The impact of the coronavirus disease 2019 (COVID-19) pandemic on private equity-backed mergers and acquisitions is quickly evolving. This alert aims to assist private equity buyers in considering (i) certain expansions to their standard set of due diligence considerations in light of the COVID-19 pandemic, including specific employment, compensation and benefits considerations, and (ii) the evolving impact on representations and warranties insurance (RWI) policies on any transactions in which the target is or could be negatively affected by the COVID-19 pandemic.
I. Due diligence
A. General considerations
- Business interruption/succession/business continuity planning. Most standard due diligence request lists include requests related to current officers, directors, managers, etc. A consideration for buyers in this environment, especially private equity buyers who expect current management (or some portion thereof) to operate the target post-closing, is the level of succession planning currently in place with respect to key managers and employees. Buyers may consider inquiring as to the extent of the target’s succession planning, points of failure for execution and information and what policies and procedures are in place to document the target’s operations and controls. Buyers may evaluate whether the target is prepared to continue operations in substantially the same manner in the unexpected absence of certain key management personnel or groups of related personnel. Similarly, many companies have business continuity or crisis management plans that typically cover cybersecurity incidents, natural disasters and similar matters.Many such plans have been put to the test with the COVID-19 pandemic and the recent travel restrictions, school closures and other widespread effects the pandemic has had on businesses and communities.Buyers should examine the efficacy of these plans and require additional measures to be put in place if such plans have not been adequate or successful.Of course, if a target does not have any business continuity plans in place, that may be a red flag.
- Business interruption/key man insurance. Related to the above, a buyer may also consider conducting a thorough review of the target’s business interruption insurance coverage and its key man insurance (if any) to determine whether and to what extent there is coverage for losses related to a slowdown or full stoppage in business because of the COVID-19 pandemic or the death of key management. For targets that do not have policies in place, private equity buyers may consider requiring policies as a condition to closing or as a post-closing matter. That said, most businesses will not have a material amount of insurance coverage for business interruption since insurers are taking the position that interruption due to general COVID-19 conditions does not constitute “physical loss or damage” to insured property that triggers most such coverage. Furthermore, most going-forward placements are expected to have a blanket virus exclusion.
- Termination or re-negotiation of existing contracts. A buyer may consider the ability of the target and its counterparties to perform their respective obligations under existing contracts. The COVID-19 pandemic has already had a major impact on supply chains and has caused buyers to further scrutinize material adverse effect/material adverse change, force majeure, default/termination, take or pay, exclusivity, minimum requirements and related provisions in commercial contracts. Further, a buyer may examine any potential events of default or any current re-negotiations under existing contracts that are ongoing.In many circumstances, the target or one of its counterparties may have already taken actions that are in violation of its obligations under its existing contracts (or are considering taking such actions). It is in the interest of the buyer to be aware of such circumstances and the impact that termination or modification of such contracts will have on the target.
- Financial diligence/working capital. Financial performance for many targets may be impacted dramatically by industry-specific declines, as well as the local, state, domestic and foreign jurisdiction shutdowns caused by the COVID-19 pandemic. As a result, a buyer may consider the applicability of the pre-COVID-19 pandemic financials (including working capital) to the current state of the target.Along these lines, a buyer may consider a longer post-closing purchase price adjustment period to allow for more time to recognize any implications from the impact of the COVID-19 pandemic on the business and should also reevaluate what constitutes normalized working capital during this crisis as historic averages may not be a reliable metric going forward. Private equity buyers may also need to modify their financial models to take into account the heightened uncertainty with respect to projections, forecasts and business plans during this crisis.
- Physical inspections/interviews. Because of the growing imposition of travel restrictions, shelter at home orders and restrictions on gatherings, the ability of buyers to physically observe and inspect the target, its equipment and/or its personnel is severely limited, which will delay the diligence process. The use of video conferencing and related technology has been positive and become more widespread, but still has not completely replaced the traditional diligence process. Nevertheless, buyers may need to be more flexible and creative with their diligence processes until the restrictions imposed as a result of COVID-19 are lifted.
- Regulatory compliance. The regulatory landscape is changing daily, if not hourly, with the foreign, domestic and local governmental authorities implementing measures aimed at stopping the spread of COVID-19. Compliance with such orders and regulations is critical to the extent applicable to the target’s business. It is in the interest of the buyer, as well as the target, to consistently review and stay abreast of current regulations to understand their impact on the target, its existing commitments, its customers and its partners.
