2021 M&A Outlook: Cautious Optimism for Robust Dealmaking

As we look back on the mergers and acquisitions landscape of 2020, clear trends emerge and paint a picture of what can be expected in 2021. Certain of these trends seemingly came from nowhere, while others have long been brewing. In either case, directors of both potential acquirors and potential targets will need to consider the implications, if any, of these trends as they approach M&A in 2021.

The Seller’s Market Continues

Other than a relatively brief swoon following the initial outbreak of COVID-19 in the United States in the spring, 2020 largely saw the continuation of the robust seller’s market we have witnessed over much of the last decade. This has played out not only in the high valuations sellers have enjoyed but also in the deal terms that sellers (particularly sellers of private companies) have been able to extract from buyers. The key contributing factor to the seller’s market? Demand, of course. With more players on the prowl for attractive investments – not only private equity funds and strategic investors but also sovereign wealth funds, family offices and now SPACs (as discussed in greater detail below) – sellers continue to have the luxury of being picky when it comes to choosing their dance partners.

Private equity-backed M&A transactions accounted for 16% of overall M&A activity in the first nine months of 2020, the highest level since before the global financial crisis,[1] and private equity sponsors have been increasingly willing to get a deal done by accepting seller favorable deal terms. The advent of representation and warranty insurance (RWI) has exacerbated this trend, as premiums remain sufficiently low such that, for many buyers, procurement of RWI continues to be an attractive alternative to in-depth (and time consuming) due diligence and difficult and competitively undesirable negotiations of indemnity provisions.

SPACs – Another Competitor for Transactions Enters the Ring

2020 was the year of Zoom, Peloton and special purpose acquisition companies (SPACs). As of December 12, 2020, a total of 230 SPAC IPOs raised over $77 billion in 2020 – five times the amount of money raised by SPACs in 2019, and 20 times the amount raised in 2015. In fact, SPACs raised more money than traditional initial public offerings in 2020.[2] As discussed above, we have seen a seller-friendly market develop over the last decade, and adding SPACs to the private company toolbox as an alternative means to achieve liquidity creates more competition among potential acquirers for accretive transactions.

A SPAC is a shell company that generally raises money from public markets with the intention to later merge with a private company. The SPAC engages in an IPO shortly after its formation, attracting interest among public investors based largely on the track record and reputation of its sponsor and management team. Flush with the proceeds from its IPO, the SPAC searches for a private company with which to merge. In the early days of the SPAC evolution, SPACs typically acquired private targets for cash, much like a private equity buyout. More recent transactions have involved mergers of SPACs with target companies many times their size, more akin to a reverse IPO.

The merger between the SPAC and the private target company, which effectively results in the target company becoming a public company, is referred to as a “De-SPAC transaction.” The De-SPAC transaction requires the approval of the SPAC’s shareholders. In addition, SPAC shareholders may require the SPAC to redeem their shares for cash (and a small return) at any time, while retaining some exposure to future upside appreciation from the transaction via warrants that are issued by the SPAC together with its shares in the IPO.

For private companies, going public by merging with a SPAC offers two principal benefits – avoiding the unpredictability of the IPO market and speed. In a SPAC transaction, a firm exchange ratio – and thus economic value for the target company – is agreed upon up-front by the parties. Also, IPOs can take six to 12 months to complete with additional time necessary to prepare, while De-SPAC transactions can be completed within two to three months of signing, providing immediate liquidity and access to the sponsors’ expertise and public company infrastructure. On the other side of the coin, the potential target must weigh the dilution resulting from the sponsors’ typical 20% ownership stake and the uncertainty created by the requirement of SPAC shareholder approval and the possibility of shareholder redemption.

Nonetheless, SPACs have become a significant player in the M&A market, and the uncertainties created by COVID-19 have made SPACs a more attractive alternative than an IPO. Further, current low interest rates make locking up a significant portion of cash for the length of a SPAC far less disadvantageous to investors, and the recent history of public market “busts” for venture capital-backed companies, e.g., Uber and WeWork, has ignited even more interest in SPACs.

Of course, long-term results remain an open question. A recent Goldman Sachs report indicates that in deals completed since 2018, SPAC equities following completion of the acquisition have underperformed the broader market. Time will tell if this year’s spate of SPACs perform and if SPACs and similar vehicles retain their current popularity.

