5 points to consider before entering a distressed M&A deal
In the waning months of 2019, market commentators and investment professionals could increasingly be heard sounding the alarm for a potential economic downturn. Right or wrong in their prognostications, none could have anticipated the economic calamity that we are now experiencing as the impact of the Covid-19 pandemic continues to ripple across the globe from its Wuhan, China epicenter.
Actions taken by governments across the globe to “flatten the curve” and alleviate some of the pressure on front-line healthcare workers have pushed economies into suspended animation. Following the spending of trillions of dollars, the G7, together with Russia, China, and South Korea are starting to see decreasing infection and death rates and their economies are beginning the process of slowly re-emerging from stasis.
In anticipation of economic recovery, Wall Street has begun to erase some of the heavy losses incurred in Q1 2020 and while lagging behind Wall Street, Main Street is working hard to adapt to the new normal so that it can get back to work. Notwithstanding the nascent reawakening of the economy, some businesses will never reopen and many of those that reopen will find themselves in distress for the foreseeable future. While no rationale economic actor wants to see the wholesale devastation we have seen in the past few months, investors shouldn’t ignore the opportunities that result and how to capitalize on them.
Many distressed businesses are likely to need additional capital, which they may raise via new investment, or disposition of non-core business lines and assets. Others may be sufficiently distressed such that they are ripe for acquisition, either within or outside of, a court-organized process. Given the foregoing, with financial sponsors and strategic buyers sitting on a record amount of cash and available dry powder, there is a high level of liquidity amongst potential buyers, which should allow them to act quickly on arising opportunities, and irrespective of the status of debt markets. Buyers that are open to pursuing distressed situations are, and should continue to be, closely monitoring the value of potential targets, evaluating the merits of those opportunities in the short-term, and also the medium- and long-term.
The economic disruption across industries and geographies is creating opportunities and the investment landscape is setting up for what could be a significant uptick in distressed M&A activity. Below are a few key considerations that potential buyers should take into account in evaluating those opportunities.
1. Model, model and remodel
With the Covid-19 crisis, we all find ourselves in uncharted waters, which is why it is even more important to run numbers for a potential investment in a wide range of scenarios, both positive and negative, in an effort to identify the potential strengths, weaknesses, opportunities, and threats resulting from various potential developments. Comprehensive modeling can help investment professionals develop the strategy and necessary tactics for dealing with positive and less-positive developments. As discussed further below, it is always helpful to engage outside advisers with distressed transactional experience early in the process of evaluating a potential target. They will help a buyer identify issues for consideration and inclusion in modeling that a buyer may not identify on their own.
2. Due diligence is important
It’s important for buyers to engage in a robust due diligence process to fully appreciate the assets and liabilities they will be responsible for after the acquisition. Distressed M&A transactions can result in a compressed timeline for due diligence, and engaging experienced advisers who are able to quickly identify material risks and issues and provide strategies for countering any such discoveries is critical to a successful transaction. In particular, and as discussed further below, experienced advisers can help the buyer identify potential creditor issues that could lead to, and help develop strategies to protect against, a fraudulent conveyance claim. By engaging in a comprehensive due diligence process, buyers should have the information necessary to secure appropriate contractual protections through representations and warranties, as well as indemnities, where available.
3. Plan and strategize for incentivizing key stakeholders of the business
Key stakeholders are important to consider both during the transaction, and as a part of the post-acquisition or investment strategy. For example, in an asset sale, the consent of key stakeholders, such as creditors, landlords, customers and suppliers, could be required in advance of a transaction closing. Additionally, key stakeholders often include the management team who will continue to run the business post-acquisition. Consequently, a buyer should be thinking about how to incentivize management to continue growing and operating the business following the closing. Overall, incentives for key stakeholders are often an important consideration for how a deal is structured. Identifying those key constituencies and assessing their appetite for seeing short term payouts versus their interest in participating in the future results of the business will help drive structuring considerations. Furthermore, understanding and maintaining these relationships can be a key factor to retaining goodwill and growing the business following the closing.
4. Strategy and structure
Transactional and bankruptcy attorneys can provide extremely valuable insight to drive strategic and structural efficiencies, which can help maximize the value of an investors offer. They can also help strategize appropriate ways to approach a target, which may vary depending on its distressed status. Attorneys are particularly helpful in determining the most time and cost-efficient route, whether that is in or out-of-court, to approach an acquisition or investment, and avoid potential fraudulent conveyance claims. It is also important to engage financial advisers to consider the ramifications to both buyer and seller of the potential structure of the deal, as tax implications often have a significant impact on value and are a key driver of structuring considerations.
While a distressed acquisition may be structured as a purchase of equity or an acquisition of assets, buyers generally prefer asset transactions. Asset transactions enable buyers to cherry-pick the assets they want, and the liabilities they will assume, while reducing their exposure to successor liabilities to the largest extent possible, including any unknown or contingent liabilities. While asset sales have their advantages, keep in mind that these transactions can sometimes take longer to complete, and have increased execution risk, as many times negotiating with third-parties may be necessary in order to obtain their consent to the transfer of certain types of assets, such as leases and commercial contracts. Those issues can also arise in connection with an equity transaction, albeit less frequently.
5. Fraudulent transfers
At the end of a court-run distressed transaction process, buyers can, as a general matter, take comfort in the fact that the court’s final order gives them the acquired assets free and clear of any encumbrances, other than those that the court specifically allows to remain in place, which mitigates any potential fraudulent conveyance claims.
Acquiring a distressed business’ equity or its assets outside of a formal insolvency process increases the risk to the buyer of a subsequent fraudulent conveyance claim by the business’ creditors; in particular, if the creditors consider the value of the transaction to be low relative to their expectation of what the assets or business was worth. In a claim of constructive fraud, the creditor may try to assert that the seller received less than reasonably equivalent value in exchange for the transfer, was insolvent at the time of the transfer, or was rendered insolvent by the transfer. This is a facts and circumstances specific inquiry, and as a result, the court is generally not interested in the buyer and seller’s intent. If the creditor is able to prove constructive fraud in court, the court can void the transfer, and require the return of the money and assets exchanged. Buyers should confer with outside advisers to determine appropriate protections before embarking on a transaction in order to mitigate such a claim, including in certain circumstances obtaining a fairness opinion, and otherwise creating a record that can demonstrate that the value exchanged was reasonably equivalent.
We all hope for a swift end to the Covid-19 pandemic, but we also know that the impact will continue to reverberate for quite some time, while we settle into the new normal. While as a general matter nobody hopes for an economic downturn in any circumstance, one silver lining to the current economic reality are the distressed opportunities that will arise. Those players with the right knowledge and financial capacity should have a robust number of opportunities to explore in the short- and medium-term.
-- Kathryn Haines, associate, Hogan Lovells, also contributed to this article.