- Litigation. In most jurisdictions throughout the United States, courts have delayed hearings and extended filing deadlines. A buyer should analyze the extent to which these extensions increase the level of risk and/or uncertainty and cost of litigation involving target or the transaction.
- Real estate. To the extent that the target leases any real property, a buyer may confirm that the target is current on its rent and is not in violation of any of the provisions of its existing lease(s), including whether the target and its landlord(s) have negotiated, or whether the buyer should consider attempting to negotiate, any special concessions related to a hardship related to COVID-19.
- Indebtedness. With the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the massive $2+ trillion stimulus package, a target may be able to turn to additional and alternative sources to obtain additional finances to buoy it through the COVID-19 pandemic. It is in the interest of the buyer, on a real-time basis, to be well informed of any existing or pending applications for target’s additional indebtedness obligations, including but not limited to any disaster relief loan, paycheck protection loan under the CARES Act or SBA loan applied for in response to COVID-19. DLA Piper’s alert on the CARES Act can be found here. In addition, a private equity buyer should specifically consider how the applications would be impacted if the transaction is consummated, including for example whether the target could become ineligible for relief because of affiliation or aggregation rules.
B. Specific employment, compensation and benefits considerations
- Reductions in force. Many companies have already been forced to reduce personnel costs due to COVID-19 by reducing employee hours, implementing furloughs and/or conducting layoffs.As a result, a buyer should understand who is part of the target’s “active” workforce, whether the target has implemented any of these cost-cutting measures and, in the case of furloughs or temporary layoffs, the anticipated return-to-work dates of impacted employees). Importantly, a buyer may consider reviewing a copy (or description) of all employee communications shared with employees regarding the above. Related to these diligence considerations, a buyer should also consider tightening interim covenants to restrict the target from making additional reductions to its personnel between signing and closing.And finally, while many governments (including the State of California) are currently taking a more relaxed position about statutory notifications to employees in the event of mass layoffs or site closures, buyers may consider addressing Workers Adjustment and Retraining Notification (WARN) Act liability in the representations and warranties of the purchase agreement.
- Office closures/telework/leaves of absence. As noted earlier, many major metropolitan areas and states have instituted stay at home orders or have closed non-essential businesses to the public and more companies than ever are allowing, or even requiring, employees to work from home where feasible. Buyers may consider seeking to better understand whether (i) the target has any office or plant closures (including whether temporary or permanent and the reason for the closure); (ii) any employees are out on leave (including under the Families First Coronavirus Response Act (FFCRA)) or teleworking (including whether voluntary or mandatory and the reason for the telework arrangement); and (iii) any employees have tested positive for COVID-19 and, if so, the steps implemented to address such situations. In terms of paid sick and Family Medical Leave Act leave under the FFCRA, buyers will want to understand whether any of the target’s employees are taking or seeking to take leave under the FFCRA. While leave amounts under the FFCRA are not paid out on termination of employment and do not carry over after December 31, 2020, buyers may still have an affirmative obligation to provide, or to cause an acquired affiliate to provide, such leave to acquired employees through the end of 2020.As such, buyers may need clear records (as well as representations and warranties) from the target in respect of all leave taken and requested under the FFCRA. And to the extent the target has other paid or unpaid leave policies in place that employees may seek to use in light of the COVID-19 pandemic (e.g., paid time off, paid sick leave, unpaid leaves of absence), these must be reviewed and considered as well. Buyers will also want to make sure that the target is properly calculating and categorizing leave to be in compliance with the FFCRA, including all caps and hour requirements.
- Employee health and safety. Employees are nervous about the COVID-19 pandemic − whether they have it, where they might catch it, what they can do to stay safe. Requiring employees to show up to work during the COVID-19 pandemic (especially where teleworking is an option) could lead to actual employee illness or injury as well as reputational injury to businesses. There have been well-publicized examples of companies requiring their employees to continue to come into work despite a lack of proper health and safety measures at the worksite, even where such businesses are not seen as “essential.” Regardless of the target’s industry, a buyer may consider inquiring whether there have been any (i) employee complaints (external or internal); requests, or demands related to health, safety, compensation, or benefits; or (ii) communications or inquiries to or from any governmental authority, in either case arising out of or related to the COVID-19 pandemic (including any incident reports filed with OSHA or applicable state authorities), and the target’s response to any such complaint, request, demand, or communication. Buyers who are acquiring a target wholesale also may want to know whether the target is in compliance with applicable stay at home/shelter in place orders, as this may provide a sense of how much risk the target is willing to undertake to remain operational.
