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Resurgent M&A Strategies Accentuate Important Tax Considerations

Posted on July 10, 2020

The revival of mergers and acquisitions expected in the coming months, including an uptick in asset deals and transactions involving special purpose acquisition companies, calls for a heightened focus on tax implications.

The government lockdowns in response to the coronavirus pandemic and resulting dire global economic situation, albeit uneven across industry sectors and geographic regions, led to a sharp decline in M&A transactions, Barry Perkins of EY said June 29 on his firm’s webinar.

Philip Tretiak of UBS Securities LLC said that, for him personally, since the significant drop in activity toward the end of the first quarter and into the second quarter, it had been “reasonably slow and then a little bit of daylight” emerged.

Recently, people seem keener on having meetings to discuss deals and “more willing perhaps to sell assets in the usual buy-and-sell transactions we’re familiar with — so I think a good bit of optimism after a long slog,” said Tretiak, who spoke during a June 17 webinar hosted by the Tax Executives Institute.

Joseph M. Pari of Weil, Gotshal & Manges LLP, who joined Tretiak on the TEI webinar, agreed, saying, “We’ve definitely seen an uptick [in M&A deals] these days compared to a couple of months ago.”

Deal Drivers

According to Perkins, several factors are expected to drive increased M&A activity in the latter part of this year and into 2021, which could influence the types of transactions.

Deals that fall into the category of “too important not to do,” for example, are motivated by mega trends, like technology, which existed before the coronavirus pandemic and have accelerated transactions amid the current crisis, Perkins said.

Perkins pointed to big tech companies that have been buying cloud assets to enhance customer engagement. He also noted deal activity that’s occurred in the battery subsector of the automotive industry for companies aiming to develop the electric vehicle of the future.

In other strategic deals, companies are acquiring businesses that provide differentiating capabilities — such as technology, people, or intellectual property — “that allow them to accelerate their development, again along these mega trends,” which could be driven by the current situation, Perkins said.

The coronavirus and its impact on the economy have also created “potential opportunities to accelerate growth and market share,” Perkins said. He noted that many companies with healthy balance sheets are looking for acquisitions of less resilient ones, such as consumer, financial services, and start-up companies.

A strong balance sheet is “the key differentiator for buyers,” Perkins said. However, in the current situation, “capital markets aren’t necessarily reflecting the full impact of the economic downturn . . . making it quite hard to [interpret] valuations,” Perkins said. Those valuation issues will likely lead to more all-share business combinations, he added.

The desire to “bolster the bottom line” — for financial resilience and to build up cash reserves — is also expected to drive deals, which could enhance pricing power but also generate free cash flow to reinvest for the future, Perkins said.

Raising Capital

“Cash is king” now as it was during the financial crisis, Alexander Reiter of EY said. “It’s a question of how to raise capital,” which means considering the tax implications of equity, debt, and asset transactions, Reiter said.

Raising equity is the easiest approach, either from shareholder’s private capital or within the group through upstream transactions, such as “dividend distributions, repayment of capital, and share redemptions . . . all of which have tax consequences,” Reiter said.

Equity contributions that aren’t cash but in-kind — that is, contributions of receivables — “could have tax consequences as well and lead to taxable income,” Reiter warned.

The growth in private equity funding is expected to continue, said John Van Rossen, also of EY, adding that “with all that dry powder” — more than $1.4 trillion in cash to be invested — “the industry needs to put its capital to work.”

For nearly two decades, the number of private-equity-backed companies has been increasing while the number of public companies has been declining, Van Rossen said. “It’s remarkable to see the number of companies now under private capital ownership,” and that seems to be a feature of the economy that’s expected to continue, he said.

“We would expect some very, very large deals just after the summer to take off again,” Van Rossen said.

Private equity deals during the pandemic have included, among other things, public-private transactions, Van Rossen said. About 15 percent of the global private equity deal activity since April 1 has been private investments in public equity, commonly referred to as PIPEs, he said, adding that those transactions have been more prevalent in the United States, with some occurring in Europe.

Corporate divesture transactions should accelerate across a wide range of sectors, either to strengthen the balance sheet or “free up capital for acquisitions or investment in the business,” Perkins said, noting that he expects private equity firms “to be one of the major acquirers of these assets.”

“From a timing perspective . . . some of the best vintages for private equity have been straight after these crises have been worked through,” Van Rossen said. “We would expect a relatively active market — probably a couple of months away — but we will see some deal pickup as we go forward given the combination of both the pressure of the dry [powder] on the one hand, but also opportunity coming out from the sale side [with] some assets coming to market either [by] corporate divestures or otherwise.”

Monetizing Tax Attributes

Some companies are considering debt transactions, which could involve raising new debt, transferring cash upstream or downstream within a group via intercompany loans, or using cash pools, all of which have tax implications and must be monitored, according to Reiter.

