Conducting Due Diligence During COVID-19
Across all industries and sectors, businesses are experiencing the effects of COVID-19 on their day-to-day operations. With prolonged stay-at-home orders in place and mounting travel restrictions, many employees now find themselves working from home and adjusting to their new normal. While it is not yet clear the total impact the pandemic will have on business operations, companies are beginning to understand the effects of COVID-19 on various functions and workstreams. This is especially true of the M&A landscape, where deal timelines have been pushed and key risks are shifting. As a result, the way that companies must now approach a prospective deal is changing.
Being aware of the risks involved in any new deal and the procedures to mitigate them will assist in preventing further delays as companies navigate the challenges ahead. Here are a few key things companies should take into account when considering transactions during this uncertain time.
Due diligence is going remote
Travel restrictions are preventing companies from conducting onsite diligence, which was traditionally used for diligence teams to have face-to-face conversations with management teams to better understand key aspects of the business and assess the capabilities of the team. As a result, deal timelines are lengthening. In this unprecedented environment, companies have no choice but to turn to remote diligence in order to move forward with the deal. Becoming more comfortable in a remote setting will lead to more effective diligence.
Deal timelines are lengthening. In this unprecedented environment, companies have no choice but to turn to remote diligence in order to move forward with the deal.
With stay-at-home orders in place, travel for onsite meetings is ill-advised. In lieu of onsite meetings with management, companies should set-up a series of video conferences and consider other innovative tools and platforms to engage in conversations virtually. Although face-to-face meetings are important, conducting meetings over video can be highly effective to read body language and have diligence conversations.
Deal timelines are increasing
Companies should anticipate prolonged diligence timelines and work with their consultants, third-party advisors, and internal resources to develop the right strategy. The trend of lower M&A announcements and deal closings will likely continue until there is more certainty around valuations, operations, and markets.
When conducting diligence during this period of uncertainty, active buyers and sellers should develop a scope that identifies key risks and allows for remote procedures. Scoping has always been an integral part of diligence to ensure risk areas are adequately addressed. In this time of uncertainty, companies must ask different questions to address the potential for increased risk in transactions, such as:
- How will the outbreak impact customers and their ability to pay invoices and product pricing?
- Do customer or vendor contracts have any performance obligations or future commitments?
- What changes to current operations have occurred (supply chain interruptions, business shutdowns, layoffs)?
- What other diligence work streams should be turned on in the current environment (supply chain, IT, insurance, human resources)?
- What are additional areas for potential risk?
After understanding the answers to these questions, a scope can be customized for the appropriate level of diligence. Once the scope has been finalized, a plan can be developed and tailored for a remote setting.
Companies should take steps to mitigate potential disruption to deal processes and timelines caused by COVID-19 by setting up an internal and external cadence for communication.
Deals are continuing, but at a slower pace
In addition to the impact on diligence timelines, COVID-19 has impacted the strategy and considerations given in various types of transactions.
- Buy-side transactions – Processes that have been signed are generally continuing, although at a slower pace. Companies are focused on the credit risk of the target’s customers and the quality of assets on their balance sheets. While the impact of the pandemic on buy-side transactions varies by industry of exposure, companies should consider whether their target has: potential liability or contingency exposure; any solvency risk related to covenants under a credit facility; the ability to perform or terminate obligations under contracts (including material adverse effect and force majeure clauses); alternative vendors or suppliers in its supply chain and the price differences; the effect on end-market demand; tax considerations; and business interruption insurance. In addition, buyers should take this opportunity to perform diligence over the most recently financial statements available and obtain future forecasts post COVID-19
- Sell-side transactions- There has been an increase in demand for sell-side advisory services with regards to distressed M&A. A number of businesses are busy making significant operational changes to adapt to the new challenges of this environment (i.e., restructuring initiatives, supply chain improvements, customer/vendor contract negotiations, etc.). As such, these businesses are in need of support validating the go-forward impact of these changes on earnings in order to achieve their objectives and maximize value in a process. They are also seeing increased demand to achieve additional liquidity as quickly as possible through the M&A process, whether through refinancing, a divestiture of a business line or asset, or the full sale of the business. As lenders and investors increase scrutiny and become more risk-adverse, the risk associated with closing a deal becomes higher.
- Restructuring/turnaround- Many businesses are facing significant and urgent challenges resulting from COVID-19. In many cases, organizations may need to preserve capital/enterprise value, stabilize cash flows/earnings, proactively establish communication channels with stakeholders, and in certain instances, drive critical reorganization initiatives. The typical starting point is understanding a company’s 13-week cash flow to determine the peaks and troughs of liquidity are that may require management to make essential decisions regarding liquidity management. It is critical to define critical and non-critical cash disbursements, as well as having clear visibility into cash inflows, to ensure cash and liquidity remain at adequate levels during these uncertain times. Lastly, management should identify what levers exist in the short and long term that may enhance liquidity positions when enacted upon. Through early and frequent analysis, organizations can prioritize actions and considerations related to liquidity management, cost control, covenant compliance, operational continuity, and stakeholder management.
- Lender services- Market uncertainty and credit volatility will increase the difficulty in obtaining committed financing with limited conditions. As a result, companies must address areas of higher risk and find creative solutions to evaluate collateral, cash flows, and core business fundamentals in order to identify and mitigate credit risk in a remote setting.Companies are losing liquidity as collateral deteriorates and cash flows contract, which requires immediate, focused assessments of credit risk and quick action to bring stability. There is also a high amount of borrower and portfolio credit quality volatility, which affects pricing, structure, credit appetite, and regulatory capital requirements. Lenders may have difficulty accessing capital due to portfolio volatility and limited capital markets options.
- Rapid Supply chain risk modeling and remediation plan- Identifying supply chain risks and actions during COVID-19 spans across a wide range of capabilities but most clients are executing some immediate tactical response to absorb the shock while they figure out medium term actions. There are three immediate actions that we have recommended in the last couple of months. Firstly, companies should assess their customer and supplier contracts to determine specific risk exposures to their immediate obligations (e.g. Force majeure, performance-based termination, deferments, common law defenses, etc.). There are a variety of clauses and they need to be understood in detail to determine what actions are financially and legally viable in collaboration with customers and suppliers.Secondly, most companies are also experiencing an immediate need to refresh their budget and forecast models to include extraordinary scenarios related to the COVID-19 impact as they assess their liquidity and trade support requirements. In addition to the sales impact, the impact on the end to supply chain should be considered. You should task your internal resources to determine the impact of import tariffs/deferment, purchasing timing differences, stranded inventory valuation, alternative supplier and distribution networks, shipping and last mile freight costs, volume reallocation across distribution channels, and price-volume attribution. While not all of these impacts will be felt by every company, all impacts should be analyzed and considered in companies’ reforecasts and cashflow models. Once the impact has been determined, the last step is to have a transparent communication and plan with the internal and external stakeholders and reconfigure the execution plan.
As we all work through the challenges ahead, becoming more comfortable in a remote setting will lead to more effective diligence. Understanding the changing diligence process and taking the timeline and scope into consideration accordingly may not alleviate all potential roadblocks but will increase preparedness when issues do arise.