Sovereign Wealth Funds Update: A Buyers’ Opportunity – The European Market and Key Considerations for Distressed M&A Transactions

Economic turmoil as a result of political instability and from the coronavirus (COVID-19) pandemic, together with unallocated capital and low interest rates, means that non-core, but potentially profitable, operations or underperforming distressed assets are increasingly available across Europe. Countries across the region have also adapted insolvency laws to facilitate transactions and support economic activity. This first edition of our Sovereign Wealth Funds Update discusses the prevailing conditions, with particular reference to the United Kingdom, France, and Germany, including key considerations for sovereign wealth funds seeking to engage in distressed M&A transactions.

• The economic impact of COVID-19 may increase sales of non-core, but potentially profitable, operations or underperforming assets to allow distressed sellers to free up cash and focus on core operations.
• Buyers may exploit distressed disposals and benefit from reduced competition from bidders in order to expand product lines, service offerings, or geographic territories at a reduced price.
• Several European jurisdictions have sought to suspend or amend existing insolvency laws to ease the immediate burden on companies and to seek to encourage the survival of businesses which might otherwise fail under the burden of immediate lockdown measures and economic slowdown.
• In the United Kingdom, temporary measures were introduced to provide a breathing space for businesses, and a new restructuring plan procedure, akin to a scheme of arrangement for distressed UK companies, with a “cross-class cram down” mechanism may smoothen a distressed target’s negotiations with its creditors as part of any restructuring or sale of assets.
• France and Germany have also adapted their procedures temporarily in response to the pandemic and to ease the burden on struggling businesses.
• Distressed M&A transactions often tend to involve an accelerated sales process and buyers should be aware of the risks and potential mitigants.
• Limited warranty and indemnity protection will be a key concern, for which buyers may consider purchasing “synthetic warranty” insurance and/or lowering their purchase price.

Market Trends

Recent economic turmoil as a result of political instability and from COVID-19, combined with high levels of potential financial investors’ “dry powder” of committed but unallocated capital and low interest rates, has created favourable market conditions for an uptick in distressed M&A.

• An Intertrust survey at the beginning of June found that 92% of private equity fund managers expect a rise in the volume of distressed transaction activity over the next 12 months.
• This sentiment is off the back of one of the best performing first quarters this calendar year for M&A by deal value since 2006.
• There was a 33.5% decrease in the number of European deals between February 2020 and June 2020, and a 47.8% decrease between December 2019 and June 2020.
• There was a 32.7% decrease in the number of deals in H1 2019 compared to H1 2020.

[Image source – Mergermarket – based on announcement date, data per 22-7-2020; KPMG analysis]

Anecdotally, a number of pipeline deals have paused or been terminated due to the uncertainty of national lockdowns and broader public policy due to COVID-19. There is an expectation of a decline in activity from strategic trade buyers. However, many financial investors are reportedly positioning themselves to make investments against a background of muted competition and reduced pricing pressures. Some trade buyers may also be looking to combine with competitors in transactions to help share the risk and deal with market challenges going forward.

In addition to acquisitions, significant volumes of restructurings and distressed deals may also arise as cash-strapped companies dispose of attractive, non-core assets, readjust their strategic focus, and reinforce their resilience.

These sellers, while wanting to avoid undervaluing their business and/or assets, will at the same time be conscious of the likely future loss of revenue as a result of instability and uncertainty. This may mean that many sellers will be looking to sell quickly and be more amenable to considering lower purchase prices.

With M&A activity poised to continue, these transactions lend themselves to a number of elements and considerations specific to distressed M&A.

Support for Distressed Businesses

A number of temporary measures have been put in place to ease the effect of COVID-19. In the United Kingdom, protection for directors from the application of the “wrongful trading” regime during the early stages of the COVID-19 lockdown, along with government support in the form of the employee furlough schemes and loan support arrangements, allowed more breathing space for businesses to assess their future direction and needs. As these support measures unwind, there is an expectation that more long-term restructuring and distressed M&A will arise.

In the United Kingdom, insolvency laws were amended over the summer.

• A moratorium from certain payment obligations, insolvency proceedings, enforcement of security, and landlords’ exercise of forfeiture rights, among other matters, for 20 business days, extendable by a further 20 business days without creditors’ consent, in order to allow a company in financial distress the opportunity to explore its rescue and restructuring options. An insolvency practitioner will oversee the moratorium and monitor directors, and so would need to be kept abreast of rescue discussions with buyers during this period.
• A “restructuring plan” procedure for rescuing a company was introduced and has already been used by struggling airline Virgin Atlantic. Akin to a scheme of arrangement, dissenting creditors may be bound if 75% (by value) of all creditors or class of creditors who vote on the plan voted in favor of it. Importantly, a “cross-class cram down” feature will allow a court to sanction a restructuring plan even if less 75% of a particular class of creditors approved the plan, if (i) the court is satisfied that if the plan were to be approved, none of the members of the dissenting class would be any worse off than they would be in the event of the relevant alternative (i.e., insolvency), and (ii) the plan has been agreed by at least 75% in value of a class who would receive a payment, or have a genuine economic interest in the company, if the relevant alternative were to occur. This feature could smoothen negotiations in distressed M&A, though class classification will likely be a hot topic in any restructuring plan.

