This article is written by Bhavna Hemrajani, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

COVID-19 was declared as a pandemic by the World Health Organisation in March 2020 which impacted each sector in its unique way. COVID-19 can be easily said to have dramatically affected the mechanisms and procedures for M&A transactions like never before. With regards to the Merger and Acquisition (‘M&A’) transaction, the companies have been impacted to such a large extent that where some companies are looking to exit from the deal, if possible; others are looking for an interested seller. The most important part of an M&A transaction is the due-diligence conducted by the professionals. Elements such as market multiples, past cash flow generations and labour/ working environment forming the bases for measurement for due diligence have to be looked at from different perspectives in the times of COVID-19. In this article, we shall be discussing the change of route in due diligence conducted in an M&A transaction amidst COVID-19. 

Due diligence 

Before finalizing the finer details of an M&A transaction, when either of the parties undertakes to examine and review the financial position, management and operations and the contracts of the opposite party to satisfy itself like a prudent man of the position of the company in actuality. Though it is a long-drawn and expensive process, it is highly advisable to undertake the same as well. In circumstances before the occurrence of COVID-19, due diligence was often conducted personally however, COVID-19 and the new normal have turned the table. It has also shifted the focal points for different sectors accordingly i.e. depending upon the impact on the sector and company. Further, due diligence with reduced demand for services, shortages of workforce and disruptions in operations has made the environment for companies undertaking an M&A transaction extremely taxing. 

Due diligence in times of COVID-19 

Allowing a company to peek behind the curtain into the books of the company to analyse risks and legal aspects of the business have not remained the same in the times of new normal. Following are the points that must be noted by companies who are looking to undertake an M&A transaction:

• Focus on novel issues: it is to be noted and understood that each company depending upon its sector of operations, location/ jurisdiction, size has been impacted differently than another company. Therefore, firstly it is necessary to note all the prevalent impact on the following points i.e. 

Legal aspects:

1. the extent of the target company’s compliance to work-from-home guidelines and which aspect of the operations have commenced their normal operations;
2. the applicability of employee paid leave laws to a target’s workforce;
3. the target’s receipt of SBA and other governmental financial assistance;
4. any industry-specific regulatory changes (both state and federal) applicable to the target company.

Operational aspects:

1. the extent of disruption to supply chain and customer base, and
2. impact on financial position due to reduced cash flow.

In the present times, the companies should look into expanding the due-diligence to a specific branch i.e. ‘potential and actual impact of COVID-19’. Such an approach will allow the companies to understand the mechanisms and functioning of the company along with the responses of the company to situations relating to the Act of God. Such knowledge will aid the parties to draft clauses concerning Force Majeure and Material Adverse Effect. 

• Incorporation of new risks vis-à-vis Representation and Warranties Clause: Before COVID-19, the focus of the companies would be to look at the financial security and position of the company and check for possible financial risks. However, the COVID-19 has pushed the companies to look at operational risks with equal precision and attention because COVID-19 has caused a drastic change in the operations of every business differently. Switching to online mediums, cutting any extra middle-men handling or outsourcing an entire set of operations etc. are a few types of responses to new and different risks which must be noted during the due diligence process as the same will accordingly help the parties to draft the Representation and Warranties Clause. 

The Representation and Warranties Clause is inserted to mitigate any potential exposure to risk in the future. With the incorporation of new types of risk with the adoption of new normal, parties will have to negotiate the extent of coverage of each of these possible risks in the future in light of the new methods adopted to adapt. 

• Adjusting Purchase Price to reflect COVID-19: A financial risk due diligence is aimed to find answers regarding questions such as: 

1. whether previous financial results accurately reflect the run-rate profitability and whether the documents and data was relied upon to support the forecast; or 
2. what are the factors which are likely to affect the purchase price or what kind of exposures can be noted from looking at the balance sheet of previous financial years which are likely to affect the other party post the closing date; or
3. how could accounting issues materially affect the reported results or disclosures after closing date. 

It is of material importance to streamline the due diligence process towards finding the answers to the above questions as they all will have a potential impact on the purchase price. Further, companies engaged in hospitality and travel have faced the worst impact due to COVID-19 while companies in the pharmaceutical sector or FMGC have seen an increase in profitability. Therefore, the M&A transaction in the hospitality sector may cost less now as compared to earlier and the advantage of the same should be noted by the buyer to negotiate. 

The third key aspect to be noted is to undertake due diligence in a way to adjust the purchase price in its favour while ensuring sufficient security i.e. hold a portion of the purchase price in an escrow account with the release of such funds tied directly to the satisfaction of the COVID-19-related representations. Such a precedent condition may be opposed by the seller but when presented with another alternative of reduction in the purchase price, it may get on board. 

• Security and Non-Disclosure agreement: Earlier, due diligence was undertaken in offline mode wherein security of documents could have been maintained. However, the shift to work-from-home has left no avenue but to share confidential and sensitive information online. Sharing such information or documents online increases the exposure to the risk of hacking or misuse or abuse of the same. In the times of WFH, it is of utmost importance that all parties indulge in the highest affordable cybersecurity measures. Further, to maintain maximum level of protection and secrecy, a Non-Disclosure Agreement with appropriate terms discussing the plan of action in case of misuse of such sensitive information seems a must part of the due diligence process. It may seem like a small step but the consequences arising from omitting the same are grave for either of the parties. 
• Employee contracts: the most direct impact of the pandemic has been on the workforce irrespective of the sector and jurisdiction of the company. The pandemic has posed important questions such as: 

1. Whether the pandemic caused a reduction in the workforce;
2. What kind of healthcare facilities such as insurance, paid leaves etc. has been provided by the company; 
3. Whether the target company was/ is able to sustain successfully in the work-from-home working environment and to what extent;
4. Have any modifications to the terms and conditions of employment triggered the right of any executive group of employees to resign for “good reason” and become entitled to severance. 

A company with a weak workforce will definitely harm or hurt the position of the company overall. The health and safety of all employees have come to be the biggest concern for the management of the company amidst the pandemic. Understanding the actions and responses of the target company towards its workers reflects upon the working environment of the company. The due diligence conducted should note the present challenges faced by the target company, its relationship with its employees in light of safety, well-being, confidentiality and privacy-related restrictions. Understanding these factors can allow the buyer or merger company to either follow the path laid down or change it accordingly to ensure maximum benefit to the workforce.  

• Debt obligations: with the moratorium being imposed by the RBI as an interim relaxation, the impact of the same must be noted as part of financial due diligence as well. The buyer should understand the change in the overall timeline in respect to payment of all debt obligations considering the burden may come on its head. If the target’s indebtedness is to remain outstanding, the buyer should closely exercise diligence over the recent covenant calculations under the target’s agreements, in particular any adjustments taken as a result of the impact of COVID-19, as buyers will inherit these calculations and positions taken by the target. In addition, buyers should determine whether the target has taken advantage of any government finance programs. 

Conclusion 

It is of utmost importance to adjust the due diligence process to specifically consider the impact of COVID-19 on the target’s business, operations, financial condition, prospects, and personnel. Some of the consequences of COVID-19 for a target may be relatively obvious, including the health and safety consequences for the target’s employees and the implications of stay-at-home and social-distancing orders. However, some of the implications of COVID-19 for a target and its business may be less obvious, including issues that may impact the target’s customers or suppliers rather than the target itself. The process may take a longer period of time before the parties reach the negotiations but the same must not be avoided in any circumstances.

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