As transactions previously delayed due to the pandemic begin to pick up, acquirors and investors in the middle market should evaluate the target’s performance during the unprecedented disruption presented by the pandemic, and adjust expectations for the immediate and medium term. Supplemental due diligence is not only prudent — it is likely to be required as a condition to the placement of any representations and warranties insurance.
Essential considerations include whether the target has been able to innovate and whether the valuation agreed to in a letter of intent should be revisited. Buyers should also review any termination provisions to determine whether any breakup fee would be payable. If a purchase agreement has already been signed, parties should understand to what extent the agreement includes a “no material adverse change” closing condition, and evaluate liability for failure to close.
Supplemental due diligence requests should focus on any material changes to the company’s performance in 2020 as well as the durability of its supply chain, customer demand, customer concentration and solvency, business interruption insurance coverage, government assistance, and personnel issues including health and safety protocols and furloughs and layoffs. A buyer may reasonably request an extension of any exclusivity period in the letter of intent while digesting new information.
The following topics and questions may serve as drivers for internal analysis and supplemental due diligence efforts:
Innovation often means the difference between survival and bankruptcy. Determine whether and how the target innovated during the pandemic and how such innovations are reflected on interim financial statements.
Evaluate whether the costs of innovation present increased or decreased ongoing costs. Has innovation increased market share? Have competitors innovated also? Is there data on new customer acquisitions and repeat purchases? Also find out if the innovation is proprietary and, if so, to what extent is the target protecting its new intellectual property, if at all.
The quality of a target’s earnings should be analyzed for distortions and how soon it will be able to revert to mean performance (e.g., retail and hospitality), or how long it can be expected to benefit from increased demand (e.g., sanitizing products and cold remedies).
When comparing historical and interim financial statements during a valuation exercise, pay close attention to the reasons management gives for favorable and unfavorable changes, whether any increased expenses are recurring or “one-time charges”, and whether their projections are credible guidance as to future results.
Investors should analyze and compare the aging of accounts receivable and revisit “concentration of largest customers.” Material contracts with key customers should be scrutinized for risk of breach.
Government actions / Paycheck Protection Program (PPP)
PPP loan proceeds are forgivable if used for payroll-related and other limited purposes. Determine whether the target has risked forgiveness by using proceeds for non-forgivable purposes, or has dismissed additional employees since receiving the funds. If not, will the unforgivable portion violate any existing debt covenants? Was shareholder approval required?
Money is fungible and PPP loan proceeds may have “freed up” other cash previously intended for payroll. Accordingly, what are the target’s plans for existing cash? Has it maintained a reserve for employees? Can and should it pay down existing debt? Is the company still paying dividends and bonuses?
Determine whether the company is in compliance with laws relating to employee layoffs (e.g., the WARN Act). Evaluate whether and to what extent working from home has been an option and whether that has impacted performance. Are employees now required to work in shifts of fewer employees?
If so, what extra expenses are incurred? Determine whether employees are “essential” “front line” workers (supermarkets, healthcare), and if so, whether the target has maximized precautions to protect employees, particularly vulnerable ones, from contracting the virus in the workplace.
Insurance policies and claims
The target’s existing insurance policies may cover Covid-19-related (or civil unrest-related) business interruption claims. Has the target properly notified its carrier of any claims? Do the policies contain a “virus exclusion”? Directors and Officers (“D&O”) policies should also be reviewed, particularly if an investor seeks to join the board of directors.
Business continuity and disaster recovery plan (BCDR plan)
Determine whether the target has implemented a BCDR Plan which maps out the special operations of the company to ensure that its business processes can continue during a significant business interruption.
A BCDR Plan will typically contain instructions for personnel safety and company assets security, a detailed list of primary tasks intended to stabilize the organizational operations, remote access and on-site data security and backups, and communication of the expected level of cooperation from employees.
Regulated entities in many industries have been required to report their Covid-19 BCDR plans. Such report/correspondence should be reviewed.
The processing of critical governmental license applications, such as liquor or cannabis licenses, has been suspended or slowed, blocking access to markets for pending applicants and giving existing license holders an oligopoly. An investor or acquirer should gain an understanding of when governmental entities are expected to resume processing.
Investors should evaluate the strength of the target’s supply chain and identify any concentration of dependencies.
Are there bankruptcies arising along the supply chain? Have any suppliers who are party to material contracts invoked force majeure, or “impossibility of performance,” “frustration of purpose” or “impracticability” principals on material contracts? Has the target requested assurances from its suppliers as to their ability to perform?
Ascertain whether there is any new litigation and find out whether the target’s managers are aware, after due inquiry, of any new facts or circumstances which may give rise to litigation. Has the likelihood of settlement of any existing litigation increased or decreased?
Change in laws, regulations, policies and treaties.
The pandemic has affected the economies of different countries to different degrees. Thus, it can be anticipated that each country will pass new laws, regulations, policies and treaties. Evaluate the impact of change of laws, regulations, policies and treaties on target’s business, market share, supply chain, and even the feasibility of target’s entire business structure.
Even in light of strong performance resulting from the pandemic (e.g., increased home video streaming subscriptions), overall uncertain outlook increases beta, and investors/merger partners should take such downward pressure on valuations into account.
As a way forward, the parties can negotiate safeguards, including price floors, collars, deferred consideration, or other contingent price mechanisms which require additional consideration if certain internal or external conditions are met.
— Eric Huang co-authored this article. Huang is an attorney at Anderson Kill and a member of the corporate and securities group.