For its part, France has introduced a series of measures seeking to support companies during the pandemic, including amendments to certain aspects of insolvency procedures, with the aim of assisting temporarily impaired companies. These COVID-19 measures are temporary and are expected to gradually expire at the end of 2020 or by July 2021 at the latest.

• As part of existing French processes it is possible for the French courts to assist with a conciliation process to engage with creditors to restructure debts over an initial four-month period, with a potential one-month extension. Temporary changes were made over the summer to allow the courts to impose a moratorium against those creditors who seek to enforce claims during this conciliation process.
• Changes were also made to the safeguard procedure, a procedure which is designed to enable a reorganization of a company in financial distress in order to continue its business, preserve jobs and settle debts. The changes have simplified the process and time period for engaging with creditors and an accelerated safeguard procedure, normally only available to large companies which meet certain turnover and headcount thresholds, has been extended to all companies.
• The judicial recovery procedure, whereby a business is restructured through a court monitored recovery plan and potentially sold, has been temporarily amended to allow for recovery plans to be put in place for up to two years.
• Where a company is placed in liquidation, the usual prohibition on officers, their family members and creditors supervising the liquidation from acquiring assets has been suspended where the acquisition would enable the preservation of jobs.

After a record low in 2019, the number of corporate insolvencies in Germany remained low during the first half of 2020 despite the outbreak of the COVID-19 pandemic. Consequently, distressed M&A has not been an area of high activity in Germany recently.

One reason for the low number of corporate insolvencies during the COVID-19 pandemic may be a law which was adopted by the German Parliament on 25 March 2020 to mitigate the consequences of the pandemic in civil, insolvency, and criminal procedural laws. The core points of this law were:

• A temporary suspension of the obligation to file for insolvency as well as exemptions from certain payment prohibitions for managers of insolvent companies for the period from its effective date until 30 September 2020, unless the insolvency is not a consequence of the COVID-19 pandemic or there is no prospect of eliminating the insolvency. Where a company was not insolvent on 31 December 2019, the new law provides for a statutory assumption that a later insolvency is due to the COVID-19 pandemic and that there are prospects of eliminating the inability to pay. Therefore, it is relatively easy to rely on this exemption and it is assumed that a large number of companies have used this exemption to avoid the immediate impact of insolvency laws.
• This suspension is likely to be extended depending on the company concerned until October or December 2020 and corporate insolvencies are likely to remain low. Indeed, the German government’s decision has been criticized for keeping “zombie firms” artificially alive and that there may be a wave of insolvencies following termination of the suspension period.

Therefore, distressed M&A investors with interest in Germany will likely have to remain patient until 2021 to see more opportunities and better prices.

Key Considerations for Distressed M&A Transactions

Distressed sales of companies or their assets tend to be accelerated and may be run through an insolvency procedure. Common issues include:

• limited time to conduct due diligence and negotiate the terms of the deal;
• ·narrowed scope and limited depth of a due diligence review;
• staff shortages as key employees leave or are laid off, creating difficulty in accessing information from the target; and
• the target’s finance team and auditors being focussed on the immediate liquidity issues, and so available financial records may not be updated to accurately reflect the impact of the financial distress.

Structure. In the United Kingdom, the most common modes of acquiring distressed targets prior to the introduction of the new restructuring plan were an asset sale by way of either a “pre-packaged” or a post appointment administration sale. These enable selected assets (as well as a business as a going concern) to be sold to a buyer, leaving behind unsecured creditors. Importantly, the seller will be the company in administration acting by its administrators, who for a pre-packaged sale are obliged to market the business and satisfy themselves that they have received a reasonable deal in the circumstances.

In France as well, the so-called “prépack cession,” a form of pre-packaged sale codified in the French commercial code in 2014, enables the sale of the distressed entity for a cash amount, irrespective of the level of indebtedness of the company, in order to preserve the business and the employment of its employees. Again the proposed administrator would assess potential buyers ahead of appointment during an ad hoc or conciliation process following consultation with creditors. The sale would then be effected using the safeguard, judicial recovery, or liquidation processes. Offers must be submitted to the administrator in writing and include details of the timing of the assets to be acquired, employment prospects, and potential disposals planned for the following two years. Once an offer is submitted, it cannot be withdrawn and can only be modified to improve the offer terms until the court decides. Unlike the UK process, the court will decide on the offer to be accepted and will decide from the “prepacked” offers only, without opening up a bid process and allowing further offers, if the offers submitted through the “prépack cession” procedure are determined to be satisfactory, so as to effect a rapid disposal.

