A Buyer’s Market: Deal Structure & Risk Sharing in the COVID-19 Era
Prairie Capital recently published a report on the COVID-19 pandemic’s impact on the M&A market. The publication covers many topics, but I thought what it had to say about how the crisis has impacted deal structure and risk sharing was particularly interesting. Here’s an excerpt:
In the midst of the pre-pandemic seller’s market, all cash M&A deals were the market norm. Occasionally, rolled equity structures were used if the seller wanted to ride along with the buyer for a “second bite of the apple,” but generally, cash was king. Earn-outs and seller notes were reserved for deals where a full valuation could not be supported by the current cash flow, but the buyer still wanted to entertain the seller’s high valuation expectations. In a majority of the transactions, most – if not all – of the deal valuation risk was borne by the buyer.
Those were the “good old days” in the M&A market. However, because of the pandemic, we are in a new M&A environment. The results of the economic shutdown have seriously affected companies’ short-run financial results. Many potential company sell-side candidates will have good historical operating results through 2019 and then a significant change in 2020, with expectations of a return to normal in 2021 and beyond. The EBITDA adjustments described earlier can be used to explain 2020 and will have to be fully documented and supported. Nevertheless, these adjustments may not be as useful to support the return to normal projections provided by the seller.
When EBITDA adjustments or projected financial results are not fully accepted by the buyer, an earn-out or special escrow can be used to bridge the gap and create risk sharing between the buyer and the seller. It is anticipated that many of the pandemic-related EBITDA adjustments and projected performance will be at least partially challenged by buyers, which will lead to potentially larger deal escrows and earn-out provisions.
The seller’s market in M&A during the past several years has also been fueled by an extremely accommodating lending environment. The white paper suggests that lenders are likely to become much more conservative. Among other things, that means sellers will be asked more frequently to take back paper as part of the transaction.
Overall, the message is that the uncertainties created by COVID-19 have created a buyer’s market, and if sellers want to get a deal done now, they’re going to need to be more flexible and willing to accept deal terms that wouldn’t have been on the table just a few months ago.
-John Jenkins, DealLawyers.com May 21, 2020
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