In unstable market conditions, a company in financial difficulty may be rapidly forced to exit a loss-making business. Refinancing may not be possible, and the company's current bankers may not be prepared to put fresh funds at risk. A distressed M&A solution may be the only way forward to avoid insolvency. So what are the key tactics and strategy to achieve value from a distressed M&A situation?
To maximise value sellers of a distressed business should establish a credible turnaround plan which excites interest from buyers. This may involve:
identifying areas for cost cutting;
addressing underperforming employees (including management team);
a strategy for re-negotiating or exiting loss-making contracts or resolving time-consuming litigation;
the sale of previously undervalued assets;
considering whether there is any value in tax losses which the buyer could utilise; and/or
identifying opportunities to improve revenue.
Care needs to be taken to resolve management conflicts, for example, where the incumbent management team is one of the bidders for the business.
Any issues that can adversely affect the sale need to be identified early in the process, and a strategy developed about how to address these with bidders.
Where a distressed corporate has a complex debt structure with layers of senior and junior debt (perhaps held by bond holders or hedge funds), it is necessary to work out a strategy for dealing with the different stakeholders, who may have widely differing interests. Often a distressed sale is preceded by a “standstill agreement” between the key finance creditors, to avoid taking action pending an agreed solution to the company's difficulties. Corralling a diverse investor and funding base can be extremely difficult and challenging and the company's advisers must play a proactive role in managing this. Stakeholders who can veto or obstruct the exit strategy should be identified. It may be necessary to negotiate with them to secure their commitment to the sale process up front.
Depending on the cash flow situation, there may be a need to secure on-going funding during the sale period. The terms on which any such funding is made available and any additional security required by the lender as a condition of such funding may need to be negotiated.
From the buyer's viewpoint, it may try to find ways to reduce the purchase price, knowing the seller has a finite time period before the money runs out in which to secure a sale.
A sophisticated buyer will press for exclusivity, and once achieved, often exploits problems arising out of due diligence and seeks to renegotiate the transaction.
The buyer may try to delay the sale to get a better deal by buying the business through a pre-packaged administration process, having forced the directors of the target company into a situation where no other exit options are available. The use of insolvency tactics are less likely if a solvent process is the only way to guarantee preserving the goodwill in the business, perhaps because key contracts terminate on an insolvency event.
A buyer of a distressed business will have to factor in the fact that it will receive limited warranty comfort from the seller. There is normally only a restricted due diligence process; either because the distressed company does not have complete and accurate records or because of the time pressures. This will all be factored into the price that the buyer is prepared to pay, and retentions that the buyer may seek from the purchase price.
Deal structure and process
So what is the usual structure and process during a distressed M&A transaction?
Cash is king. The seller will wish to receive an immediate cash payment to pay off creditors.
The buyer may try to address the concerns over the seller's financial covenant by warranty insurance or retentions of the purchase price to cover breaches of warranty or indemnities.
Preparation time is absolutely key. The more issues identified by the seller early in the process, the greater the ability to resolve these and the less likely that nasty surprises will leap out of the woodwork to reduce value at a time critical stage.
The buyer may not be prepared to take all liabilities of the business under a share sale agreement, and may press for an asset sale. This will require the novation of contracts which may be subject to third party consents not readily available within the timeframe. There will be TUPE issues with the employees including consultation requirements, the timing of which is more critical than usual, given the financial pressure and commercial sensitivities. There may be a negotiation over allocating costs associated with employee liabilities, such as the costs of making employees redundant.
The seller usually prefers a share sale as it wishes to exit the distressed business with a minimum of residual liabilities. There may also be positive advantages to share sales such as the ability of the buyer to utilise tax losses or make recoveries of tax.
It is increasingly common for sales of distressed businesses to be structured using pre-packed administration processes. Directors are able to use administration to protect them from liabilities that may otherwise arise on a distressed sale, for example concerns that they may be transferring assets at an undervalue.
A data room will normally be produced but in a company with a history of mismanagement, the quality of information may be problematic. The seller should enlist external financial and legal advisors to prepare the sales memorandum and seller's due diligence as early as possible, to ensure objectivity and work out the tactics for addressing weaknesses in the available information.
Maintaining a competitive sale process is essential to prevent a buyer holding the seller to ransom. Driving the timetable forward is also critical. Delay usually adversely affects the trading and cash flow position of the distressed business. Bidders may drop out of the process and ultimately the only solution is using an insolvency process.
Other areas to look out for in a distressed M&A transaction
Here are some other issues (not exhaustive) to consider:
Transitional issues. It may well be that to secure a sale within a very tight timeframe the buyer will not have time to gear up the sorts of services that will be needed to support the target business and the seller will have to provide certain services such as IT systems, for a limited period after the sale, subject to resolving any change of control problems in any IT licences.
Pensions. With the increasing power of the Pensions Regulator, you may need to consider whether a transaction requires regulatory clearance if it weakens the position of the pension scheme. In some circumstances a distressed M&A deal may even result in the involvement of the Pension Protection Fund.
Competition. The timing of any competition clearances in a distressed situation can also prove extremely challenging and need to be grappled with up front. A bidder who does not need clearance will have a distinct advantage over one that does.
Tax. Distressed M&A transactions which involve the transfer of assets to new companies in exchange for the forgiveness of debt throw up specific tax issues which should be carefully considered during the planning process.
Regulatory. Listed companies facing a distressed M&A transaction will have to carefully consider regulatory requirements such as disclosure to the market of price sensitive information, and whether any dispensations from the need for shareholder consent are available.
Distressed sales often throw up many unexpected issues, and are always undertaken under pressure caused by the financial position in which the company finds itself and related commercial sensitivities. Planning is key and all those involved need to adopt a mindset to predict problems, think through tactics and adopt a proactive approach throughout. With careful thought, it is often possible to maximise value in a distressed sale situation, saving the business and jobs. In the most successful situations, the business will be put back into a sounder financial position by maximising value through the sale process, possibly restructuring its finances at the same time in agreement with its bankers, and be able to continue its activities successfully going forward.