Buyer Protection. It is unlikely that a distressed seller or target will be in a position to provide much warranty and indemnity protection. Insolvency practitioners will not offer warranties and indemnities and there may be little recourse to a distressed seller in practice. The insurance market, which has seen warranty and indemnity insurance in M&A deals increased from 6% to over 40% in the past five years, has been offering tailored solutions during the COVID-19 crisis. One such solution is for the insurer to give a “synthetic warranty” (as part of its policy) where the insurer is effectively giving the warranty instead of the target or seller. Synthetic warranties will likely come at much higher premiums. It will be important to examine how “loss” is defined in the policy if shares are sold at nominal value or assets are sold at significantly reduced price.

Any remaining issues with a seller’s or a target’s warranties and indemnities, even after insurance coverage, are likely to be reflected in a lower valuation of the target. As a result, buyers may face the risk that the process or the terms of the sale is challenged by creditors or minority equity holders. Additionally, buyers should be wary of the duty to maximize the value of a company’s assets that directors owe to their companies. While an initial bidder for the target may be able to obtain some protections, there may still be only limited or no exclusivity and in some cases the bid may undergo a full auction process.

Transaction Risk. A distressed seller or target may be at risk of insolvency between agreement and closing of the transaction. Agreements may contain material adverse change (MAC) clauses that enable a buyer to withdraw the offer in specified circumstances. However, the application of such clauses is fraught with difficulties. In the United Kingdom, the Takeover Panel’s ruling on 19 May 2020 against invocation of a MAC by Brigadier/Moss Bros even in the face of the COVID-19 pandemic was consistent with its past decisions, and indicates continued reticence in UK public deals to allow a buyer to invoke a MAC. In the private sphere, such clauses are often tailored so as to limit the buyer’s ability to invoke post signing market events.

Competition. Mergers and acquisitions may give rise to merger control notifications. Generally, competition law concerns are more likely to arise with respect to a change of control in a merger or acquisition involving competitors, or otherwise giving rise to overlaps. However, the current unprecedented circumstances may enable bidders to take advantage of the “failing firm” defence with European competition authorities. Although the failing firm defence has been notoriously difficult to use either at an EU level or nationally, a clearance decision from the UK Competition and Markets Authority (CMA) on 23 April 2020 provisionally referred to the target’s financial position caused by COVID-19 as the main principle guiding its decision (ultimately overriding its own concerns) – although the CMA subsequently backtracked from that statement. More recently, the CMA prohibited another proposed merger despite “failing firm” arguments. The European Commission has recently suggested that there should not be an easing of merger control rules as a result of COVID-19. Accordingly, COVID-19 will not necessarily result in more lenient merger control assessments even in heavily impacted industries, although as always this will depend on the particular circumstances of the individual merger.

It is also worth bearing in mind that there has been a growing trend in Europe to tighten foreign direct investment (FDI) screening of foreign acquisitions and free movement of capital from non-EU countries with regard to foreign investments in strategic industries in the European Union (including healthcare). This has been accelerated as a result of COVID-19, with both the European Commission and national governments, including the United Kingdom, being concerned that, as a result of the COVID-19 pandemic, certain EU companies may come under financial strain or otherwise become easier targets for non-EU acquirers. Accordingly, bidders can expect that both the European Commission and national governments will closely follow FDI into their respective economies, and that cross-border transactions may face increased national scrutiny.

Finally, transactions involving distressed assets may involve EU state aid risk; that is, the EU’s anti-subsidies regulations. A finding of unlawful state aid could result in an order that the relevant beneficiary repays all of the unlawful aid that it has received, with interest.

Additional Resources

You may also be interested to read our latest COVID-19 Legal Issue Compendium, which brings together in one place an overview of our key publications covering the legal and regulatory landscape, including matters related to business operations and industry-specific issues faced by many companies around the world amid the pandemic.

Contacts

If you have any questions or would like more information on the issues discussed in this Insight, please contact any of the following Morgan Lewis lawyers:

Sovereign Wealth Funds Contacts

Europe
Mark Geday

Middle East
William L. Nash III
Ayman A. Khaleq
Alishia K. Sullivan

United States
Courtney C. Nowell
Daniel A. Nelson
Aaron D. Suh

Asia
Alice Huang
Carol Tsuchida