Acquirers may come to rue deals struck in happier times

For US retailers, every dollar has counted for a long time. Bed Bath & Beyond was trying to restructure itself to fight the might of Amazon, even before the coronavirus crisis that has shut down most of its stores. 

In mid-February the New Jersey-based retail chain had announced the sale of PersonalizationMall.com, a unit that sells knick-knacks such as picture frames and coaster sets, to 1-800-Flowers.com. The divestiture, for $252m in cash, was set to close on March 30 with the funds set to be wired over that day.

But in the days leading up to consummation, 1-800-Flowers.com had second thoughts, and told Bed Bath & Beyond it wanted to wait 30 days before sending over the money. The coronavirus pandemic had been so disruptive that the company said it needed to pay attention to its own business for now and there was no way to clinch such a big deal.

The seller believed that 1-800-Flowers had no legal basis to avoid completion, and has now sued it in a Delaware court.

It is one of several transactions now in purgatory across the US, suspended between signing and closing. The dramatic Covid-19 slump has weakened the balance sheets of buyers who now may prefer to take on the risk of violating deal contracts rather than hand over precious cash or take on a mountain of debt for a business that is suddenly worth a lot less.

Investors seem to have priced in that risk. According to a Financial Times analysis of nearly 40 pending public company deals in the US, on March 18 the average spread between deal price and targets’ trading price approached a whopping 15 per cent — more than three times the usual gap.

Part of that chasm could be attributed to a wave of indiscriminate, panic-driven selling that week. However, a large portion came from the view that skittish buyers would walk away from or recut deals. That view still lingers, judging by discounts of about 7 per cent or 8 per cent.

In theory, such manoeuvres should not work. For a long time, investors have thought that companies and private equity firms would not renege because of the risk of damage to their reputations. Moreover, sellers have tightened terms considerably since the last financial crisis, writing contracts that compel buyers to live up to obligations under almost any set of circumstances.

“During their pre-signing negotiations, lawyers on both sides are trying to anticipate what could happen between signing and closing and provide for deal certainty,” said Richard Langan, an attorney at Nixon Peabody.

The key exception is the so-called material adverse effect, where a target company suffers such great damage that the buyer is allowed to walk away. However, sellers tend to carve out very broad exceptions, meaning that deep recessions, natural disasters or even pandemics do not count as an MAE. Only in one single case, decided two years ago, did a court find in favour of a buyer looking to exploit an MAE to avoid completion.

Still, buyers know that tying up a seller in court can be a mean but effective strategy. In 2007 and 2008, private equity buyers, in particular, tried to walk away from risky leveraged buyouts as financing markets collapsed.

In several instances, purchase prices were either negotiated down, or a different transaction was agreed instead, such as a minority equity investment. Meantime, contracts that were looser than today’s equivalents allowed some private equity firms to pay a fee of just a few per cent of the deal price to exit.

In the last week of March, 1-800Flowers told Bed Bath & Beyond that it was too soon to determine if PersonalizationMall.com had suffered an MAE. But it also argued that Bed Bath & Beyond had not adhered to certain, unspecified conditions. Between signing and closing, sellers and buyers agree on how the seller will run the company and other straightforward items that ensure that the buyer gets what it ordered.

In a similar case that escalated last week, auto parts maker BorgWarner said its rival Delphi Technologies had violated covenants in the pair’s $3bn merger agreement, struck in January, by drawing down $500m from a bank line of credit — without BorgWarner’s approval. Delphi fired back by accusing its acquirer of unreasonably withholding its consent. The pair will now tussle over whether such an event can derail a large deal.

Most M&A deals are a bad idea, ultimately, because acquirers end up paying too much. In the rare instances that this becomes obvious in the period before closing the deal, it is understandable that buyers will try — and probably fail — to bolt for the exits.