M&A Forecast 2020: June update

In this update, our experts comment on the impact that COVID-19 has had on New Zealand’s M&A landscape and make predictions for the remainder of 2020.

In January, we predicted that M&A activity in New Zealand would slow down in the second half of the year. Little did we know how right we would be.

In this update, we comment on the impact that COVID-19 has had on New Zealand’s M&A landscape and make predictions for the remainder of 2020.

The immediate impact of Level 4 Lock-Down

Our 2020 Forecast contained commentary by Economist Shamubeel Eaqub who predicted a positive long-term outlook for New Zealand M&A and speculated that while a recession was possible, it would need some kind of catalyst to become a reality. As we all now know, that catalyst arrived on 23 March, when the Government announced the Country’s move into Level 4 lockdown.

In early March, MinterEllisonRuddWatts’ corporate team had a full complement of transactions in its pipeline. On 23 March, almost every single one of those deals were abandoned or placed on hold.

Relatively few of the transactions that fell over did so because of concerns about the underlying target businesses. In many cases the reaction was much more to do with the buyers than the sellers.

In the case of corporates (particularly multi-national corporates) we saw boards adopting a ‘wait and see approach’ – preferring to hold onto cash reserves as an insurance policy to shore up their existing COVID-19 affected operations.

The private equity industry’s response was to also down tools – but for very different reasons. PE funds run small teams and spend half their time as investors and the other half as governors. The arrival of Level 4 meant that they had to put new deals on hold and focus entirely on existing portfolio investments, assessing the situation, amending the strategy and empowering management to deliver.

In some limited cases, we saw underlying targets lose significant value as the pandemic hit their bottom line. In these situations, realism kicked in and the sellers voluntarily removed them from the market.

In some high-profile deals that had already been signed up but had not yet closed, the impact on the underlying business became much more important. Material adverse change clauses were invoked in many transactions where businesses were adversely impacted, such as with Augusta, Abano and Metlifecare (albeit in this case accompanied by a significant dispute), but in other cases transactions were able to complete because the target wasn’t significantly affected (for example, RMS completing its agreement to sell its forestry estate to China Forest Group).

PE comes back

The first buyers back to the party were the PE funds. This is perhaps unsurprising. After a slew of emergency board meetings and having set management off to execute new strategies, they found themselves able to be investors again. They have money to spend and a new world of opportunity in which to spend it.

Within two weeks of entering Level 4 we saw PE firms return to deal-making. Many funds (domestic and international) have kept their powder dry and are keen to explore bolt-on opportunities that may not have existed 12 months ago.

While we would not call it a stampede, we have seen activity across most of the domestic funds and MinterEllisonRuddWatts has been instructed on new investments that have emerged during the lockdown.

‘Brave’ corporates follow suit

Hot on the heels of the PE players, we saw a developing theme of ‘brave corporates’ who decided to push-on with delayed transactions due to the fear of losing them if they didn’t behave decisively. In one case, we saw an Australian listed entity raise $39m in 24 hours so it could re-enter a bid process for a mid-market New Zealand asset.

This theme of ‘not missing out’ has persisted in the intervening weeks, with several transactions signed or completed by corporates prepared to take a longer-term view and locking in deals now.

New Zealand as a ‘haven’

Another theme that has emerged is the idea of New Zealand being a safer place to invest money in post-COVID-19. We saw international buyers put deals on hold elsewhere so that focus could be placed on their New Zealand opportunity. This is perhaps unsurprising given the apparent success of the country’s public health response.

We think this theme could continue for some time as investors compare New Zealand to elsewhere when assessing risk for future deals. Having said that, our new emergency Overseas Investment Office (OIO) regime may be in danger of tempering that enthusiasm for in-bound investment (read more below).

Activity returns

In the last 4 weeks we have seen a marked increase in activity as a number of deals have signed and/or closed. This has included (in the last two weeks alone):

  • The sale of Bauer Media’s Australian and New Zealand print and digital assets to Mercury Capital. The sale is subject to regulatory approvals and completion is expected in late July. The firm acted for Bauer Media.
  • Advent Partners investment in New Zealand-based supply chain software and project management business, Flintfox International. Advent is investing alongside Flintfox’s existing shareholders and aims to fast-track the business’ growth. MinterEllisonRuddWatts advised Advent.
  • AJ Park’s planned acquisition of well-known New Zealand intellectual property firm, Baldwins Intellectual Property with MinterEllisonRuddWatts acting for Baldwins on its sale.
  • Integral Diagnostics intended acquisition of Ascot Radiology, a leading diagnostic imaging specialist based in Auckland. MinterEllisonRuddWatts advised Ascot Radiology on all aspects of the sale. The transaction is expected to complete in September 2020.
  • Australian retail chain 99 Bikes’ acquisition of Bike Barn which sees the national bike retailer rebranded and under new ownership from 1 July 2020. MinterEllisonRuddWatts acted for the owners of Bike Barn.

