Key Considerations for M&A during COVID-19

15 July 2020

There is no hiding from the fact that the Scottish M&A market has been hit hard by the Covid-19 outbreak.  A staggering number of deals have been put on hold or shelved completely over the past 3 months, as both buyers and sellers come to terms with the significant disruption caused by lockdown.  Many industries, such as the hospitality and leisure sector, that have been severely impacted by the outbreak are unlikely to see proactive M&A activity, outside of distressed sales.

That being said, from recent discussions we have had with large trade buyers with strong balance sheets and Private Equity (PE) Funds, it is clear that they are still eager to make strategic acquisitions to complement either existing operations or portfolio companies, respectively.  Organic growth will be difficult to achieve for most over the next 6-12 months, with customers reluctant to change service suppliers and wider business and consumer spending depressed, therefore M&A presents a far more realistic growth opportunity for businesses looking to continue to grow. 

As we continue to exit lockdown, we have started to see some promising signs of M&A deal flow returning, and barring a severe second-wave of the virus leading to significant lockdown restrictions being reimposed, we expect the Scottish M&A market to pick up in the latter half of 2020.  Below we have outlined some key considerations for buyers and sellers which we have been discussing with our clients looking at M&A in the coming months:

EBITDAC – soon to be found in most information memorandums - Earnings Before Interest, Tax, Depreciation, Amortisation and Coronavirus.  Many businesses will look to present their earnings figure based on a normalised, maintainable level, so we are expecting to see some creativity around what sellers and their advisors present for this.  It is important for buyers to take careful consideration when diligencing companies, especially where loss of revenue and income due to Coronavirus has been adjusted for.  Undertaking a detailed diligence process will ensure that a Buyer will gain a full understanding of the maintainable earnings of the business.  For sellers, it is important to engage with experienced M&A professionals to ensure your financials are robust and will stand up to scrutiny from acquirers. 

Earn-outsowners who had sold their business in the year(s) before March 2020 may have included an earn-out mechanism as part of the sale and could be facing a reduction in the overall consideration they were expecting.  This may also be of concern to buyers, particularly where the former owners are still involved in the day-to-day managing of the company for business continuity purposes – if the earn-out is no longer realistically achievable, the management could become demotivated, further compounding the impact.  Buyers may consider an extension to the earn-out period but must also be confident that the business can support future payments of earn-out amounts.

For new deals where businesses have been impacted by the outbreak, there is likely to be an increase in earn-out or deferral mechanisms used by buyers, in order to provide comfort that the business can rebound to pre-Covid levels.  Where earn-outs or deferrals represent a significant portion of the consideration, sellers must get comfortable that the business will be able to meet the agreed targets in future periods.

Robust M&A activity in the technology sector – many businesses in the technology sector, particularly those in the IT Managed Services, Telecoms and Software sub-sectors (assuming customer bases are not predominantly from sectors that are currently facing extreme difficulties) are still attractive propositions for PE Funds, both as platform acquisitions and as bolt-ons to existing portfolio companies. The businesses that have demonstrated they are resilient throughout the crisis, as well as those that are enabling improved connectivity and support the ability to work from home long term, will be attractive acquisition prospects. 

Accelerated M&A and distressed sales on the rise - Over the coming months, as businesses are gradually weaned off the Job Retention Scheme, we expect to see many companies face difficulty as they are unable to generate cash inflows quickly enough, leaving them without sufficient working capital to continue operations.  Under these circumstances, many can find themselves entering into financial difficulty, and may see an accelerated M&A process as a way of securing the company’s future. Larger trade buyers with balance sheets to support acquisitions are likely to take advantage of the M&A opportunities that emerge.

Diligence considerations – there are a range of issues that should see increased focus, or added to, the normal due diligence process.  Where businesses have made use of the Job Retention Scheme, this is likely to be a key area of diligence, to ensure that claims were made correctly (for example, gaining comfort that staff were not working while on furlough).  Some insurance companies have already introduced new products to protect against claims made by the Government, which may be of interest to both buyers and sellers.

Detailed understanding of working capital cycles will likely be a focus for buyers, as they look to understand a normal level of working capital, outside of Covid-related issues, to be delivered on Completion.  We advise sellers to discuss this in detail with their M&A advisor, and buyers to seek out sufficient due diligence support before agreeing positions.

It is promising to see that the Scottish M&A market has started to show signs of a recovery as the country comes out of lockdown.  Significant levels of dry powder in the market will entice PE Funds to deploy capital into companies that are well positioned to survive and thrive after lockdown, which will hopefully improve deal activity across the UK.

We are optimistic that activity levels will continue to rise in the second half of the year as more and more businesses begin to get back to some level of normality, and we look forward to working with existing and new clients on their M&A objectives.

If you would like to discuss any of the topics above in more detail, or if you are considering acquiring or selling a business, please contact Chris Thompson (chris.thompson@aab.uk) or your usual AAB contact.

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