Stephen Hales of EY said that transferring cash upstream generally would be the first choice, but “we’re now seeing [companies] transferring assets in exchange for cash” to move the cash that’s trapped to the right place.

“What we’re also seeing for the first time” are transactions in which businesses are selling assets, realizing a gain, and sheltering the gain against current-year losses, Hales said, adding that the acquiring entities are willing to pay a higher price because they can amortize the assets.

Thus, deal structures are shifting to “unlock commercial value attributed to tax attributes,” Hales said. Historically, sellers wanted to keep tax attributes in their group and tended to carve out assets and dispose of them in a tax-free transaction, Hales explained.

If a group wants to monetize tax attributes of a profitable subsidiary — not an “uncommon fact pattern in today’s world based on some transactions we’re seeing in the market” — selling the subsidiary’s assets is one option that would yield higher gain recognition that could be sheltered against NOL carryforwards or current losses from the economic downturn compared with selling the shares of the subsidiary with a built-in gain, Donald Stephenson of EY said.

Sellers, however, must “appropriately [negotiate] the price a potential buyer would pay for the future tax shield from an asset purchase — the future cost recovery deductions for depreciation [and] amortization,” Stephenson advised.

Thus, the tax attributes that can be monetized today and perhaps realizable in the future could also provide “additional proceeds from the transaction related to the future value of the [basis] step-up from a tax perspective and related tax shields,” Stephenson said.

SPAC Momentum

According to Tretiak, “there’s a lot of buzz lately” in the M&A market about special purpose acquisition companies (SPACs), also referred to as “blank check” companies, which are acquisition vehicles that allow “investors to co-invest alongside a sponsor.”

In a SPAC transaction, a sponsor raises a blind pool through an initial public offering for the purpose of acquiring a private operating company, Tretiak said. Investors don’t know what they are investing in — other than perhaps the industry or geographic region — and the sponsor generally has 24 months to find a private target, Tretiak explained. If a target is found, the shareholders vote on the deal, otherwise the funds are returned to them, he added.

The competition between SPACs and traditional IPOs has been “neck and neck” in 2020, in part because there’s about $22 billion of cash held by SPACs, Tretiak said, adding that he expects to see a lot of SPAC activity in the coming year.

Marketing of traditional IPOs is often based on historical financials, and to the extent the COVID-19 pandemic results in a “fair amount of uncertainty . . . [that’s] been a negative for the traditional IPO market,” Tretiak explained. He said that’s because banks believe that SPACs’ ability to disclose financial projections, which can be discussed with potential investors, provides more flexibility.

SPACs make sense as an alternative to the traditional IPO in several situations, Tretiak said, pointing to a June 5 announcement of plans to take snack food manufacturer Utz Quality Foods LLC public by combining it with Collier Creek Holdings (a SPAC) to form Utz Brands Inc.

Utz embarked on a sales process that failed — that is, it was unable to identify a buyer — in part because it was somewhat over-leveraged compared with comparable companies, but the SPAC, which had significant cash, gave Utz the opportunity to deleverage, Tretiak said.

Tax-Free Threats

According to Pari, there’s been “an enormous amount of interest in SPACs,” both in formation and acquisition transactions, but “there are certainly tax issues.”

The SPAC shareholders “really care about tax-free treatment,” and one question that arises is whether the SPAC transaction satisfies the continuity of business enterprise requirement for tax-free reorganizations, Pari said.

Under reg. section 1.368-1(d), that requirement generally is satisfied if the acquiring entity continues the target corporation’s historic business or uses a significant portion of the target’s historic business assets in a business.

Thus, the plan of reorganization can’t involve entering into a new business and there are differing views as to whether a SPAC can be an acquisition target in a reorganization, Pari said, adding, “It’s a very important issue.”

Another concern is whether the SPAC can be “a counterparty in a reverse Morris Trust transaction,” Pari said.

Reverse Morris Trust situations involve a tax-free spinoff of a newly created controlled corporation that is undertaken to facilitate a subsequent tax-free merger.

If a SPAC acquires the “SpinCo target” and instead of paying cash for the target company’s shares, the SPAC shares are exchanged for SpinCo’s shares and the SPAC uses its cash to deleverage SpinCo, that transaction might work, Pari said. But generally it depends on the facts whether the SPAC can be a counterparty in a reverse Morris Trust transaction, he added.

Pari explained that spinoffs normally won’t qualify for tax-free treatment if SpinCo is “acquired pursuant to a plan by any entity that’s going to pay cash for its shares.” If the acquiring company provides too much cash in the deal, that could trigger a host of issues, such as the transaction being viewed as a device for distributing earnings and profits to shareholders and potentially running afoul of the continuity of interest requirements, Pari said.

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