Other deals announced in the market included:

  • ANZ’s agreement to sell UDC Finance to Shinsei Bank.
  • WEL’s agreement to sell UltraFastFibre to First State Investments.

Many of the deals we advised on picked up pace rapidly as we moved to Level 1, and as optimism returned to the New Zealand market. In some cases, timing was dictated by a desire to transact ahead of the new emergency OIO rules coming into effect on 16 June 2020.

Looking ahead

Given the recent glut of activity, our firm is cautiously optimistic about the prospect of deal-making for the remainder of 2020. We are receiving new instructions on a daily basis but our view is that deal-flow will be sluggish and that deals will take longer in the post-COVID-19 economy – in the short term at least.

One issue our clients are grappling with is the closed border. Some international buyers cannot get their heads around the prospect of signing a deal when they haven’t been able to set foot on New Zealand soil, eyeball the business and shake hands with the owners.

While activity may slow down, we anticipate that it will be stronger than the global trend (for the reasons stated above), noting that a recent Harvard Business School survey of C-Suite executives reported that 26% of respondents acknowledged their anticipated future deal volume for Q2-4 2020 was expected to be substantially reduced and that 51% of acquirers anticipated keeping their deals on temporary pause until the timing and nature of economic recovery is evident through late 2020.

For those buyers with a strong stomach, strong balance sheets, a buoyant stock price or sufficient credit facilities, Harvard Business School invites them to pick their “dance partners” now in the most promising growth technologies, solutions, and sectors to gain first mover advantage while other prospective buyers are still in shock or sorting out next steps. This call to arms resonates with us in the New Zealand context and we expect to see a “winners and losers” dynamic emerge over the next few months.

Themes going forward are likely to include:

  1. Vertical integrations as firms get bought by their customers in an attempt to secure future supply.
  2. Growth through acquisition as the only viable option in otherwise flat markets.
  3. Increased focus on due diligence with boards, investment committees, warranty insurers and funders wanting to see more detailed analysis of issues and prospects as well as some new areas of focus (see below).
  4. More focus on earn-outs and down-side protection.
  5. Increased attention to material adverse change conditions.
  6. Plenty of arm wrestling over the issue of “COVID-19 add backs”, as sellers try to justify valuations.
  7. De-leveraged transactions as buyers write bigger equity cheques and apply less debt to their deals.
  8. Emergence of new funds, especially in the SME and startup landscape. We’ve already had discussions with several funds that did not exist six months ago.
  9. In the longer term, the emergence of the ‘sanctuary New Zealand’ acquirer – with overseas high net worth individuals buying businesses as part of a move to what they perceive to be a safer and more stable corner of the world.
  10. Buyers taking advantage of new tax rules allowing the roll-forward of tax losses despite the ownership continuity changes that previously put an end to their use following a change of control. See here for our article on this development.

A new wave of roll ups?

There has been some speculation that aggregation and roll up activity will emerge in the second half of this year. We agree that this is a possibility. We are already aware of active roll up projects in industries such as technology and software.

We were involved in a number of roll up deals between 2014 and 2016 and these were characterised as “multiple arbitrage” plays. Our view is that the market is still pretty jaded from the subsequent failure of most of these projects but we think there will still be activity along the following lines:

  1. Traditional ‘buy and build’ strategies typically employed by the Private Equity industry. We expect to see a lot of bolt-on activity by industry players owned by PE funds, where there is access to funding to buy competitors who may have not been on the market 12 months ago.
  2. Vertical aggregation to prop-up suppliers or customers in distress.
  3. Cashless aggregation in distressed industries (such as tourism or hospitality) where there are benefits in clubbing together to weather the storm. These strategies could be led by industry associations.

See our article here on roll up strategies and how to manage them successfully.

An onslaught of misery to come?

Our experience to date has been that banks and other funders have been remarkably sensitive to borrowers affected by the pandemic. In many cases, it appears that the Government measures have kept many companies together in the short-term and the banks have been reluctant to resort to formal insolvency – preferring instead to work with and support borrowers through these initial stages of the fallout from COVID-19.

While we have been involved in some insolvency triggered transactions, in most cases these have related to businesses that were struggling before the pandemic (for example, we advised the administrators of New Zealand Office Supplies on the sale of that business to NXP (National Express Products)).

However, we do not expect that funders will have an indefinite level of patience and we know that insolvency practitioners are frantically hiring right now. It is an unfortunate inevitability that distressed transactions will be a feature of Q4 of 2020 and into early 2021.

