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Volatility and uncertainty are the watchwords at the moment and these are impacting on the M&A market.  But long term, once the economy has adjusted to the impact of the pandemic and some stability returns, what will happen?  

The impact of the pandemic on individual businesses and sectors will vary considerably.   But will there be a more fundamental change to the basis on which all businesses are assessed and valued? 

Black and white swans

Nassim Nicholas Taleb (he of black swan fame) argues that this pandemic was a “white swan event”, a foreseeable risk that businesses should have planned for.  Looking at the UK’s National Risk Register, it’s hard to argue with this.

However, it appears that, in purchasing pandemic insurance, the Lawn Tennis Association was in a minority, in both assessing the risk of a pandemic and planning for it.  Given the scale of the support packages available in the UK and globally, many more businesses appear to be relying on government support than their long term planning to get them through this crisis. 

Assessing risk

The Merger Market Private Equity Trends Report from February 2020 states that only 1% of respondents expected an extensive global economic contraction this year.  This was the wrong question to ask. It almost certainly produced an answer which gave a misleading sense of the confidence of the respondents.  Asking whether an extensive global economic contraction, pandemic, major natural disaster or similar will occur at a specific time is not useful.  Events such as these will almost certainly occur in the future; yet predicting the precise timing is impossible. 

Had the respondents to the Merger Market report been asked to put a percentage figure as to the chances of an extensive global economic contraction happening in 2020, it's unlikely many would have chosen 1%.  Assessing the chances of something happening allows a business to more accurately assess risk and plan accordingly, for example:

  • contingency planning can be done and risk mitigation measures can be put in place
  • financial forecasts should be more robust and realistic.

It also allows acquirers to more fully appraise businesses they are considering purchasing.  Bain suggest that the scope of due diligence will change as a result of the pandemic “Factoring in foreseeable but unpredictable disruption will become a standard part of due diligence”.  Based on past experience, it’s not clear whether this will come to pass in a meaningful way. No doubt for the next few years questions about pandemic planning will find their way into legal due diligence questionnaires just as questions about the Y2K bug did in 1999. 

But will there be focus on fundamentally assessing risks which are not just the talk of the day?  Or will the attitude revert to “it won't happen next year”?  Lightning doesn't strike twice after all, does it?  It seems as likely that not assessing “foreseeable but unpredictable disruption” will become a standard carve out from engagement letters for due diligence providers. 

The cost of being sensible

Contingency planning and realistic and robust forecasts sound like sensible things to do.  They may well ensure that a business has firmer foundations and is better able to withstand shocks and unpredictable events.

But there may well be costs associated with contingency planning and risk mitigation which will impact on profitability.  The costs of "foreseeable but unpredictable disruption" planning,  however sensible, may well result in lower financial forecasts which are unlikely to make a company more attractive to future acquirers.  So there will be reasons as to why it will be difficult for owners who are planning to exit to be quite so prudent for very long, once the current pandemic passes.

Do as I say and not as I do

Any acquirer will want to purchase a business that is well run and manages risk effectively.  Some will no doubt do as Bain suggest.  If they do, and assess that a target business is not managing risk effectively, what will happen? 

Clearly, whether the seller will accept a lower valuation will depend on what other offers are out there.  If it’s a competitive situation, will an acquirer really be willing to miss out on the opportunity because of how the target manages an indeterminate risk?

As with any other risk identified during due diligence, will the acquirer be able to implement its own practices and will this cause significant disruption and costs that might justify a price negotiation or, perhaps, give the acquirer a competitive edge over other likely acquirers?

Sellers will also rightly look at how an acquirer operates its own business and challenge a reduced valuation if it appears that the acquirer is not managing its own risk in the way it suggests the target should.

So, all change?

It seems unlikely that we will all become avid readers of the National Risk Register.  But if you do decide to buy that nuclear bunker in New Zealand do remember how to unlock it!

For more information please email: charles.vdl@roxburghmilkins.com.