The Expected Economic Downturn Could Lead to a Rise in M&A Disputes

Here’s What Dealmakers and Disputes Lawyers Need to Know

Critical factors, including economic volatility and the increasing importance of ESG, will shape M&A disputes in the coming months

Ahead of BRG’s 2022 M&A Disputes Report—scheduled for release this fall—BRG’s Mustafa Hadi and Kevin Hagon provide their views on potential M&A disputes. Among other topics, we discuss the impact the current economic climate might have on disputes, as well as the increasing importance of environmental, social, and governance (ESG), private equity dealmaking, and the state of special purpose acquisition companies (SPACs).

This is the second Q&A in our M&A disputes series. Read our recent discussion with Dan Galante, and download the 2021 M&A Disputes Report.

Let’s start with the economy, which is facing numerous headwinds at the moment. With interest rates rising and asset prices declining, what sort of M&A disputes might dealmakers encounter?

Hagon: With today’s market conditions, a buyer who purchased an acquisition using debt likely will be unable to service that debt; consequently, the bank may have to take ownership of the asset and sell it to protect itself. That could lead to an uptick in disputes because these sales typically entail a misalignment of interests: the equity holder wants the maximum price, whereas the bank probably wants the quickest, most secure deal simply to recoup what it’s owed. When this happens, the equity holder might sue the bank for loss of value, saying the bank’s actions did not adequately protect the equity holder’s interests.

Hadi: This is closely linked, of course, to the distressed M&A market, where companies look to buy assets at a bargain price from these lenders or businesses facing financial pressure. With the market for such assets heating up, we could see a steep increase in the number of disputes, as these transactions are made quickly, with limited time for thorough due diligence.

In last year’s report, over half of respondents said material adverse change (MAC) or material adverse effect (MAE) clauses were the best ways for buyers to guard against future disputes. What role might these clauses play in the current economic environment?

Hadi: Economic conditions like we’re seeing now naturally tempt buyers to pull out—and to seek provisions under their contracts that give them some ability to do so. It’s unlikely, however, that the current economic environment would allow them to invoke these clauses, as they’ve become more specific to the business under consideration and tend to exclude things that affect the entire economy or sector in which that business operates.

Hagon: There also has to be a change, not merely a continuation of unfavorable market conditions. If they were already bad pre-deal, then it’s not much of a change if they continue to show weakness.

Hadi: With that said, you certainly could see people looking for any conditions within their contracts that would allow them to not complete the deal or to renegotiate the price.

ESG is increasingly affecting the way that financial decisions, including M&A, are being made—and regulators (e.g., the SEC) are looking at it closely too. Do you anticipate this heightened focus leading to a new wave of M&A disputes and liabilities?

Hagon: Yes. For instance, if you’re a public company, you probably have ongoing ESG obligations, whether imposed by regulations or your own shareholders. If you make an acquisition, then, you need to be able to say that you’ll continue to comply with those regulations or requirements—therefore the seller likely would have to assure you pre-deal that it would be in compliance too.

But what happens if, later on, you discover your new acquisition is not in compliance? Then you’re suddenly noncompliant, which could be costly to rectify. You might then try and recover those costs from the seller.

Hadi: It also could be that you’ve purchased a business that you later discover has ESG issues that affect the value of that business or could bring regulatory penalties. And you’re saying, well, I bought this business, but now it’s worth less than I thought it would be. That in itself might lead to disputes between buyers and sellers.

How might buyers mitigate their risk in the due diligence phase given those ESG pressures?

Hadi: The key thing is to have ESG on their radar. It sounds pretty simple, but I’m not sure most buyers are looking back at the last six or seven years and factoring in ESG performance. In my experience, a deal’s due diligence documents often do not have an ESG-specific report. Maybe in some sectors where this is a high priority—like mining or commodities—but any number of others traditionally have not been as impacted by this and should start giving it more attention.

Hagon: Part of this might stem from the fact that the due diligence folks on the ground may not have prioritized these issues historically. So there could be a disconnect between this big corporate priority at the top levels of management and the practitioners on the ground. Organizations therefore should try and ensure that ESG priorities filter down and are maintained and protected during the M&A process.

Though we’ve seen a slowdown in private equity dealmaking, there’s still plenty of dry powder out there, and PE funds continue to dominate investments. How might the current environment impact these transactions and related disputes?

Hadi: Private equity deals tend to be highly leveraged, so there may be risks around their ability to service that debt—whether it’s because the newly acquired business’s performance declines or is overexposed, or the cost of servicing the interest goes up. A lot of PE funds hedge against this risk, fixing their interest rates and exposure up front. But some might not fix those rates for long enough, and others might not do it at all.

At the same time, they’re facing a higher interest-rate environment as they consider new investments. While there’s still a lot of capital in terms of the equity they can inject into these deals, it may be harder to leverage those transactions as much as they’ve been doing—and this in turn may impact prices, valuations, or their returns.

Hagon: Also, the banks underwriting these deals might start to get nervous about being stuck with the associated debt. Usually they can offload it to investors, but if they can’t, it’s a massive problem for them. This might have a downstream impact on deals more broadly—they might be less able to get off the ground. It also could lead to disputes as banks look to find reasons to pull out of financing commitments.

The fervor behind SPACs seems to have cooled, but last year’s report underscored how this vehicle might contribute to a spike in disputes. Where do SPACs stand right now, and will we continue to see associated disputes?

Hadi: Though investors have become more alive to the risks SPACs pose, SPACs still may be out there with money to spend and looking for deals in this distressed environment. The volatility of the current economic climate, however, might compound the potential for misalignment of incentives between sponsors and investors. It’s an area worth paying close attention to.