By Truc To and Neal McNamara
(earlier posts in the series here)
Some thoughts for corporate boards and private equity investment committees:
The Ukraine war is a humanitarian tragedy; it also marks a tectonic shift in geopolitical relations. The world is at an elevated risk level not seen for decades, fostering widespread fear, uncertainty and doubt, elevating business risks and creating opportunity in some cases.
Self-sanctioning / expanded diligence:
Many corporates and PE portfolio companies are “self-sanctioning” by avoiding Ukrainian and Russian counterparties. They will also carefully diligence entities with recent or ongoing business with Russia and Ukraine. In essence, a “carve out” will need to be performed on a target’s entanglements with Ukraine and Russia (i.e., its historical and projected earnings, working capital, HR, IT, operational, supply chain, commitments and contingencies and obligations with Ukraine and Russia).
For example, one of our clients stopped selling to Russia businesses but is continuing to sell to Ukrainian agricultural, commercial and governmental customers, where sales have fallen precipitously, and credit risks have increased substantially.
Proximate countries at risk for escalating conflict or sanctions:
In addition, a risk matrix should be adopted on business with countries in the following “risk” categories:
- Potential Russian “friendlies” (Belarus, Georgia, Kazakhstan, Azerbaijan, Armenia and Moldova)
- Countries geographically proximate to Russia (Bulgaria, Poland, Estonia, Romania, Hungary, Latvia, Lithuania, Sweden, Czech Republic, Slovakia; all EU members), and Finland (decision pending on requested NATO membership)
- Countries economically impacted by commodity price inflation (Germany, in particular, but to a lesser degree, all of Europe)
- China and Taiwan in the event of escalating tensions
Buyers should stress test to “quantify, discount (deeply for some, moderately for others) and ring-fence” any entanglement or transaction with operations, sales or materials from these countries. The above is a long list and a target’s FP&A and MD&A may need some digging into to quantify and evaluate risks.
Commodity input costs in cost of sales:
Some might expect the direct economic impacts of the war to be minimal due to the size of the Russian and Ukrainian economies. However, there will be potentially material second order effects on input costs because oil, gas, coal, nickel, palladium, uranium, wheat, potash, cobalt and freight costs have all been impacted by the war and factor into production of key components in many sectors.
Business countermeasures:
Targets may need to forward buy and stockpile key materials / inputs and diversify their supplier base to avoid supply chain disruption which may mean their working capital needs post-close could increase at a faster rate than a historical backward- looking working capital peg.
A target may need to increase its focus and expenditure on cybersecurity in the event of the kinetic war escalating to Russian or criminal measures.
Representations, warranties and indemnifications:
Counsel will ask for reps & warranties on the results of the diligence findings above, which will vary with industries but could include sanction compliance, material adverse change impacts, energy and mining, supply chain, insurance, customers and the ability to perform on material contracts. Insurers have little appetite for underwriting representation and warranty insurance for operations with exposure to Ukraine and Russia and will ask for “extensive” diligence during underwriting, let alone premia and coverage.
Central bank considerations:
Finally, there is an on-going debate on how the increased geopolitical risks and energy disruption exacerbating inflation, combined with heightened recession risks and overall economic uncertainty, will result in central banks being more dovish or more hawkish on QE and the prospects of an economic “soft-landing.” We believe that raging inflation, political agendas and populist anger, will lead to QE tightening and lift-off will accelerate.
M&A is always tricky; ongoing events make it a lot trickier. Much to ponder, debate and discuss.