Covid-19 consequences in M&A and Private Equity during 2020 and 2021 in Spain

Le séchage des voiles - André Derain

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Once the confinement phase is over, we begin to see where M&A and private equity transactions are headed. Although these kind of transactions have been almost completely paralyzed during the months of March, April and May in Spain, the confinement has served as an opportunity for investors and General Partners to reflect on their role in the second half of 2020 and 2021. It seems that the path is quite clear for many of them. Before continuing, it is worth noting two reasons why M&A and private equity will remain active despite Covid-19. The first is the large amount of liquidity of investment funds and the second is the need for companies to both refloat and to grow in order to compete.

The first aspect that will change will be the valuation of companies, due to the extraordinary EBITDA deviation that companies will sustain this year. Companies and investors will have to adjust the EBITDA for 2020 to try to reflect the new reality post Covid-19. Currently, the most common valuation method is to multiply the average EBITDA of the last 3 years by a number, depending this multiple according to the specific sector and company. However, in many cases, the EBITDA of recent years will not reflect either the present or the future of the company, nor will 2020 give a true picture, and 2021 will not be a reliable projection.

Given the problems of valuing EBITDA per multiple, the alternative could be to agree on a fixed price (locked box). However, most of the investors oppose this form of valuation, due to the risk of overvaluing the company.

Therefore, the alternative to be imposed, at least until normality is restored in 2022 (when the 2021 financial statements are closed), is to continue with the EBITDA method with a multiple, but making strong adjustments to the EBITDA to obtain one adapted to the new reality, together with the use of variable prices (earn-out) and, in most cases, a reduction in the multiple compared to the one that could be used before Covid-19.

With all this, the sales prices of companies are reduced or payment of part of the price is deferred (with the risk of not receiving it in the event of contingencies arising after the sale). As a result of this, and in addition to the generalised need for financing, the operations that are best adapted to the new situation are those of private equity.

Private equity allows a third party to invest in a company, with the current owners maintaining part of the capital, either the majority or a minority of it. Furthermore, they not only allow the valuation to be adjusted according to the evolution of the market and the company, but also align the interests of both parties, meanwhile both participate in the increase or decrease of the company's value. This alignment of interests in private equity does not occur as such a direct manner in the case of earn-outs in M&A transactions.

Another aspect that will change significantly is the increase of the investor’s bargaining power. As a result, it will be easier to achieve a period of exclusivity in his favour, to obtain compensation in the event of negotiations breaking down because of the seller's fault (break fees) and to increase the seller's liability, especially in representations and warranties (R&W).

Finally, the last aspect that will change significantly is the regulation of uncertainty in sale and purchase agreements and investment agreements. The best example of this is the generalization expected with regard to the material adverse change clause (MAC clause), which will include more detail and more grounds, due to investors' fear of being caught up in purchases or investments if a new outbreak of Covid-19 or another destabilizing aspect of the economy appears.

Consequently, in 2020 and 2021, we can expect that M&A transactions will continue, with a rebound in favor of private equity transactions compared to M&A, but with greater complexity in the negotiations. This will result in even more detailed contracts and longer preparation, formalisation and execution periods.