Commercial Leases and Real Estate Issues
The UK Government policy of working from home as far as possible and until recently only re-opening some non-essential retail businesses (provided they observe social distancing measures) has had a drastically negative impact on many businesses, including bricks and mortar retail. A priority for many tenants has been to renegotiate their existing commercial leases.
A practical consideration for many businesses across different sectors is how business performance has been impacted due to employees working from home (assuming non- essential workers). Businesses and sectors which involve providing services to clients on site at their premises have also been heavily impacted.
Whilst a lot of the commercial (or financial) due diligence will need to focus on the financial impact of recent UK Government policy, more detailed legal due diligence enquiries on the target may focus on issues concerning:
- The extent to which negotiations for rent holiday or rent deductions with landlord(s) have taken place;
- Whether the target business has sought to invoke Force Majeure or the landlord has sought to terminate; and
- The increased importance of health and safety and access issues.
The uncertain economic outlook is likely to warrant putting the target business's insurance coverage under additional scrutiny, including in relation to business interruption, professional indemnity or product recall. The pressure on suppliers and third-party contractors caused by the current economic climate may also increase the risk of an insurance claim due to sub-standard performance.
Diligence will need to focus on to what extent the target has complied with Covid-19 related legislation regarding the health and safety of its workforce and UK Government policy, together with compliance around the target's own internal HR policy and procedures, including its work from home policy. To the extent the target business has been forced to furlough employees or effect a redundancy program, legal compliance and increased risk of employee claims will need to be taken into consideration. The long-term commercial impact on the business may also need to be considered.
Understanding to what extent the target business has been receiving funding under the UK's Coronavirus Job Retention Scheme or any other government funding will also need to be properly investigated (and the impact on the business when such funding ends considered).
Understanding whether the target business is dependent on any other government funding or tax advantages (other than the Coronavirus Job Retention Scheme), as a result of Covid-19 should also be considered.
Working Capital and Finance
Commercially it will be important to understand whether the target business has experienced liquidity pressure or faced increased working capital requirements. To what extent has it attempted to alleviate this pressure by re-negotiating its employment, supply chain or commercial lease arrangements, together with its approach to its own existing lending facilities and attempts to maximise these will be key diligence items.
Due diligence will need to focus on any amendments to existing facilities and recent communications with lenders. Assessing a downturn in the target's business in relation to the terms of its existing facility agreements, including potentially triggering financial covenants, cross default, notification and material adverse change (MAC) provisions will be key.
The solvency of the target will also need to be scrutinised from a financial due diligence perspective.
Material contracts and Supply Chain
Due to Covid-19's impact on businesses throughout the supply chain, there is an increased likelihood that the target business is in material breach of contracts with its customers or that its suppliers, agents, distributors, licencees or third party contractors have themselves committed a material breach. In light of Covid-19 commercial contract due diligence in addition to typical enquiries should focus on:
- Whether there has been any re-negotiation of any customer or third-party contracts;
- Whether any material terms have been waived (which might affect future enforcement);
- Whether any contracting party has sought to invoke a MAC clause or Force Majeure clause or otherwise sought to terminate the contract;
- How revenue is recognised under contract(s) and whether contractual arrangements can continue to be performed on a profitable basis; and
- Any practical consequences from enforcement.
- Any potential strain on the supply chain caused by Covid-19 should be robustly tested.
Understanding to what extent the IT systems of the target business have coped or have had to adapt because of Covid-19 (e.g. because of the workforce working remotely or reaching out to customers on line) and to what extent they can support the business going forward is likely to warrant greater attention.
A heavier emphasis on IT support and disaster recovery systems is also likely.
Consideration should also be given to the potential likelihood that since the outbreak of the pandemic, management may have potentially become distracted from other considerations (e.g. day to day management of the business, corporate governance, data protection or anti-corruption issues).
Whilst this blog focuses on legal due diligence, any financial due diligence might also need a shift in focus. Historical financial information forming the basis of valuation multiples and future cash flow generation might have a perceived lesser relevance than forecasted information. The working capital required to make a previously (pre-Covid-19) profit generative business profitable again or to re-start the business after having been "moth-balled" is likely to take a lot of the financial focus.
The original post can be found here