As the global tally of COVID-19 cases rises steadily, the pandemic has proven to be an unprecedented public health emergency of our time. With nations enforcing social distancing, lockdowns and travel restrictions, the global economy has witnessed a drastic downturn. Closer to home, in India, RBI has warned of a growth slowdown, and the capital markets have slumped. Private equity investments in the country have taken a hit, and the pandemic has caused investors to reassess new and existing investments.
Given the likely economic aftermath of COVID-19, key issues that have come to the forefront are: (a) whether COVID-19 constitutes ‘material adverse effect’ or ‘material adverse change’ (hereinafter, referred to as “MAE”) under existing agreements; and (b) with the economic uncertainty in the backdrop, the manner in which price or value of new deals can be accurately determined, going forward. This post sheds light on the abovementioned issues and chalks out ways to redress the same.
I. Does COVID-19 constitute MAE?
MAE clauses are standard to private equity deals, and typically, are incorporated in the definitive documents as a condition precedent to closing, i.e., no MAE has occurred prior to closing of the transaction, and/or as a representation (provided by the target company) to the effect that there is no MAE as on the date of signing, and closing of the transaction. In this vein, MAE clauses serve many functions, and most importantly, occurrence of MAE provides the investor an option to walk out of the deal. Bestowing the investor with such an option, incentivises the target company and its management to ensure that value, on the basis of which the investor had agreed to invest, is protected, and allocation of business risks and risks arising from unforeseen events between the target company and investors.
It is important to note that MAE and its consequences do not find any source in statutes and are purely contractual rights. Therefore, the occurrence of MAE is essentially a matter of contractual interpretation and is required to be determined on a case to case basis. While the exact scope of MAE is influenced by factors such as the sector in which the target company operates, any specific requirements of the parties and the negotiating power of the parties, the definition has in the last few years increasingly been standardised in the Indian private equity space.
In the context of private equity transactions, MAE is typically defined as any circumstance, change or effect that has, or is reasonably likely to have a material adverse effect on: (i) the business, business prospects, financial condition or assets of the target company, and (ii) the enforceability of the transaction documents and the ability of the target company to perform its obligations thereunder. In some cases, target companies negotiate carve outs for general market and industry related risks, except where they have been disproportionately impacted by the same. With few exceptions, the definition of MAE is intentionally kept subjective, broad and to a certain extent vague, presumably because it is impossible for the parties to upfront pen down all possible unforeseen events, which may impact the commercials of the deal, quantify the impact of such events and agree on risk allocation between themselves in relation to the same.
With respect to judicial treatment of MAE, Indian jurisprudence provides limited guidance on MAE, and no standard test has been developed to determine if an act constitutes MAE. In other countries such as the US, courts have generally been reluctant and have imposed a high bar to conclude the occurrence of MAE. A Delaware court in the case of Akorn v Fresenius, found that MAE had occurred, which entitled the acquiror to terminate the merger agreement on account of severe under performance by the target company, making the judgment a first of its kind. Much like the preceding case law on the subject, the court in Akorn also emphasised on the ‘materiality’ and ‘durational significance’ of the change/ event in question. Some of the key elements that may be considered for the purpose of assessing whether COVID-19 would constitute are as follows:
- the quantum of economic impact of COVID-19 outbreak on the business of the target company – the economic impact on the target company as a result of COVID-19 outbreak would be considered as the trigger for MAE, rather than the pandemic as a whole. The investor invoking the MAE clause may be required to exhibit that a material adverse effect has or is reasonably likely to occur with regard to the target company due to the COVID-19 outbreak.
- the durational significance of the economic impact of COVID-19 outbreak on the target company – the duration of the economic impact on the target company should be long enough to make an impact, as a whole, materially adverse to the target company. The courts in the US and the UK have focussed on ‘durational significance’ and the fact that the impact needs to be for more than a short period. However, it is pertinent to note that most of these cases, including, Akorn v Fresenius, dealt with strategic investments involving mergers and 100% acquisition where the transaction by its nature is expected to be of long-term significance to parties. In the context of private equity deals, it could be argued that the threshold for durational significance is lower, taking into account the nature of investment and purely financial objective of the investment.
