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Coronavirus alters the merger playbook for dealmakers

As most buyers don’t have an option to walk away from an acquisition and cite the coronavirus, corporate lawyers are advising clients to do more aggressive due diligence.

Morgan Stanley's acquisition of E-Trade is one of the first deals known to mention the coronavirus in its terms. (Justin Sullivan/Getty Images News)

The coronavirus epidemic has begun forcing dealmakers to rethink how to manage risk in mergers and acquisitions.

When Morgan Stanley agreed to acquire E-Trade in February, the deal included terms that precluded both parties from invoking the novel coronavirus or its fallout as cause for renegotiating the $13 billion pact. More coronavirus news: Continuing coverage from PitchBook.

Deal terms for mergers and acquisitions typically provide buyers and sellers the right to change their agreements in the case of an unforeseeable event that causes a material adverse effect. That is a legal term for factors that could have a long-term impact on the potential of a company.

The fact that the E-Trade acquisition didn’t treat the coronavirus in this way reflects how some dealmakers are viewing the crisis, which the World Health Organization declared on Wednesday to be a pandemic. But the purchase of the online brokerage appears to be one of the first major deals to explicitly make a reference to the outbreak.

The epidemic doesn’t necessarily qualify as a material adverse effect because it isn’t currently considered a long-term change, and its existence and potential business impact on various industries is highly visible, said Michael Szlamkowicz, a New York-based partner at the law firm Hogan Lovells.

Most buyers don’t have an option to cite the coronavirus as a reason to walk away from a deal. But Szlamkowicz said corporate lawyers are advising their clients to do more aggressive due diligence—including closer scrutiny of supply chain and insurance policies.

Szlamkowicz, who represents buyout firms and pension fund sponsors, said that the way people evaluate companies has not changed, but the focus has become sharper.

“From a due diligence perspective, people are thinking about what the impact of this virus could be on a business, and that is causing target companies to perhaps look at things in slightly different ways than they did before,” he said.

Some indicators are more straightforward than others: If the revenue of the target company is derived from situations where large groups of people are in close proximity, due diligence would be expected to dig deeper into how the virus might affect the health of the business. If staff is unable to gather, for example, even routine processes such as conducting a physical inventory during the outbreak could be challenging.

In addition, many companies have been advised by investors to gauge whether they are overly dependent on suppliers in specific geographies and devise ways to diversify their supply chain to be better prepared for the pandemic.

“We all know that several companies are suffering because they’re trying to get a product out of China, and that’s proving to be very difficult,” Szlamkowicz said. “Alternate resources for raw materials and finished goods is definitely something that people are thinking about.”

Some executives on both sides of a deal are checking for sound business continuity and contingency plans, which could mitigate negative effects of the virus.

“The idea is to make sure that buyers are able to factor in potential effects of the outbreak in the agreement—either as a material adverse clause or the valuation,” said Brandee Diamond, a Silicon Valley-based partner at law firm DLA Piper.

According to Szlamkowicz, one of the biggest threats to M&A deals is uncertainty over the duration of the pandemic.

“There is a lot of discussion about how the coronavirus will affect companies, but ultimately not a lot is changing in agreements,” Szlamkowicz said. “That’s because people don’t yet know whether coronavirus is a short-term issue or a long-term issue.”

Beyond the current pandemic, uncertainty in general can create a blind spot: Buyers wonder whether they are paying too much, and sellers wonder whether they are getting the right price for whatever it is that they’re selling.

These days, buyers would certainly want the definition of a material adverse effect to include something explicit about the coronavirus. But sellers are likely to push back. What will the common ground be?

One area for negotiation could be to explore if there is a disproportionate effect the epidemic would have on a given target business as compared to the general impact on an industry or a particular geography.

But it is going to be challenging to negotiate, as buyers and sellers are likely to have a fundamentally different view on whether that effect is material enough to allow a buyer to abandon a deal.

The market is expected to eventually adjust to the new normal once it’s known whether the coronavirus outbreak is going to be a more straightforward or complicated disease to manage from this point on.

Said Szlamkowicz: “But until we know what that normal is, there’s room for a lot of concern.”

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    Written by Priyamvada Mathur
    Priyamvada Mathur writes about venture capital at PitchBook.

    She is an Indian chartered accountant and has studied economics and journalism.
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