In distressed acquisitions the "as is, where is" principle that governs the terms on which the assets will be acquired tends to shift risk from the seller to the buyer. Buyers should therefore pay attention to the ways in which they might mitigate such risks and this article considers the three most important of those.

Warranties and indemnities and the impact of COVID-19

In conventional acquisitions, contractual warranties (including tax warranties) from the seller are, along with thorough due diligence, the first direction in which a buyer will look, but in distressed acquisitions sellers can be reluctant or unable to provide warranties (especially where the seller is an Administrator). The extent to which the seller is willing to give warranties and the scope they will cover varies from deal to deal. For example, management sellers are much more willing to give warranties to a buyer if they are incentivised play their part in delivering the deal, perhaps because they stand to receive sweet equity or a transaction bonus. It should be noted that even when a seller is willing to give warranties, there will often be scepticism about the seller's covenant strength and the likelihood of the buyer ever being able to successfully recover from the seller for a breach of warranty.

When sellers of distressed assets are willing and able to give warranties, buyers are often now requesting specific warranties that relate to commercial and legal risks associated with COVID-19. These warranties tend to concern the target's compliance with matters such as the furlough job retention scheme, COVID loans provided by the government, and the target's compliance with, and implementation of, health and safety regulations and policies. 

As we note below, warranty and indemnity insurance policies can sometimes close the gap created by an absence of warranties, but when buyers have been using W&I policies on distressed deals we have been seeing insurers include a broad COVID-19 exclusion in the policy terms. In some situations, we have managed to move the underwriter to a position where the COVID-19 exclusion only applies to the specific warranties that are directly impacted by COVID-19. 

If sellers are unlikely to provide warranties, they are even more unlikely to indemnify buyers for identified risks, notably in relation to tax. The same principle applies as it does with warranty protection: even if the seller can be persuaded to provide an indemnity, the buyer ought to be wary of the credit worthiness of the seller if it ever needs to claim under the indemnity. 

Warranty and indemnity (W&I) insurance and synthetic warranty protection

Knowing that warranties and indemnities are scarce to come by on distressed acquisitions and that, as we discussed in an earlier article, due diligence is usually limited in scope and timeframe, helping buyers to ensure that they don't miss out on distressed acquisition opportunities whilst at the same time managing the risks and uncertainties that go with these transactions is a key role for the advisers.

In 'normal' acquisitions, W&I insurance has become a mainstream tool to protect buyers from losses arising from breached warranties and indemnified losses including tax. Historically, however, W&I insurance has not been readily available in distressed scenarios for two main reasons: 1) there are often no meaningful warranties being given which the W&I policy can attach to; and 2) insurers have wanted to see that a reasonably extensive due diligence process has been carried out by the buyer before agreeing to provide cover. COVID-19 has caused a shift in this thinking though, and insurers have been evaluating how they can evolve their products to meet demand.

The result is the Synthetic Warranty Deed (or "SWD"), a bespoke solution which appears to be offered by many M&A insurers for transactions where time is of the essence and the seller is unwilling or unable to meaningfully warrant the condition of the target or indemnify the buyer against certain loss. 

An SWD will form part of the W&I policy and is separate from the acquisition agreement.  It is agreed with the insurer itself, as opposed to the seller, provided the buyer is able to carry out such due diligence on the target as the insurer requires. It may come as no surprise that these policies are more expensive than typical W&I policies.

Some argue that the use of SWDs will mean that distressed acquisitions can be expedited, as there is no need for the buyer and seller to negotiate warranties and indemnities. SWDs could also potentially mitigate buyer risk to such an extent that buyers are willing to pay more for the asset in question. Indeed, some even predict that there will be buyers who look to use SWDs as a bid differentiator in non-distressed but aggressively run processes.

Whilst the advantages of SWDs are clear, this is largely uncharted territory – SWDs have often been talked about in the past but rarely implemented.  One area of concern is around the level of due diligence which an insurer will require. As noted in an earlier article, one of the key hurdles for distressed acquisitions is the limited time available for the buyer to conduct an extensive due diligence process. If the insurer requires the buyer to carry out a full due diligence process, this could provide the buyer with sufficient comfort such that it negates the need for the W&I policy or SWD. Carrying out the due diligence could also mean that any advantage afforded by putting the W&I policy in place to close the deal quickly is lost.

On a distressed acquisition, it is possible that due diligence information won’t be available or, even if it is, that the buyer and its advisers won't have time to assess such information. If this is the case, the insurer won't be able to provide the SWD and the buyer will have to make a risk adjustment by reducing the amount it is willing to pay for the asset. Sellers who wish to avoid this could at least have an eye on the diligence requirements of insurers when preparing data rooms, to at least give buyers a fighting chance of doing the work the insurer requires as quickly as possible.

Deferred consideration and post-completion price adjustments 

The ability to close the deal for a distressed asset quickly can be of paramount importance for both the buyer and the seller. The buyer will want to gain control of the business to provide the necessary liquidity, to take steps to start improving trading or to begin integrating it into its own business, and the seller will want to avoid further value erosion and to access the sale proceeds. Material periods of time between signing and completion are therefore very unusual. Equally, whilst prior to COVID-19 about 90% of the deals we were involved in included a post-completion price adjustment mechanism (split roughly equally between completion accounts and locked-box mechanisms), such mechanisms are less common in distressed scenarios, especially locked-boxes.

A fixed purchase price is therefore much more usual to see, as well as deferring a proportion of the consideration through an earn-out mechanism.  An earn-out mechanism can be especially useful in the current climate and can provide protection for both buyer and seller – the buyer is protected to a degree if the business does not return to pre COVID-19 trading and the seller has the prospect of upside benefit if trading does fully recover. There is speculation that we may see new financial metrics being used regularly in earn-out mechanisms, for example, "EBITDAC" (which looks to normalise earnings against the impact of the pandemic on the business) or business-specific commercial KPIs, such as customer retention rates. A word of caution though: even prior to COVID-19, our research has shown that earn-out mechanisms are the most commonly disputed provision of purchase agreements, so they are not without risks.

Buyers should also be careful not to pay upfront for tax losses (i.e. via an increase in the purchase price) that the seller claims will be available in respect of the target business. It is unlikely that the buyer will be able to conduct extensive financial and tax due diligence to assess the true availability of these tax losses. A more sensible approach would therefore be to agree to pay for such losses when the target business actually gets the benefit of them.

If you would like to know more about how we can support you or about some of the interesting developments we are seeing in earn-outs and other pricing mechanisms, please get in touch.