Conducting M&A in Coronavirus World: Management Agreements

While the global M&A market is currently experiencing a significant reduction in activity, let’s fast forward in time to July 2020. Despite the murky environment, a Buyer and Seller have agreed on valuation for a business and signed an LOI to complete a sale. The Buyer is ready to begin its due diligence process when it receives the bad news: none of its usual lenders are willing to underwrite this business until they see a quarter of financial performance consistent with pre-coronavirus production.

Let’s use an example of an $8M EBITDA business. The Buyer and Seller agree on a purchase price of $50M, which will be funded in part by debt financing. In good times, the Buyer may expect to receive four turns of leverage from a lender—that is, $32M of debt to buy the business. Further, assume the target company consistently averaged $2M of EBITDA each quarter before declining to $1M in the second quarter of 2020. How will lenders value this business: as an entity that has produced $7M of EBITDA over the trailing twelve months or as business that’s now a $4M EBITDA business based on its Q2 performance?

Buyers and borrowers will try to convince lenders that a bad Q2 was a one-time blip, but lenders will justifiably ask: will Q3 be as bad (or worse!) than Q2, or will Q3 represent a return to normal? Without enough upside to engage in a speculation game, most lenders will want to see the target business rebound before agreeing to underwrite the business based on pre- (and now post-) pandemic performance.

So what does that mean for the leveraged buyout world? Without confirmation from their lenders that the financing is there, buyers will be discouraged to spend time (on diligence) or money (on legal and accounting) even on deals under LOI. The Q3 results for most businesses won’t be ready until late October at the earliest. Without the ability to kick off real diligence and negotiations until November, this hypothetical transaction won’t be closed until year end—and that’s if everything goes right (a rarity even in good times).

So what can Buyers and Sellers do in the interim—what would otherwise be the quiet period from July to October? One solution is for the parties to enter into a management agreement, which will keep the parties talking to each other throughout this quiet period. A management agreement can help the two parties begin the partnership process while waiting to see the financial performance of the target business. The management agreement should cover ways in which the Buyer can assist, including:
 

• Create and implement a COVID-19 response plan.
• Coordinate "Quality of Earnings" report for the company (which, in the event the deal ultimately dies, may be used by the Seller in discussions with other buyers)
• Assist management in the professionalization of the company’s financial, accounting, HR, and legal needs.
• Connect the company with potential business relations, upstream and downstream, through the Buyer’s network (a particular strength of private equity funds due to their portfolio companies).
• Assist the company in any negotiations with existing lenders, customers, or suppliers.

As a separate but related matter, it is important for all Buyers negotiating LOIs during the COVID-19 pandemic to seek longer exclusivity periods than normal. All parts of deal activity will be delayed (management meetings, government searches and filings, customer consents, etc.), and the parties should not expect to close on a pre-COVID-19 timeline. In consideration of the commitment to expend significant time, effort and expense in proceeding with their diligence efforts, Buyers should seek a six-month exclusivity period with automatic extensions.

Advantages of a Management Agreement

There are many reasons why entering a management agreement would be attractive for both Buyer and Seller. If the Q3 financials are positive, the Buyer will be able to fast track the diligence process. By not having to wait until November to conduct a Quality of Earnings report, a 2020 closing will be well within reach for both sides. In addition, the parties will be able to come to an agreement on working capital much more easily, as the Buyer will have a much more comprehensive understanding of the business.

From the Seller’s perspective, it can justifiably ask the Buyer to cut down on the breadth and depth of representations, warranties, and disclosures that are customarily provided: the Buyer will be able to rely on what it learned about the operations of the business during the “quiet period” and can be more accommodating when it comes to certain disclosures. And a Seller risks letting an attractive Buyer for its business walk away if it is not willing to accommodate during these challenging times.

Many sale transactions have the owner and/or management team stay on following the closing; for both Buyers and Sellers, getting to work together for a substantial amount of time pre-closing will give insight into the working styles of both Buyer and Seller. If the parties can’t work well together during this quiet period, that may be a signal a partnership is simply not in the cards. Conversely, during this “feeling out” period, the parties may find they have strong chemistry, which will help ease the tense negotiations that may otherwise occur during the final stages of the M&A process.

Seller Concerns

There are three material concerns sellers will have with a management agreement:
 

• Confidentiality. By giving more access to the Buyer while there are still questions outstanding surrounding financing, Sellers should be careful to have strong NDAs in place. For private equity fund buyers (or an upstream or downstream business relation), this will be less of a concern. However, for a strategic acquisition, allowing an extended “look under the hood” should be viewed disfavorably.
• Auctions. Some sellers want to run a true auction process and avoid giving exclusivity for as long as possible. That obviously won’t work here, where a Seller has to pick one Buyer and work with it during the quiet period.
• Leverage. By agreeing to a six-month exclusivity period, a Seller may give up some leverage in negotiations with the Buyer. This makes it all the more important for Sellers to diligence their buyers before agreeing to exclusivity.

Ultimately, whether a management agreement relationship makes sense will depend on each individual transaction opportunity. Both Buyers and Sellers will need to be more creative to complete any M&A transactions during this pandemic, and a management agreement relationship post-LOI is one such way.

Ice Miller is happy to provide a template management agreement with key terms and conditions for both buyers and sellers, including payment amounts, exclusivity provisions, and duration. If you would like to see an example, or have questions regarding this article, please reach out to Chase Stuart or a member of the Business Group.

Please contact our COVID-19 Task Force if you have any questions about managing the risks of the coronavirus pandemic. Our Task Force leadership consists of partners Josh Christie, Tami Earnhart and Christina Fugate. Also see our Coronavirus (COVID-19) Resource Center for additional resources, which is updated daily.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. It speaks only to guidance available as of May 6, 2020. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.