The Covid-19 pandemic has seen previously sky-high M&A valuations plummet, at least for now. As a result, buyers looking to press on and do deals in this environment need to find creative ways to bridge gaps between the value at which deals can get done & what sellers believe their businesses are worth under normal conditions. This Dechert memo discusses strategies that buyers can employ in order to accomplish that objective.
Perhaps the memo’s most interesting suggestion is to look to Asia for insights as to how dealmakers there have approached valuation issues in the current environment. Asian financial markets have dealt with the effect of COVID-19 longer than U.S. or European markets, and have also had experience dealing with SARS and similar market disruptions. As a result, it may be helpful to consider recent valuation trends in those markets. These include:
– The use by sponsors of downside protections typically incorporated in venture capital transactions, given the similarities between the current environment of valuation uncertainty and the valuation uncertainties inherent in venture capital investments. These measures include negotiating for most favored nation clauses, down-round protections and enhanced liquidity and dividend preferences.
– Investors increasingly structuring their investment as a hybrid debt/equity instrument to ensure there is down-side protection, with the prospect of equity upside in the future.
– Investors providing convertible bridge loans with an agreed-upon conversion discount triggered by a subsequent equity investment, which provides initial capital to the target business and also provides the investor with more time to conduct diligence and determine the appropriate equity valuation.
The memo also addresses the possible use of earnouts, noting that while they are often complex and frequently end up in litigation, the can be a useful tool in an economic downturn. In addition, it discusses the possible use of toe-hold and other minority investments, which – if properly structured – can allow a company to obtain needed capital without a full exit at a depressed valuation, and also provide a path to control for the investor.
– John Jenkins