Conducting M&A in Tumultuous Times

Use an earnout to align business and economic risks

While the short-term health of the economy may appear bleak, the long-term impact of COVID-19 remains uncertain. Buyers and sellers can align interests by more heavily treating purchase price in the form of an earnout. An earnout is a great way to align incentives since a buyer can cover the risk of the struggling business in the near future in the event that economic recovery is slow, while a seller can rest assured that a quick recovery will result in transaction-price maximization. An earnout also incentivizes the buyer and seller to work together following the transaction to maximize customer retention and satisfaction, and effective supply chain management.

Consider a partial acquisition with an option to increase investment over time

Another way for parties to pursue M&A amidst an uncertain outlook is through a minority investment or a piecemeal acquisition, where the buyer obtains a smaller percentage of the target initially, with an option to increase its investment over time in the future. Such a structure allows the seller to experience a liquidity event on Day 1 and potentially strengthen its capital structure, while still allowing the buyer the upside if the business performs well in the future. Similarly, a piecemeal acquisition may allow the buyer to partially “test the water” and partially reduce risk before fully acquiring a company. Given that the seller retains an interest initially, a partial acquisition also ensures that incentives are aligned between parties and that risks are shared.

Remember that economic distress can represent opportunity

Buyers should remember that times of economic distress can create buying opportunities where companies can be acquired and integrated for value-maximization. As private equity funds still have record amounts of cash reserves on the sidelines waiting to be deployed strategically, the current economic environment can help buyers avoid the “winner’s curse” of overpaying for a target in order to win. Focus on the long term is key. For example, if a buyer has had its eyes on a particular target company for a while, the downturn may be an opportunity to acquire a company which wasn’t previously on the market. Simply sitting out due to economic uncertainty may eliminate certain targets that might have strategically come on market, and at a time where competitors are risk averse.

Similarly, for sellers, times of distress can represent opportunities to reallocate resources from certain areas of the business to others in order to strengthen an operating model, allowing the business to emerge stronger once the economic environment turns around. For example, a business that has not historically paid close attention to its working capital cycle or cash management policy may be able to implement more robust KPI tracking and liquidity management forecasts in the near term, which may allow it to streamline its working capital cycle post-closing or optimize costs. On the other hand, a business with current slowing sales may be able to redeploy business development resources to areas such as customer experience, which may result in long-term benefits in areas such as customer retention once economic recovery takes place.

While M&A may seemingly be a non-starter for some buyers and sellers amidst periods of economic uncertainty, shrewd buyers and sellers should remain focused on the long term and still consider M&A, as the current environment may present special long-term opportunities. Through considering alternative acquisition structures and value-maximization opportunities, M&A amid periods of economic downturn can strategically prepare certain buyers and sellers for long-term success.