“Distress” generally means that the company is having difficulty dealing with its liabilities. Before a crisis erupts and thoughts turn to formal bankruptcy proceedings, a distressed company may try to mitigate its exposure by seeking amendments or waivers to its credit facilities or debt securities. If those options are not sufficient, then it may take other measures, for example seeking to sell assets as part of its plan to improve its financial condition. These are all out-of-court options. Companies can also undergo other corporate debt reconstructurings. In these cases, most distressed M&A transactions are structured as asset sales rather than corporate mergers.
Distressed companies can be attractive acquisition targets, as their price often reflects the difficulties the company faces. Purchasing distressed assets and companies carries some dangers and challenges, but also offers more significant opportunities than in non-distressed M&A transactions. A potential purchaser must be focused on identifying distressed sellers and manage the acquisition process minimizing the dangers and maximizing the opportunities.
Signs of distressed M&A
There are many indicators that a company is distressed. Identifying them early on provides a purchaser with a recognizable advantage in buying the distressed assets. In-depth due diligence is an often-used method for discovering distress. A purchaser should be careful not to misinterpret financial distress that is not only caused by too much debt. This may fool a purchaser into thinking that the company’s problems can easily be fixed. Many internal and external factors may also cause financial distress, such as being over-leveraged or poorly managed. A company which has undertaken cost reductions as part of a debt reduction program, such as lay-offs, asset sales, equity offerings or changes in senior management, especially in the finance department, is likely to be a distressed company. Furthermore, a company’s capital structure can be an indicator of distress. If a company has had a series of public debts, asset sales and fundraising activities, these may lead to liquidity problems due to too many debt-related restrictions.
It is also important for a purchaser to take a close look at the company’s products, its relationships with its customers and suppliers , its know-how, its production costs etc., as all of these, if poorly managed, can lead to financial distress.
To avoid being mislead into thinking that a distressed company can be easily turned around, the purchaser must determine the corrective measures required. The better a purchaser understands the reasons for the distress, the better its chances of successfully turning the company around.
The 5 Traps
As it has become increasingly difficult for distressed companies to refinance their existing debts as a consequence of contraction of the capital market, distressed M&A have become more and more common. By purchasing assets from a distressed business, the purchaser bails it out and disburdens the assets from the company’s debts.
Distressed M&A transactions present a great risk. Often the seller will not willingly be selling assets but will be forced to do so by senior lenders, making it more difficult to get the deal done. To manage the risk, any potential purchaser evaluating a distressed acquisition should have the following five traps in mind:
1. Implementing the right process
How to implement the sale is one of the most important decisions a purchaser has to make. Many factors will influence this decision: the company’s activities and its assets, the seller’s need and access to administrative capital in the period prior to closing, the duration of current liens, the belligerence of the company’s creditors, and the time available to complete the transaction. As each transaction is unique, a purchaser should give careful thought to the proper procedural approach, because choosing the wrong approach can obscure the transaction.
In contrast to a healthy M&A transaction, a distressed M&A transaction is not only a transaction between a seller and a purchaser. Often the purchaser will be required to negotiate with senior and junior lien holders and lenders, secured and unsecured creditors and a bankruptcy judge, each with their own agenda, which may or may not be consistent with the purchasers’ agenda. Dealing with creditors requires a great deal of flexibility on the part of the purchaser.
3. Credit Bidding
It is critical that the purchaser reaches an agreement with the senior lien holders regarding the terms of the sale and that they are involved in the sale process. The senior lien holders will often have initiated the asset-selling process. Furthermore, it is unlikely that the seller can go ahead with the sale without obtaining financing from the senior lenders, whose lack of consent and support would make it unlikely for the sale to go through.
4. Stalking horse Protections
As distressed sales are often market-tested, it is a tremendous advantage for a purchaser to act quickly and become a “stalking horse”, with an inside track and an opportunity to shape the sale to protect its interests, to ensure its strategic advantage and to prevent the sale being lost to another bidder.
5. Due diligence
Due diligence must be executed efficiently during a distressed transaction as the purchaser is not given much time, contractual protection nor meaningful rights to compensation. Additionally there is no hold-back or escrow to protect the purchaser from subsequent disputes. The purchaser’s focus during due diligence must be on the most critical aspects of the transaction.
Before entering into an agreement regarding a distressed M&A transaction, the purchaser must exercise caution. In particular, the purchaser should avoid clauses in a confidentiality agreement that prevent the purchaser informing third parties that the sale is being discussed or negotiated. In a distressed M&A situation, the purchaser should ensure it retains the ability to discuss the sale with the seller’s creditors and other bidders.
Standstill agreements are often requested by sellers as an attempt to restrain the purchaser from purchasing claims against seller to gain the upper hand in negotiations. This should be resisted by the purchaser, as without claims, it will be unable to object to the sale process.
Purchasers should also avoid signing exclusivity agreements in exchange for the purchasers’ agreement to another issue in favor of the seller.
The beginning of the credit crisis in mid-2007 increased the number of distressed companies looking to sell assets as part of their plans to improve their financial conditions. However, the crisis made investors reluctant to purchase, which led to an overall reduction in M&A activity.
In 2012, global M&A activity by value fell by 2.7% and by 4.7% by number of transactions. Eurozone deals in 2012 accounted for 13.6 % of the global M&A market, down from 16.1 % in 2011. 2012 was the worst for Eurozone M&A since 2009, when the financial crisis peaked. Non-Eurozone European M&A accounted for 17.6 % of global M&A, up from 16.4 % in 2011, the highest portion since 2007.
Global PE buyouts (worth USD 254.9 billion) fell to their lowest level in 2012 since 2010. The total value of global insolvency deals in 2012 was USD 17.3 billion (for 344 transactions), which was on a par with 2007, before the crisis. In 2012, Eurozone insolvencies were at their second highest level by deal value since 2004, but fell 6 % compared to 2011.
One-third of global M&A transactions were cross-border, 3 % more than in 2011. Excluding other parts of the world, 40 % of cross-border deal targets were in the US, 40 % in Europe and 20 % in Asia.
The following tables show the top 20 global outbound acquisitions and inbound target markets, and the number of global deals and deal types.
Distressed Mergers and Acquisitions can be attractive purchases, as the price often reflects the financial crises the company faces. As a purchaser interested in distressed mergers and acquisitions, it is crucial to take the correct measures when investigating if a company is financially distressed and to avoid the traps. Once a purchaser understands the company’s financial situation, it will be more aware of what is required to return it to profitability. When closing a transaction, the purchaser should be very careful about signing agreements with the seller.
Western Europe, notably Germany, Netherlands and the UK, has seen some sizable deals, but that has not been enough to counterbalance the crisis in the Eurozone. Deal volume in the US is rather weak, despite strong fundamentals and low interest rates. Investors in the US and China share the same fears and frustrations about European economics, and this is reflected in their deal volume.
What the market participants felt in 2012 is confirmed by the statistics. The euro crisis and the continued Eurozone sovereign debt crisis led European entrepreneurs to take a more cautious approach, hesitating before making major investments. This meant that many sellers sold slowly or not at all. Calling a market upturn, though, remains a very tricky business, and depends on the Eurozone crisis being brought to an end.
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