What might attract buyers and investors?
One effect of lockdown has been the acceleration of digital transformation. This may translate into more M&A deals and investments which help accelerate the digital transformation of the buyer with larger companies carrying on the trend of buying stakes in technology companies rather than wait for in-house development projects to come to fruition. We also expect more seed investments by industry veterans in online offerings – we have done several of these deals in the last year. We are already seeing applications by staffing platforms for investment from the UK Government's Future Fund.
Will we see some buyers look to transform the profitability of targets by introducing new automated systems such as greater automation of matching and rota–filling technology? Will we see a wave of tech-backed consolidation in a number of sub-sectors? We are aware of a number of investors looking at buy-and-build projects on this basis, and when private equity companies start feeling more confident about the future, expect them to back this model.
Will investors flock to technology staffing, recruitment and consultancy companies who seem well-placed to help clients renew investment in digital transformation? Will they also focus on companies helping likely government-funded healthcare and infrastructure projects?
Will it be strategically attractive to have government framework appointments – might buying a small on-framework company be a quick win? We have seen this in previous downturns.
Will the surge in remote working reverse the hit that many suppliers of Personal Service Company contractors suffered pre-IR35? Does remote working allow some PSC contractors more easily to sit outside IR35? Will the future prospects of suppliers and users of PSC contractors look up?
Will there be tax breaks and government grants for any company which helps re-skill workers who will otherwise be left on the scrapheap in any job-lite recovery? Will companies with an ability to provide volume training and practical work experience command a premium?
Will the many long-term owners of businesses start taking offers more seriously? There is likely to be a window, falling 6-18 months after the bottom of the market, in which owners still bears the scars of the darkest period of the downturn, and realise they don't have the capital to invest as heavily as they need to in digital transformation, but can show 4-6 quarters of growth trend. Sensible offers to those in this position may look more attractive than usual. This window could coincide with a rise in private equity interest in the sector.
Historically, this window has tended to close fairly rapidly once any recovery is in full swing with the innate optimism of many sector operators about the future prospects of their businesses soon taking hold again.
What about deals with companies that are struggling?
There will be decent businesses that need rescuing sooner rather than later. Businesses which are otherwise good propositions can come unstuck by a rise in bad debt, or too great an exposure to one client in one part of their business (perhaps via a Managed Service Provider tasked with cutting staffing and consultancy cost). What we are hearing from many companies is that in some cases volumes have held up ok but no one is quite sure what Q3 and Q4 2020 will hold – will projects be extended by clients after the summer? And what will happen when deferred VAT becomes due?
Companies who have taken on government-backed loans will also need to start paying interest in 12 months or so – will they be able to cover those interest payments? Even if they can, will this be at the expense of being able to invest in the future growth of the business, such that they become zombie companies? Many commentators predict a wave of equity deals in 2020-2022 to rescue these companies who have taken on much more debt than would normally be considered sensible.
But how will these "new era" deals be structured?
Asset deals for stressed businesses
In this environment, where a distressed business is the target, buyers may prefer an asset purchase to acquire only parts of a target they want (avoiding historic debt or disputes), rather than a 'warts and all' 100% share purchase. This is also invariably the deal structure in any situation where a company has tipped over from distressed into a formal insolvency process.
Asset deals are a well-trodden path, but they can be more complicated than share sales: relevant assets need both to be identified and effectively transferred/assigned/novated; creditors and debtors dealt with appropriately; employees consulted with and transferred with additional processes such as TUPE; and there are a number of additional tax considerations.
Acquirers who are seeking to take advantage of a target's framework contract or other key client contracts will need check the change of control provisions and the risks around these, and structure the acquisition to ensure the framework appointment continues (which is not straightforward but is achievable). And although new legislation and government guidance is seeking to moderate contractual counterparties' behaviour in relation to defaults, it is unlikely to stray into moderating parties' termination rights in circumstances where there has been a change of control.
Bridging the value gap
Making deals happen will rely on finding a way to bridge the gap between what sellers my see as a short term depression in valuations (for some companies at least) , and what buyers see as an appropriate reduction for the increased level of risk being taken. Earn outs are one way of bridging that gap.
Earn outs have always been prevalent in deals in the workforce solutions sector, often as a safeguard against star billers leaving the target company soon after acquisition, and performance declining. For sellers, valuations are likely to be depressed post-lockdown with lower multiples applying, so an earn-out gives a chance to claw back value if the business responds well in the post lockdown environment. For buyers, the opposite applies: if the market takes longer to return, or performance does not revive as expected, that will be factored into the final price.
