Following a steep decline at the onset of the COVID-19 pandemic, the second half of 2020 saw a resurgence in M&A deal volume in the United States.
We have observed the emergence of the following trends during this period, some of which relate directly to the ongoing pandemic and some of which are independent of it.
Highlights of U.S. private M&A trends
- Buyers and sellers are using earnouts to bridge the valuation gap.
- Private equity funds are increasingly using special purpose acquisition companies (SPACs) to raise money for buyouts.
- Buyers are trying to get out of deals by claiming a material adverse effect (MAE) or a breach of the ordinary course covenant.
- Representations and warranties insurance (RWI) premiums have increased slightly and retention is now almost universally at 1%. Some carriers are modifying representations and warranties to reduce coverage.
- RWI carriers are considering the need for COVID-related exclusions on a case-by-case basis.
- Employee loans appear to be on the rise, and employers should take care in their documentation and structuring.
A 2020 trend that can be attributed to the pandemic is the increased use of earnouts in M&A transactions, which involve the buyer agreeing to pay a portion of the purchase price in the future based on the performance of the target post-acquisition. Earnouts allow buyers (who are assigning reduced valuations to targets due to the current economic uncertainty) and sellers (who continue to believe in the value of their businesses) to bridge the value gap. While limited data is available on this trend so far, some advisers report that earnouts have appeared in nearly half of middle-market transactions since the beginning of the pandemic, up from less than a quarter of non-life sciences deals in 2019. Earnouts, when not carefully designed, can easily become the subject of disputes, so earnout-related litigation may well be a new trend to look out for in 2021.
2. SPACs and private equity funds
SPACs, which are formed by private equity funds or other sponsors, raise funds from investors through an initial public offering (IPO) to be used in a to-be-determined acquisition of a private company. The popularity of SPACs has increased gradually over the past decade before reaching a veritable explosion in 2020 (with 247 SPAC IPOs recorded in the United States through the end of November 2020).
SPACs’ ability to provide capital and secure access to public markets became more attractive to targets during the pandemic (in spite of arguably greater costs and lack of a “pop” compared to IPOs). In addition, a proliferation of new SPAC sponsors, in competition for the same potential targets, has offered attractive valuations and terms notwithstanding the pandemic. Sponsoring a SPAC IPO is often easier for private equity firms than raising a new fund. It can also be more lucrative: sponsors typically acquire 20% of a SPAC’s shares for nominal consideration as “promote”.
3. M&A disputes
Since the beginning of the pandemic, there has been a surge in M&A buyers litigating to terminate or delay pending acquisitions as a result of COVID-19. In particular, buyers have claimed that a MAE has occurred or that the target has breached interim operating covenants. Different buyers have argued both that 1) layoffs and reductions in capital spending are deviations from the ordinary course, and 2) the failure to take these actions in the face of a pandemic constitutes a failure to operate in the ordinary course. While much of this litigation remains unresolved, it has reemphasized the importance of the interim covenant, the “bringdown” covenant and, more generally, the importance of tailoring these provisions to the specifics of the deal.
4. Trends in RWI
As representation and warranty insurance (RWI) has transitioned from novelty to a mature industry and the number of claims and the size of loss payments have grown, premiums (which had been falling for years) have slightly increased. The retention amount (the value of the policy deductible as a percentage of enterprise value) has simultaneously stabilized at 1%. Only RWI policies for very large transactions (i.e., multibillion-dollar deals) might still see a retention amount smaller than 1%.
Several insurers are abandoning their practice of underwriting all of the representations and warranties in the acquisition agreement as written and are proposing finite “tweaks” to some of the reps, reducing the scope of the policy coverage and resulting, potentially, in a coverage gap between the agreement and policy. While RWI carriers initially insisted on broad exclusions for losses arising from COVID-19, most have now adopted more nuanced positions, which vary from insurer to insurer.
5. Employee loans
The COVID-19 pandemic has seen increased use of employee loans in the private equity space, in funding management co-investment, enhancing employee liquidity and otherwise attracting and retaining talent. While employee loan features vary widely depending on the parties’ priorities and the loan purpose, broadly speaking, five- to nine-year outside terms are within market, and interest is typically at the applicable federal rate, or one to two percentage points greater, and in some cases at the interest rate paid by the employer under its debt documents. If improperly structured, employee loans may have negative tax consequences; adequate documentation, interest and recourse are key to establishing a bona fide loan for tax purposes.