Beyond COVID-19: Deal considerations in a COVID-19 world

Ideally, companies put in place real-time tracking of COVID-19 impact to underpin decision making with quantifiable evidence. This may enable us to better assess management’s actions and any proposed adjustments in diligence. In instances of less robust financial reporting, rigorous diligence will be needed, more so than in any other times, in order to understand the underlying value drivers and impact of COVID-19 on the growth profile of the business.

To quantify potential adjustments, best practices suggest they are: 

• Well supported - not relying on too many assumptions
• Assessed over short periods (e.g. monthly)
• Calculated as discrete items (i.e. no high level calculations)
• Evaluated for impact across all P&L accounts
• For pro forma adjustments, consider if the company has operated on a “normal” basis in recent periods to support any adjustment
• Triangulated with any balance sheet impact / adjustments.

Duration of impact needs to be considered, i.e. temporary vs. permanent, to determine if a one-time or pro forma adjustment is warranted. Continually reassess the underlying facts and circumstances (given the ongoing evolution of the health and economic environment).

Less confidence would be placed on adjustments attempting to simply normalise the P&L to a pre-COVID level (i.e. “as if” scenario without the crisis), as it is probably not realistic and not meaningful as it would likely involve too many assumptions.

Current year trading:

• We highlight the importance of splitting historical trading into i) pre-COVID-19; and ii) post-COVID-19 periods in order to pick up a step or structural change in the business trends. Pre-COVID-19 periods or run-rate based on recent results can be used as a benchmark for future projections.
• When analysing historical profitability and trends, it is important to consider both financial and non-financial KPIs to understand the key underlying drivers of performance. 
• We recommend assessing granular transactional data (e.g. daily, weekly, monthly) to fully understand the impact of COVID-19 on the business and also, to the extent information is already available, the trends in the recovery phase. 
• Rigorous diligence would look beyond traditional financial data and blend financial with other macro economic, market and health data to understand the trends and assess the impact on the business comprehensively.
  

Current year outturn and projections

• Current Year Outturn may not be a long-term indicator of performance, or indeed a base year for valuation, but it is important for cash generation and discounted cash flow (DCF) models. 
• Projections will need robust commercial insight due to current uncertainty, with investors potentially valuing businesses based on a view of a “new normal” to be achieved in FY21/FY22. 
• There will be fundamental reliance on integrating commercial and operational views, to arrive at a range of scenarios rather than “the answer”. In addition, there is a possibility of an economic downturn / recession, triggered by COVID-19, which adds uncertainty to determination of a “new normal”. 
• Historical growth trends may become irrelevant, given the likelihood of the “new normal” operating model / environment, but the most recent “clean” historical LTM period or run-rate based on recent results (i.e. pre-COVID) will be an important benchmark in assessing the reasonableness of any projections. Additional focus will need to be placed on the business model resilience and value drivers in due diligence. 
• It is important to note that due to the unprecedented impact of the pandemic, in reality there may be wide-ranging scenarios and significant variations to projections. From a buyer’s perspective, M&A transactions will need to include sufficient downside protection, such as the use of an earn-out structure. We discuss sale and purchase agreement (SPA) considerations in more depth later in this document.
• The more post-COVID recovery data available (not just from the company and local market but also from other countries that have exited lockdown earlier), the more informed views will be, and therefore, the narrower the range of scenarios.

In addition to the typical debt and debt-like items, we are expecting to see items relating to COVID-19 to be treated as net debt or be subject to indemnity in any sale and purchase agreement, for example:

• Earnings related exposures - if there is one-time COVID-19 related income or cost excluded from adjusted earnings, any related balance sheet items that result in a future cash outflow (or inflow) would be included in net debt
• Items stemming from contractual obligations with suppliers and payment deferrals, e.g. penalties for not meeting minimum purchase commitments, late payments penalties, deferred capex
• Employee liabilities, e.g. deferral of bonuses, compensation, restructuring and severance liabilities, pensions
• Government stimulus, e.g. tax incentives (deferral of VAT / payroll taxes), borrowing schemes to extent not forgivable, repayments of government aid relating to certain type of spend 
• Contingent liabilities, as there is a higher risk of fines and litigation (e.g. inappropriately accessing government funding, customer claims, etc.)

Net working capital: 

Net working capital (NWC) levels are likely to be impacted by i) external factors, e.g. governmental measures to aid solvency in the sector, customers and suppliers actions outside of the company’s control, lenders not renewing certain forms of finance (e.g. factoring) (ii) measures driven by the company in the lockdown period and in the short-term to manage working capital (procurement, inventory management, renegotiation of contractual payment terms), and (iii) structural measures, either operational or commercial in the medium-to-long term. In each case, it is important to consider if the impact is temporary (and, if so, whether reversed prior to planned exit) or may be permanent.

Cash flows:

• It is important to consider net cash flows in pre-, during, and post-COVID-19 environments to assess the company’s ability to raise and service additional debt. 
• Companies are likely to be in a ‘cash-burn’ scenario, with significant non-operating outflows (e.g. projected restructuring costs) and financing considerations.
• Attention will likely need to be paid to short-term cash flows and cash runway analyses in order to assess liquidity and when the business may run out of cash.
• Consider presenting scenario-based outcomes for the Current Year Outturn and 3-year projections, similarly to the methodology used for the P&L.
• Capex analysis should consider any delayed capex and required catch-up (e.g. contractual or regulatory capex, capex underspend, etc.). Funds required to ‘catch-up’ the capex spend could be included as a debt-like item. 

• The use of locked box mechanisms (frequently used in Europe) will decrease as buyers are less willing to bear the trading risk between the Locked Box Date and Completion (which is the economic effect of a locked box mechanism). 
• We expect to see an increase in earn-outs: buyers are pushing to defer purchase price to subsequent years given uncertainty around projections and valuations as a result of COVID-19.
• Accounting Principles: Buyers may prefer to be more flexible and introduce GAAP/IFRS prevailing language over past practices, given that past practice is unlikely to have taken account of COVID-19 effects.
• Government loans/subsidies: any government loan amount that will not be forgiven needs to be treated as Indebtedness. 
• Recently, we have seen some parties exclude these government loans from pricing, and either introduce a separate mechanism (for the purposes of not being beholden to the true-up mechanism timeline) whereby if the government loan is not forgiven, Seller will reimburse Buyer for any unforgiven amounts or address it through indemnification. 
• We have also seen Buyers considering setting aside escrows for these amounts for further protection. Furthermore, Buyers may consider introducing conduct of business restrictions around these loans to ensure Sellers comply with the terms.

As companies potentially re-emerge, the risk of a second wave persists. New waves may be limited to certain local hot spots or ignite again around the globe.  Stakeholders will be interested in understanding the impact on the business model and its resilience level after the first wave, in particular:

• What measures have been implemented by the company since the first wave (e.g. adjust product / services mix, sales channel, shift to regional / local sourcing of materials, diversification of supply chain, shift to remote working) to preserve value of the business? 
• What areas are likely to be impacted in a second wave? What duration and depth of a second wave can the company sustain?
• How flexible can the company be / how quickly can it react, with respect to shift in demand, interruptions in supply chain, staff workload? 
• Which remaining options post-COVID-19 can be used (after exhausting cash reserves, etc.)
• What areas are still lacking management attention (i.e. a second wave will hit the company unprepared)?

Effectiveness of the management’s response, actions taken, and short-term impact may be important in assessment of management and resilience of the business.