- the foreseeability of the impact – whether the parties were in a position to foresee the occurrence of the alleged MAE at the time of signing of the definitive documents may play a critical role in determining whether the MAE clause under an agreement can be invoked. For agreements signed prior to the knowledge or full understanding of COVID-19 outbreak across the globe, it may be possible for the investor to claim that the impact of COVID-19 was truly an unforeseeable adverse change.
As we know, COVID-19 is a rapidly evolving phenomenon, and the full potential of its impact is yet to be ascertained. Analysts, however, are in agreement that the economic aftermath of COVID-19 is going to be harsh on the global economy, including developing countries like India. The burden of proof to establish occurrence of MAE will likely be on the investors invoking it, therefore, prior to invoking MAE, the facts and likely impact of COVID-19 on the relevant business must be carefully assessed.
II. Valuation of Target Businesses
- PIPE Investments
For private equity deals in listed companies, the regulatory floor price is determined basis the average of weekly high and low of the stock prices of the target company during a look back period of 26 weeks from the date of shareholders approving the deal (the look back period is two weeks in case of investments by qualified institutional buyers). Given that the impact of the COVID-19 outbreak on the Indian stock market is recent and not more than 4-5 weeks old, the look back period will majorly constitute of the pre-COVID-19 period, resulting in regulatory floor price, which is higher than the current market price. As a result, a number of listed company deals, which are currently under negotiation, may not take-off until either the stock price improves or the look back period falls within the post COVID-19 period, bringing down the regulatory floor price. Recognizing this issue, SEBI has recently issued a consultation paper seeking public comments on its proposal to shorten the look back period for determining the regulatory floor price to 2 weeks. However, this relaxation is proposed only in the context of companies which qualify as ‘stressed companies’ as per the definition prescribed by SEBI. The consultation paper also states that any preferential issue undertaken by following the revised pricing norms will be subject to additional conditions such as requirement to obtain approval of majority of minority shareholders (i.e. shareholders excluding the promoter group and the shareholders participating in the preferential issue) and lock-in of 3 years on the securities being issued.
- Valuation Adjustments
In the context of transactions that are under negotiation, given that COVID-19 has created a host of uncertainties, and there is no timeline within which the outbreak is expected to be contained, it is nearly impossible to assess the true impact of COVID-19 on the Indian economy in general and on target businesses, specifically. While the extent of the impact may vary depending on the sector in which the target company operates, a general slowdown in the economy is bound to affect businesses across all sectors. This uncertainty raises a new challenge for the investors in terms of correctly valuing their target businesses.
One way of dealing with this issue is by structuring the deal in a manner which, on the one hand, gives protection to investors if the impact of COVID-19 is discovered to be more severe than expected, and at the same time, also gives the target business its true valuation if it manages to perform well. In order to achieve this objective, investors may explore investing in convertible instruments with conversion formula linked to future performance of the target company, allowing valuation adjustment at the time of conversion. Given the current scenario, the regulatory floor price for private companies is expected to be low, allowing investors to move in a wider range. To mitigate the risk further, investors may also consider investing in tranches, with an option to not invest further in case of underperformance by the target company. If permitted by the investor’s investment objectives, investors may also consider breaking up their investment between debt and equity.
While it is undisputed that COVID-19 has created challenges for private equity investors in terms of deal uncertainty for transactions, which are at advanced stages of negotiation and also in terms of management of existing portfolio, which has been impacted by COVID -19, it has, at the same time, given rise to new opportunities to invest in companies which are, or will be, in need of funds due to a steep fall in their revenues (without proportionate fall in expenses) as a result of the outbreak. With the right investment strategy, backed by a sound transaction structure, investors may mitigate the risks involved and at the same time reap benefits of the upside of the economy’s return to normalcy.