When looking at earn-outs, the key issue for each party is to ensure that the other cannot do anything artificially to distort financial performance during the earn-out period (for example, by slashing investment to give a short term boost to EBITDA if selling, or imposing inflated group management charges if a buyer). Earn-outs are often re-negotiated, and have varying degrees of success in tying in management.
Retentions and deferred consideration
We expect to see an increase in deferred or contingent payments based on identified risk areas, as accelerated or distressed M&A processes are likely to result in various issues and disputes not being fully identified or resolved (including, for example, the scale of potential future liabilities such as deferred rent or HMRC liabilities). Whilst this seems a fairly logical and simple measure to provide risk protection for the buyer and a means of giving extra value to the seller if liabilities are not as great as first thought, striking a balance can be difficult. To take an example, quantifying potential tax liability for an unproven tax scheme can be difficult and sometimes the potential amount can be too high to set aside. Careful judgement is therefore required in retaining the appropriate amount, and to negotiating the appropriate conduct provisions so both sides feel they have some control over recovery of the amounts, or protection of their ongoing relationships with HMRC.
One new "unknown" in recent deals we have advised on (outside the sector) has been the risk of clawback claims by HMRC where companies have heavily used the furlough scheme, and claims by workers for holiday pay accrual while on furlough. Expect these potentially large liabilities to be the subject of due diligence (and retentions) in any M&A deal or private equity investment in the next six years. These clawback claims would not be covered by normal tax covenants – CJRS liabilities are not tax liabilities.
In distressed sales forced by an investor or lender, there may be little or nothing in the sale for the management team that is required to continue to run the business. Whilst some will just be happy the company has a future, others will need some form of management incentive to stick around.
With regard to the tier below senior management, many will have been working from home and/or furloughed. We expect to see a growth in certain employees 'going it alone' with their own businesses, and also perhaps a reduction in job loyalty and an increase in the movement of workforce. The enforceability and scope of restrictive covenants should therefore be a key focus in due diligence, and where they are deficient, putting in place a set of up-to-date policies and covenants should be high on the list of any buyer (along with timely updates to GDPR policies covering personal handling of data by remote workers).
We expect to see more paper consideration and less cash as a preferred form of purchase price. In a similar manner to earn-outs, such a structure has the advantage of aligning both buyer and seller to the future performance of the combined business. The desire to retain cash we expect will remain for some time, so paper will be an attractive funding option.
Debts and debt funding
We expect to see some tightening in the receivables financing (i.e. invoice discounting) terms available to recruiters, which have often been used in making deal structuring viable. The increase in bad debts that hallmark more difficult economic times will limit the ability of some buyers to leverage the debtor book that they acquire.
If a struggling business is being acquired, specific provision can be made for the recovery of debtors and recognising the value in those only once received. An increase in diligence around any debtor book being acquired and how it is valued should be expected.
Warranty & indemnity insurance
We expect warranty & indemnity insurance to continue to be a popular product, particularly with distressed sales where a warranty package is not available, or there is little covenant strength behind the warrantor providing the coverage. W&I insurance will stand in the place of a warrantor, and provide recourse for a buyer if a claim for breach of warranty is uncovered after completion of a deal.
M&A issues with technology companies
If part of any revival in M&A involves Workforce Solutions companies investing in technology companies there are some very different dynamics.
Valuation mechanisms are obviously often very different to those applied to people businesses. But you will still need to be careful to work out who the key workers are and what their key aspirations are. Generous commission schemes are unlikely to be part of that and buyers will need to find other mechanisms to tie them in.
The buyer will need to make sure that intellectual property rights are properly tied down and that relevant technologies are not dependent on third parties who are not part of the deal.
And tax planning is likely to play a key part in any technology deal - buyers will need to factor in availability of government incentives for research and development and the like.
M&A will come back in the sector. Sometimes for positive reasons, and sometimes in rescue situations, and we are already seeing activity. In the shorter term there may be more rescue deals but in due course other deals will happen as well and history suggests that 2021-2023 may be a very busy time.
If there is one top tip we would give to all involved in this new world of M&A, it would be to talk to potential targets and buyers/investors – many of the new types of deal will need an element of trust to be successful. And the best way to work out if you can trust someone is to have known them and talked to them about their business over a long period. Clearly many business owners will have been focussing on talking to staff and clients and contractors in the recent past, but maybe talking to competitors and prospective investors needs to be a task for the second half of 2020.
If you want more information about the detail of how future deals may be structured our corporate team would be happy to discuss. In the meantime we have published this article, examining the key influences which we think will kick-start M&A, and how deal structuring and execution will change compared to the pre-lockdown market.