This article was first posted by Marsh in March 2020.
As confirmed cases of COVID-19 continue to escalate around the world, so too does the economic impact. Worldwide, we have seen the rapid developments in the disease cause a significant decline on global share markets and businesses of all different sizes being forced to shut their doors, contributing to a rising unemployment rate. These impacts have been felt far and wide, with the federal government stepping in with sizeable stimulus packages to save jobs and boost the economy. But what does all this mean for merger and acquisition (M&A) activity? The following are some of the observations we have seen so far in the market and what we anticipate how things may evolve.
Deal Activity
Since COVID-19 was first publicized through various media outlets, deal activity has dropped. Marsh estimates that 25% to 30% of live deals in the Pacific region have been shelved as a result of COVID-19 concerns. Importantly, a key observation for these deals is that any valuation gaps between sellers and buyers have been exacerbated by the continued uncertainty associated with COVID-19, especially when parties consider short term versus long term outlook for the target business. Despite this, we have identified that many active deals are progressing well and the parties continue to have enthusiasm to transact.
In fact, there will likely be an increase in deal activity from opportunistic buyers. A key example is distressed asset investors, such as specialized investment funds, who will be actively assessing opportunities to buy low-valued equity or debt packages.  In this regard, businesses in certain industries, such as the travel and leisure sectors, which are under great financial stress, are likely to be susceptible. We believe that even traditional investors may seek to undertake transactions involving distressed assets when the opportunity presents and there is clear strategic fit.
Risk Management Concerns
It has become clear that financial investors are increasingly concerned with risk management. We expect this to result in more robust diligence efforts in an M&A context, especially regarding financial and tax warranties as breaches in these areas often represent significant financial exposure. Warranty and Indemnity (W&I) and specific tax insurance solutions are being used as strategic risk management tools to cover investors and their portfolio companies. However, it is also likely that W&I insurers may request a new exclusion related to business interruption or bodily damage caused by COVID-19, and this may need to be considered going forward.
In addition, we have observed that portfolio companies are looking to shore up their own operational efficiencies, reduce costs, and safeguard against any additional financial uncertainties to the extent possible. Ensuring adequate insurance coverage across the business, such as mitigating potential exposures from operational tax risks, is more important now than it has ever been.
MAC Clauses
For transactions that have been signed, material adverse change (MAC) clauses have already been triggered and we expect this trend to continue. Related to this, W&I insurers are increasingly wary of offering coverage for new breaches (warranty breaches that occur and are discovered between signing and completion). New breach coverage typically contains an exclusion related to matters which would constitute a MAC, but insurers are nevertheless not as willing to offer this coverage enhancement in the current environment.
Tax Insurance Implications
For coverage of specific tax risks either in an M&A transaction or outside the deal process, it is not expected that access to insurance markets will be adversely affected by COVID-19, or that any material changes will be made to policy terms. This is largely due to the bespoke nature of tax insurance policies, and because the risk profile for insured tax liabilities is not likely to be any higher as a consequence of the current environment.
Businesses Under Financial Strain
Moreover, the uncertainty in the economy is already causing debt capital markets to become more stringent. We expect this will result in the deferral of highly leveraged buyouts and, more broadly, will impact the liquidity of businesses that are already under financial strain.
Employee Retention
Lastly, it is evident that COVID-19 has had a profound impact on employees. As a result of the pandemic, it is important that employee retention, including that of key management personnel, is properly considered when undertaking due diligence in a transaction, as a deficiency in in-house capability of an acquired business can significantly impact operations going forward.
COVID-19 has had far-reaching impacts beyond those that are regularly discussed. As the virus worsens around the world, it is expected that the impact the disease has on M&A activity will continue to evolve over some time. Businesses will benefit from monitoring trends around the world closely to guide steps that can be taken during this time of uncertainty.