- Continuing compensation and benefits. In the recent past, it was not uncommon for purchase agreements to include some form of covenant requiring the buyer to maintain employees’ base salary and bonus opportunity at pre-close levels for a certain period post-closing and maintain employee benefits that are substantially similar to pre-close benefits offered by the target. As part of due diligence, the buyer would review whether the covenant was reasonable from a business perspective. Due to the COVID-19 pandemic and resulting economic contraction, many portfolio companies are grappling with employee terminations, furloughs, and reductions in compensation and benefits. In light of this current environment, buyers may consider more closely whether a covenant of this type is actually necessary or advisable, including whether it gives the business enough flexibility to adapt as necessary.
- Miscellaneous employment considerations. In addition to the above, buyers may also consider (i) unemployment claims filed in 2020 (including whether or not filed by the employer on the employee’s behalf); and (ii) policies and practices implemented by the target in light of the COVID-19 pandemic (including any changes to the same).
II. Evolving impact of COVID-19 on representations and warranties insurance
The impact of the COVID-19 pandemic on the RWI market, including the related underwriting process, continues to be dynamic as the outbreak and its impacts touch all manner of industries and business activity. So far, RWI insurers have not had a monolithic response, and generally fall into one of three categories:
- Requiring blanket exclusions in all RWI policies for losses arising out of the COVID-19 pandemic.
- Requiring blanket exclusions only on certain classes of business for losses arising out of the COVID-19 pandemic, in particular public transportation, entertainment, healthcare and medical, hospitality, travel, personal care and certain supply-chain dependent businesses. For other classes, the insurer will underwrite to assess risks and determine if an exclusion of some scope is appropriate.
- Not requiring an automatic exclusion; the insurer will underwrite to diligence to determine if an exclusion of some scope is appropriate. Adequate diligence will be important during the underwriting process to provide insurers comfort that buyer has assessed the risks associated with COVID-19.
Initially, many insurers took the underwriting position – particularly on non-bound open quotes – that while they would not impose a blanket exclusion, they would not cover a known breach risk related to the COVID-19 pandemic, unless that risk was very remote. However, as the pandemic has evolved, we have seen most carriers for newly quoted policies in the first category, requiring a blanket exclusion. The scope of the exclusions are usually broad, and even exclusions that are limited to a particular COVID-19 effect may be broadly worded – for example, exclusions for COVID-19-related “business interruption” or “business downturn.” For the few insurers still entertaining the second and third categories of underwriting on new risks, COVID-19 is treated as a heightened underwriting risk across the board. In any event, any representations and warranties contained in the acquisition agreement that directly address the COVID-19 pandemic risks will likely be excluded.
For those carriers designating the COVID-19 pandemic as an area of heightened risk, they will typically examine the impact of COVID-19 on the target’s business operations, financial statements, supply chain, customers, leases, key employees, work force staffing and employee leave and sick time policies during the underwriting process. We have seen insurers scrutinize customer and supplier representations and disclosures as well the defined terms “Material Adverse Effect” and “Material Adverse Change” and pre-closing covenants during the interim period – in particular, the ability of the target and sellers to make bring-down representations at closing. Insurers can be expected to require additional diligence by buyers during any interim period related to the impacts of COVID-19 on the target’s business operations and relationships. Consequently, some insurers are imposing exclusions for bring-down representations only in order to limit interim period risk for the insurer.
Examples of tailored exclusions following diligence may include losses arising out of or resulting from: disruptions to the target’s business operations, logistics and supply chain; loss of key employees; and adverse effects on related counterparties that are attributable to COVID-19, such as government authorities restricting business hours of operation, forced shutdowns or quarantines, labor shortages, reduction in revenues or customer demand for the target’s products or services, failure of suppliers to timely deliver components or raw materials, and related force majeure events.
If you have any questions regarding these issues, please contact your DLA Piper relationship attorney or any member of the DLA Piper Private Equity group.
This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.