Our advice to buyers looking at distressed transactions is to make sure you have the right team. These deals require lawyers who understand how M&A works and lawyers who know their way around insolvency issues. We always field both insolvency and M&A lawyers on such deals. We are constantly amazed to see counterparties advised by either a sole M&A lawyer (who can miss vital insolvency considerations) or a sole insolvency lawyer (who does not have experience in negotiating sale and purchase agreements).

If you are planning to roll up distressed assets, insist that your lawyers field a team with both bases covered.

M&A financing

Unlike the GFC, the COVID-19 pandemic is not linked to systemic banking issues. Banks in New Zealand continue to remain well capitalised and open for business. Their response to date has focused on looking after their existing customers and their own balance sheet, rather than competing for new business.

As new deals start to re-emerge, banks are being selective about what sectors they’re willing to back and cautious on earnings forecasts. Until the outlook has settled, we expect bank appetite for leverage will be reduced. We also anticipate that:

  • Participants may need to shop around more for their debt financing and consider a wider range of innovative structures.
  • High levels of leverage will be more difficult to obtain.
  • COVID-19 presents a further opportunity for Private Capital to play an increased role in debt financings in New Zealand.
  • Sponsors should consider the drafting of MAC events in their commitment and finance documents.

Warranty Insurance – adapting to the market?

The insurance market has moved quickly to cope with the considerations surrounding the underwriting of a deal in the COVID-19 landscape. See our observations concerning insurance going forward.

More recently, we have been in discussions with the key insurers to the New Zealand market and they are signalling a new willingness to look at distressed transactions.

Distress deals are often conducted at a discount to reflect the refusal of insolvency practitioners to give buyers comfort through the giving of warranties and indemnities. The insurers are now expressing a willingness to consider these kinds of deals for underwriting. It’s a fledgling area, with some issues to be worked through but for the right transactions (where insurers can get comfortable that access to information and management knowledge has been possible and thorough due diligence has been conducted) insurers may be willing to step up, which in turn will help to support the underlying value of the assets being sold. Expect to see insolvency practitioners building ‘sell, buy, flip’ insurance requirements into larger contested insolvency processes.

We also expect to see ‘umbrella policies’ being introduced to allow aggregators to apply one policy across a range of smaller deals (each of which wouldn’t typically be large enough to justify a standalone policy).

Due diligence

We think that an inevitable outcome of the last three months is that buyers will be pushed by their investment committees, boards, funders and insurers to conduct ever more thorough due diligence on target businesses. New areas likely to be a focus include:

  • Impact of COVID-19 and ability to weather another pandemic.
  • “COVID-19 add backs” and the extent to which the normalisation of the lockdown impacts can be justified.
  • Ability to access rent abatement in the target’s lease portfolio – see here for an article on this issue.
  • Insurance cover – noting that the majority of NZ business insurance policies did not respond to the Pandemic – see here for our article on this issue.
  • COVID-19 related health and safety considerations. See here for our article on this issue.
  • Existence of force majeure and material adverse change clauses in customer and supplier contracts.
  • Correct application of the Government’s Wage Subsidy Scheme, Business Debt Hibernation Scheme and other initiatives.
  • Fraud considerations, noting that all the elements of the ‘fraud triangle’ are in play in 2020. The ‘fraud triangle’ theory dictates that fraud will occur where employees feel financial pressure, are presented with the opportunity and there is a sense of entitlement or rationalisation to the theft. Since the emergence of COVID-19, all three of these components have been present in spades, with wage cuts and redundancies, reduced security for systems (as personnel worked from home) and widespread anger, fear and uncertainty surrounding the Government’s enforced lockdown and all that it entailed.

OIO and FIRB changes

The Overseas Investment (Urgent Measures) Act came into force on 16 June 2020. The new rules effectively mean that any transaction involving an overseas person taking a 25% or greater stake in New Zealand business shares or assets (regardless of size) will have to go through a notification regime with the Overseas Investment Office (OIO). Our article outlines the key changes and their implications.

There is no doubt that these changes will make it harder to convince overseas buyers to participate in New Zealand deals. While our expectation is that the vast amount of transactions will sail through the OIO’s new 10 working day notification process, there remains considerable uncertainty as to what will and won’t constitute a “strategically important business” and this is uncertainty that already damaged buyer-confidence could do without. Time will tell as to whether the new rules have any lasting impact.

There are a slew of other OIO changes that have now come into force and many of these are designed to speed up the consenting process. It remains to be seen whether this will eventuate.

Related to this issue is the fact that Australia’s Foreign Investment Review Board (FIRB) has also changed its rules with similar notification requirements (regardless of size). See here for a summary of those changes. New Zealand buyers need to be aware that purchasing a New Zealand company with an Australian presence (however small) could now trigger FIRB consenting requirements.

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