impact of COVID-19 and related lockdowns on a business were difficult to predict. 

Even now – with the benefit of 10 months' hindsight – projections require multiple cases using different assumptions about the severity of the pandemic and the number of spikes in the infection rates, in particular geographies, relevant to the target business. Sellers had a hard time convincing buyers how past performance connects to future results – leading to a wide range of valuations.

Uncertainty regarding the performance of the target business in the future has led to an increase in the use of contingent pricing structures, such as earn-outs, milestone payments or exit joint ventures. There has also been an increase in 'earn-ins' or 'burn-outs', where sellers are obliged to repay a portion of the purchase price if certain milestones are not met/earnings fall well below projections.

Valuation and purchase-price discussions are necessarily revolving around risk: sellers are contending that COVID-19, or the possibility of other future pandemics, is a well-known market risk at this time that should be borne by buyers, while buyers are trying to avoid bearing it entirely.

The developments regarding SPA clauses, in particular around due diligence, warranties, gap controls and termination rights, have been followed closely since the outbreak of the pandemic and a clearer market practice post-COVID-19 is definitely emerging. This will be the topic of a follow-on piece in the new year.

Happy holidays.


mergers and acquisitions, carve-outs, joint ventures, private equity