Impact on deal flow
Many transactions are proceeding as normal, and we are still advising on a significant number of live deals, but others (particularly in certain sectors as outlined below) have temporarily stalled. Volatility in the stock markets has had an impact on financing arrangements, with some clients citing currency risk as a concern. A number of deal timelines are also being delayed (including auction processes) by restrictions on travel/meetings as opposed to any fundamental concern with the pandemic.
There have also been a number of processes being put on hold in the midst of underwriting, particularly in the health and aged care sectors as businesses focus all their energy on patient and occupant safety.
We anticipate deal flow to reduce in sectors most obviously affected by COVID-19 such as the health and fitness (particularly gyms), tourism and hospitality sectors (particularly in light of the lock-down and social distancing measures most recently announced in Australia and New Zealand).
Clearly as these measures continue into the longer-term, companies will begin to see distress. This will inevitably bring private equity funds and other investors who specialise in the turnaround space to the table. Given the public market volatility, private equity will also be looking for value in take private transactions.
Material adverse effect (“MAE”) clauses
We are beginning to see the inclusion of references to “epidemic” or “pandemic” or even “quarantine restrictions” into MAE definitions. We anticipate there will be an increased focus on such clauses as buyers look for enhanced termination rights in an uncertain market. Warranty and indemnity (W&I) insurance policies will generally follow the terms of MAE clauses and fall away if one is triggered, so buyers need to think carefully about the breadth of language used.
COVID-19 coverage concerns
Insurers are not flagging a significant change in their appetite for insuring M&A transactions as a result of COVID-19. That said, at least temporarily and until the picture becomes clearer, we anticipate insurers taking a more cautious approach to the jurisdictions and target sectors currently most affected by COVID-19 such as the health, aged care, fitness, tourism and hospitality sectors and where the supply chain is dependent on countries most heavily affected. Conversely, in the short term we may also see competition between insurers increase as they look to protect market share as deal flow slows.
Whilst overall deal appetite remains high, we are seeing insurers react to the risks presented by COVID-19 through additional underwriting and/or potential exclusions from coverage. In the first instance, insurers are conducting COVID-19 specific underwriting (see below) and have flagged the potential need for exclusions from cover in the event they are unable to get comfort around the impact of the pandemic on the warranties, particularly those warranties to be given at completion.
Where insurers flag the need for a COVID-19 exclusion, insureds need to ensure that it is drafted as narrowly as possible to address the underwriters’ specific concerns and avoid it applying to broadly across the entire suite of warranties.
We have not yet seen the introduction of warranties specifically relating to COVID-19, although we have heard some speculation as to the possible introduction of warranties going to the efficacy of business continuity plans. Of course, the current broad wording of many warranties would in many cases pick up COVID-19 issues (for example, warranties as to the financial condition of the target, disclosure warranties, compliance with laws warranties, warranties relating to customer and supplier contracts, etc.). Warranties relating to customer/supplier contracts will be carefully considered in the context of potential supply chain concerns and ability to fill orders. We also expect insurers to pay particular attention to solvency risks and warranties particularly given the new thresholds for bankruptcy and issuing of statutory demands. While these measures are generally more helpful to meet the necessary tests, it is also an evolving situation.
Insurers are also likely to look closely at the valuation of businesses in this environment to ensure the pricing multiple make sense in light of the revenue outlook.
Insurers will look carefully at the terms for offering cover for breaches of warranties which first occur after signing but before completion and are discovered by the buyer (New Known Breach Cover). Given the current uncertainty and how quickly the pandemic is evolving, insurers perceive a material risk between signing and completion. As mentioned above the drafting of MAE carveouts as they apply to this extension of coverage will increasingly become a focus. That being said, insurers have indicated a willingness to continue to extend this coverage provided that they have sufficient protections within the policy regarding COVID-19 and the MAE clauses.
Areas of increased underwriting focus
Given the question of COVID-19’s impact on a business is currently predominantly a forward-looking matter, the focus of underwriters’ inquiries in this area will be on the extent to which COVID-19’s future impact has been factored into the target’s valuation (particularly where the valuation methodology is based on discounted cash flow). However, this will likely change with the passage of time as deals sign in which pre-completion/locked box trading is affected by COVID-19. It will then be important for buyers to demonstrate that they have sufficiently up-to-date management accounts and other information to have obtained a clear understanding of the impact on the target’s business.
For now, key underwriting focus areas will be on general supply chain risks, financial stability, business continuity and disaster recovery plans, together with likely sector exposure as noted above– both from a health & safety as well as cancellations perspective, as more countries move from containment to delay-based strategies. Employment issues (e.g. coverage for sick leave and data protection related to employees and health) will also be a key area of focus and a particular sensitivity in the Australasian market. Insurers will also consider the target’s material contracts –notably the ability for them to be performed, together with the consequences of non-performance, particularly where the transaction is structured as a split signing and completion. We are advising our clients to ensure they update their diligence exercises accordingly, including but not limited to:
- a detailed analysis of the target company’s insurance program (noting W&I insurers’ likely focus on other insurance coverages that might respond to a claim) and in particular checks that any policies which include an element of business interruption cover are not subject to epidemic/pandemic exclusions; and
- a detailed analysis of whether any coronavirus-related claims will be covered by the key health-related insurances such as medical (domestic and expat), life, disability, critical illness and business travel policies. Additionally, HR policies may be changing on sick pay/unpaid leave that will be self-insured by the employer.
- Insurers are still open for business and want to assist at this time with facilitating deal flow albeit in a challenging environment.
- We recommend that you work closely with your advisors to understand the impact that COVID-19 has on the target business to the fullest extent possible and adjust your diligence approach accordingly.
- Engage with Aon early and provide insurers as much time as possible to analyse and understand the exposure to avoid the potential imposition of broad COVID-19 exclusions to cover.
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