The economy has come to a halt in the current unprecedented situation. Apart from medical and essential service providers, labour and capital have been idle during the coronavirus-induced lockdown, and the world economy seems to be heading towards a recession. Global M&A activity has dropped to its lowest level since 2016. The last such crisis was the 2008-09 global financial crisis (GFC) when global M&A fell sharply. Private equity (PE) volumes then dropped from 20% of the global M&A volumes in the first-half of 2007 to 6% in 2008. The current crisis could be even worse.
The coronavirus has impacted almost every sector of the world economy, whereas the GFC mainly affected global housing and financial markets. More economies have been adversely impacted at present than during the GFC. The International Monetary Fund (IMF) has predicted negative per capita income growth in 170 countries and a 3% contraction of the global economy in 2020, assuming that the coronavirus will recede in the second half of 2020. The IMF has forecast that India’s growth will fall in the FY 2021 by 3.9% to 1.9%. India’s recovery may take longer as its economy had already started slowing before the lockdown. With many non-performing assets (NPA) on the balance sheets of banks and non-banking financial companies, and an oversupply in the real estate market there was already a crisis with attendant restricted credit and spending.
Businesses will struggle until demand recovers and as they adapt to a world where social distancing will be the norm. As the economy recovers, there will be a revival of M&A activity, albeit of a different nature. Even internet businesses, which received significant PE investment in the first-quarter of 2020, have experienced a drop in demand during the lockdown. They will continue to underperform even after the lockdown, reducing their ability to raise PE funds in the short run. Sectors with higher volumes of distressed assets, such as the financial sector that persisted during 2018 to early 2020 will see less PE investment year-on-year. However, there will be increased M&A activity due to distressed asset sales and divestment from non-core businesses.
As central banks around the world reduce interest rates to tackle economic deceleration, investment capital will become cheaper and cash will replace equity as the preferred consideration. Greater liquidity will encourage cross-border M&A through PE investment. However, the recovery phase will present structuring challenges for the parties and will require a regulatory nudge from the government. As the Indian economy faces supply side disruptions, a fall in consumer and investment spending, extended payment cycles, migrant labour displacement and public health concerns, revenue projections and investor outlook will remain conservative for some time even after the lockdown ends.
The post-COVID-19 economy will negatively impact most asset valuations and buyers may make sellers accept greater valuation risk not only between signing and closing but also post-closing. Sellers will not have access to price discovery upfront. Buyers will foresake fixed-pricing or locked-box constructs in favour of more hold-backs and post-completion adjustments contingent upon business performance. The burden of valuation risk will tilt in favour of the buyers. To allow commercially viable post-completion arrangements, the Reserve Bank of India (RBI) may need to relax the 25% monetary cap and the 18-month time limit on deferred consideration and escrow arrangements under the FDI policy.
The growth of distressed M&A increased in 2018 and 2019, and this will accelerate during the post-COVID-19 recovery. India will continue to deal with the underlying NPA crisis and see more proceedings under the Insolvency and Bankruptcy Code, 2016 (IBC), spurred by the economic downturn. There will be an oversupply of distressed assets. To match supply and demand, the Securities and Exchange Board of India (SEBI), and the RBI in regard to pricing guidelines, should allow market forces to determine the prices of such assets by dispensing with, perhaps temporarily or on a case-by-case basis, the open offer and minimum pricing regulations in cases where private buyers wish to acquire shares in distressed publicly traded companies before the IBC stage. With huge fiscal deficits and its resources stretched thin, the government will not be able to bail out all critical NPAs.
In 2010, the GFC triggered a review of the pricing regulations by the SEBI and the RBI. In the current global crisis, the RBI and the SEBI should re-examine the FDI policy and the takeover-code respectively, and allow exemptions in order to encourage M&A in the post-COVID-19 economy.
Contributed by: Raghubir Menon, Regional Head – M&A and Private Equity, General Corporate; Aditya Parolia, Senior Associate
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