The Impact of COVID-19 on M&A Deal Terms

Overall, we have seen M&A deal terms adapt fairly rapidly to the COVID-19 pandemic. Following a brief period of dislocation as buyers sought to walk away from or renegotiate deals entered into prior to the outbreak of COVID-19 in the United States, we have generally seen the M&A market recover with sellers implementing some standardized edits to transaction agreements to account for the pandemic. The key revised terms are (i) express inclusion of pandemics (and COVID-19 in particular) in the carve-outs to the definition of material adverse effect and (ii) wide latitude under the interim operating covenants for actions taken by targets in response to COVID-19. We expect the former to be a feature of M&A agreements going forward, but it remains to be seen how COVID-19 and future similar as yet unknown exogenous events will be treated for purposes of interim operating covenants once the tide of this current pandemic recedes.

While many lawsuits were filed earlier in the year, mostly in the Delaware Court of Chancery, by sellers seeking to force reluctant buyers to close the vast majority settled without a ruling from the bench, leaving unanswered the question – as between buyer and seller – who bears the risk of COVID-19 and, perhaps more importantly at this point, any future similar exogenous events.

In December 2020, Delaware Vice Chancellor Laster finally provided some guidance by ruling that South Korean asset manager Mirae Asset Financial Group (Buyer) was excused from closing its purchase of 15 U.S. luxury hotels from Anbang Insurance Group, Ltd. (Seller) for $5.8 billion and was permitted to terminate the agreement. Although the Buyer failed to prove a material adverse effect had occurred, the Buyer had successfully shown that the Seller’s response to the COVID-19 pandemic, including furloughing staff, laying off employees and closing properties, breached the interim operating covenants. The court found that the Seller’s actions in response to the pandemic were not ordinary course, i.e., not routine or consistent with its past practices in ordinary times, even though the Seller’s response was consistent with actions taken by comparable companies in response to COVID-19.[3]

While sellers will likely continue to include a COVID-19 exception to interim operating covenants for some time into the future, boards of sellers should consider going forward how to prepare for the next unknown exogenous event that they may need to respond to. Sellers may consider being explicit that actions taken in response to the exogenous risks laid out in the exceptions to the material adverse effect definition (e.g., hurricanes, acts of terrorism, etc.) should be allowed under the interim operating covenants so long as they are generally in line with the responses of similarly situated companies. While this would be a major (and very seller-friendly) shift in the way that interim operating restrictions currently work – as long as the seller’s market continues and with sellers able to point to the recent COVID-19 experience – buyers may have a hard time saying no.

A Biden Presidency and M&A

With another COVID-19 stimulus package passed, providing additional support for the economy, and the Federal Reserve continuing to be hesitant to reverse low-interest policy as the U.S. economy recovers from the pandemic, inexpensive debt financing should be plentiful, encouraging more M&A. While this all sounds promising for dealmakers, if Democrats control the White House and both houses of Congress, it will enable them to pursue a broader legislative agenda that may hinder, or at least slow, the pace of M&A. As of printing, it seems likely that the Democrats will hold a majority in the Senate (with fifty Senate seats and the tie-breaking vote by Vice President Harris). While it is generally recognized that dealmakers would have preferred divided government (which would have ensured no major policy changes and would have in turn provided a stable environment for M&A activity), it is as yet unclear how activist Democrats will be in light of their slim majorities in the Senate and House. A Democratic-controlled legislative branch is more likely to pass additional COVID-19 stimulus packages, providing juice for the economy and indirect tailwinds for M&A, however proposed Democratic policies around tax increases as well as continuing focus from both sides of the aisle on consolidation in the technology sector and bipartisan wariness regarding foreign buyers in certain industries may serve as a countervailing drag on M&A activity. On balance, even with Democratic control of the legislative and executive branches, we expect that a Biden presidency will provide fertile ground for a robust M&A market in 2021.[4]

[1] Refinitiv, “Records broken in global capital markets during Q3” (November 2, 2020), available here.

[2] SPACInsider, “SPAC IPO Transactions: Summary by Year” (2020), available here.

[3] See AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, C.A. No. 2020-0310-JTL (Del. Ch. Nov. 30, 2020)

[4] For discussion of developments in U.S. and EU antitrust rules and enforcement, please see U.S. Antitrust: Developments and Outlook and EU Antitrust: Developments and Outlook in this memo.