For the last few weeks as the COVID-19 crisis ramped up, we have seen a number of transactions – most in the traditional investment arena – that are being put on hold or called off entirely during this crisis. In the coming weeks it’s very likely that we’ll all hear about many more such instances.
A host of investors are currently weighing their options and re-evaluating their deals by exercising some of their contractual rights and want to know what sort of legal recourse they might have under legal concepts such as force majeure and material adverse change (which we’ll discuss in greater detail below).
Interestingly, nearly all of these observations have been of traditional, mainstream financial market deals – thus far the impact marketplace seems to be reacting somewhat differently. Why?
Do impact investors think about risk differently? Should they think about risk differently? And how should they go about evaluating their investment portfolios and options in the age of COVID-19?
Impact investors already have a history of using tools and legal structures designed for traditional corporate finance, private equity, venture capital investors and adapting them for the impact landscape. It’s how impact investors use these tools that ultimately matters in terms of the impact we can make.
So how should impact investors chart a path forward during these deeply uncertain times? What are your options?
We believe the goals and more intentional mindsets of impact investors will give them a leg-up through this crisis, specifically in terms of how to think more creatively and expansively about risk allocation.
This differentiated approach will almost certainly have a bearing on how the impact marketplace emerges from this crisis. Here’s why.
Risk isn’t binary
In evaluating the path forward on a deal, recognize that risk is not binary.
Every investor’s risk appetite is going to be different. The first part of this process is the same for everyone: recognize that you have multiple choices. The choice is not just staying in and exposing yourself to risk or going, leaving any potential upside on the table and potentially leaving a company with a solid longer-term trajectory in the lurch.
Assessing your risk and creating a path forward should include the potential collateral effects on all stakeholders.
Just as an impact investor would consider the positive effects on employees, customers and connected businesses of a potential investee, we see impact investors looking to those same constituencies when considering their options in light of the global shocks created by COVID-19.
Fortunately, as an impact investor you have multiple levers at your disposal.
The “big guns”
One could take an extreme defensive position like many investors in the traditional arena and pull out the “big guns.” These would typically include force majeure, material adverse change (MAC) and material adverse effect (MAE) clauses.
Such provisions are a party’s “get out of jail free” cards, as they provide for conditions under which a party to the agreement could walk away from the deal or suspend performance of its obligations. Typically this occurs when a large, material event significantly reduces the value of the transaction to the party.
These types of legal options are staples of funding agreements whether you’re a general partner, limited partner or other kind of investor. Surely anyone company-side is very familiar with them as well. The thinking of some of these investors is that COVID-19 arguably rises to a level that would trigger one of these clauses.
But is this the right course for everyone?
MACs and MAEs are binary options and potentially have lots of unintended consequences. A financing that falls through can lead to loan defaults, a cash crunch that causes layoffs, the inability to proceed with business as usual, or even a failure of the business.
On the same token, simply proceeding with the transaction as if the global economic shocks were not taking place would certainly be unwise as well. Our view is that these times call for a more nuanced approach.
Exploring all options
Impact investors actually have many options at their disposal, and we encourage each of you to consider them as you determine your path forward during this crisis. Here are just a few to consider:
Purchase price adjustments. Purchase price adjustments can be a fairly elegant and simple way to protect an investor and can help ensure that a transaction concludes, albeit at an adjusted price that reflects a change in circumstances. This may be all that you need to close your deal during the current crisis.
Reps and warranties. Each party makes representations and warranties about the state of play at the time an agreement is reached. Reps and warranties should be tailored to the actual underlying assumptions the parties are making in respect of their decision to complete the deal. The question today is whether these reps and warranties are still relevant or calibrated correctly.
At the very least, reps and warranties should be revisited, as neither party wants the investee to be in breach on day one simply because conditions on the ground have changed. For example, these might include representation about the company’s financial condition. Another might be a key employee provision – perhaps they have already had (or will have) layoffs.
For many companies in the service or hospitality industries, income has clearly taken a nose-dive and a company may no longer be able to service its debt. As an investor, you can work with the company to understand the situation and see if there is some sort of waiver or cushion that can be written into these representations to ease them through this crisis.
Covenants. These are much like reps and warranties but prospective, and you should look at your covenants to see how the COVID-19 crisis may affect them. For example, if cash on hand is one of the covenants, maybe you want to strengthen that so that during this crisis the company is required to have, say, three months on hand vs. one month.
Keeping impact on track
Much of the discussion about what we mean by impact investing is often defined by the types of investments we make – what the asset class is and what the investment and impact outcomes are. But another important way to think about what defines and sets impact investing apart from traditional finance is a more thoughtful and intentional approach to investing.
At its essence, impact investing incorporates a broader aperture that encompasses the fuller context of investments, and this includes their effects – their impact – on a variety of stakeholders. As a result impact investors have a track-record of thinking more thoughtfully about a broader range of concepts.
So do impact investors have different options available than traditional investors?
The short answer is no. And yes. Here’s why: we take the view that impact investors are investors – and this means they should be as rigorous in their approach to risk analysis and their returns as much as a traditional investor. So as an impact investor evaluates their investment portfolio during the COVID-19 era, they should absolutely be thinking in terms of risk.
But as a group, impact investors have a track-record of being more intentional about a broader range of concepts than anyone else. And this is because impact investors are fundamentally different than traditional investors in one important way – we are all, to varying degrees, mission-driven investors. Considering the mission of an investment goes to the heart of how we determine the merits of a particular investment and whether it fits the stated mission and risk / return profile of an investor’s portfolio.
So in the coming days and weeks as you re-evaluate the level of risk you are comfortable taking as the effects of COVID-19 reverberate around the world, remember that your choices are far from binary. You have lots of tools at your disposal that can help you keep your impact on track and also help you protect your downside risk. You also have a different and valuable way of thinking about risk and a network of like-minded investors and funds to turn to explore your options.
As our friends at Open Road Alliance recently wrote in ImpactAlpha, now is the time to get creative. Is there a bridge loan that might help out one of your investments or perhaps a group of co-investors that can band together to provide bridge funding to an organization whose fundamentals are strong and just needs funds to make it through the next several weeks? You have options, and during an extraordinarily difficult time that is challenging all of us personally and professionally, that is an exciting place to be.
Chintan Panchal is founding partner of RPCK Rastegar Panchal. David Press is founding partner of Confluence Partners.