FORUM: Distressed M&A and investing in the current market

January 2013 | SPECIAL REPORT: GLOBAL RESTRUCTURING & INSOLVENCY

Financier Worldwide Magazine

FW moderates a discussion examining distressed M&A and investing in the current market between Kon Asimacopoulos at Kirkland & Ellis International LLP, Melanie L. Cyganowski at Otterbourg, Steindler, Houston & Rosen, P.C., Rick van Dommelen at PwC, and James G. Gereghty, Jr. at Siguler Guff & Company, L.P.

FW: How would you describe distressed M&A activity through 2012? Have investors demonstrated a strong appetite for distressed assets?

Asimacopoulos: There has been an increase in activity in certain sectors, but on the whole distressed M&A has not been as active as the market predicted this time last year. There is strong buying appetite and plenty of money for distressed assets, but buyers have found it difficult to gain access to assets for a variety of reasons.

Cyganowski: Distressed M&A activity, like M&A overall, has not been particularly robust in 2012. Through the third quarter of 2012, the dollar volume of M&A is down from the prior year. In the middle market, there is little activity. In deals valued at up to $500m, there has been a 17 percent drop. Deals valued between $500m and $1bn have seen a 9 percent decline. Putting things in a broader context, M&A activity is down in the industrial sector, real estate, telecommunications, pharmaceuticals and biotech. Mega deals are off 34 percent from years past. Billions of dollars are sitting on the sidelines looking for a place to go. Rather than M&A as a vehicle for new investment, the trend is toward bringing new investors in to help shoulder the risks of existing deals. In contrast, distressed debt has been reported to be among the best hedge fund strategies. Fewer companies have debt that trades below 100 cents on the dollar.

van Dommelen: It is true that there is a strong appetite for distressed assets. A trend we have seen since the last quarter of 2011, however, is that, of the number of transactions predicted to close, only a small number have materialised. This is mainly because it took longer to complete transactions due to a tightening of credit metrics and market sentiments being sensitive to ongoing shifts in the political climate. Against this backdrop of weakening market conditions and lower than planned earning expectations, we have seen more opportunities as well as further sophistication in the distressed M&A market.

Gereghty: Today’s market is characterised by a growing demand for opportunistic M&A activity, both from strategic partners and financial sponsors. With an expected persistent and transparent low interest rate environment in the US and Europe over the next 12-24 months, deal interest has increased, but buyers are wary of stretching as the sting of the global financial crisis remains sharp. Both US and European high yield bond issuance dramatically increased in 2012. The majority of high yield bonds issued have been used for refinancing, but a growing portion has been earmarked for M&A, particularly in the US. Although still well below the 2007 peak of 52 percent of overall high yield bonds issued, M&A high yield issuance topped 22 percent in 2011 and is on pace to do so again in 2012, following lower 2009 and 2010 levels of 5 percent and 16 percent, respectively. This trend, although promising for M&A activity, remains significantly below the 40-50 percent levels seen immediately preceding the global financial crisis. We believe that terms on the debt favour the borrower as tenors have extended to more than 10 years on some issues, coupons have declined to historically low nominal rates, and covenant packages have loosened.

FW: In your experience, are banks growing less inclined to ‘extend and pretend’ when it comes to dealing with borrowers, which may fuel a rise in distressed activity?

Cyganowski: Right now, it does not look like banks are eager to change what have become the operative rules of the game. Banks will likely continue playing ‘kick the can’. At least for the near future, loan extensions will remain the norm, as opposed to declaring defaults and forcing involuntary bankruptcies or liquidations. It is important to remember that the legal process is a two-edged sword from the vantage point of the financial players. Going to court brings finality and also allows all constituencies to be heard, both of which are critical to a mega bankruptcy. However, the finality that the legal process brings also comes with large concomitant costs. As we have seen, bankruptcy did not save the Twinkie – at least for the 18,300 employees who had hoped to keep their jobs.

van Dommelen: As there is no clear light at the end of the tunnel, banks have accepted that the ‘wait and see’, or ‘amend and extend’, strategy has failed and that the financial restructuring of troubled companies is now inevitable. This is also reflected in the volume of work that we have been involved in regarding distressed credits. The likelihood of more distressed activity is increasing, given the large number of leveraged loans being downgraded and the wall of maturity. However, the big question is whether banks will be pressured to sell.

Gereghty: The ‘extend and pretend’ phenomenon has bought runway for corporations to correct their business models, to grow into their balance sheets, and to right-size their capital structures. In the US, where the market is further along, ‘extend and pretend’ has also bought time for banks and other leveraged loan investors to work through assets and clean up their balance sheets. The temporal aspect of this phenomenon has moderated the pace of balance sheet sales activity and, in combination with the perception of declining broad market risk, contributed to a decline in overall default activity at the corporate level. With default rates hovering between one and two percent in the US and with persistent low interest rates, we do not anticipate a near-term increase in new distressed corporate activity. The market, however, continues to digest distressed activity from the global financial crisis, and M&A exits have become an increasingly important component of market activity. It should be noted that managers of collateralised loan obligations (CLOs) and asset management firms, not banks, make up the majority of leveraged loan holders in the US. In Europe, the CLO market holds a significant portion of outstanding leveraged loans and those lenders are rapidly approaching the end of their re-investment period, which may mean an increase in default activity in Europe as CLO managers are expected to be prohibited from extending loans in the near future.

Asimacopoulos: While there are exceptions, our experience continues to be that most banks would still prefer to avoid a write down, with zombie-styled extend and pretends being as popular as ever. This continues to be criticised for being short-termist on the basis that the credits usually come back requiring more radical surgery. The heat in the bond markets has, however, supported the banks’ position in a number of situations. If there is a wholesale change in the banks’ position then, without question, this will fuel a boom in distressed activity.

FW: Does distressed M&A seem to be concentrated in any particular sectors and industries?

van Dommelen: At the moment all sectors provide opportunities as no industry is immune to current market problems. Over the last few quarters, real estate businesses, financial industries and suppliers to government such as construction businesses have yielded a number of distressed investment opportunities. But in the months to come, we believe that the effects of new policies from governments will impact consumer confidence and thus affect sectors as broad as consumer products, retail, automotive and machine building.

Gereghty: The global financial crisis was driven by a rapid decline in asset prices in general and a decline in real estate valuations across residential and commercial properties in particular. Banks and other financial institutions were among the earliest and hardest hit. As a result, we have seen a tremendous amount of distressed M&A in this sector and expect to continue to see activity for the foreseeable future. Structures collateralised by real estate assets also came under extreme fundamental and technical pressure. Both the structures and many of the real estate sub-sectors have rebounded sharply over the past 12 months. Despite this rally, pockets of opportunity remain in certain sub-sectors of real estate and structured credit, and M&A activity is expected to continue for the next few years as the market works through distressed properties in the US and Europe. Of late, natural gas assets have experienced increased activity as the significant investment in shale, coupled with a market decline in pricing, has contributed to stretched balance sheets. Finally, we expect shipping to be an area of interest for the foreseeable future, as global growth and a significant decline in funding have impaired valuations.

Asimacopoulos: Real estate and financial services are the principal areas of activity at this stage. There have also been discreet disposals of divisions or businesses for many reasons, including the maintenance of compliance with covenants.

Cyganowski: Anecdotally, potential distressed M&A appears more likely among companies where the particular company’s assets have high intellectual property value. Kodak is a prime example. Kodak was a pioneer in film and cameras, but in January 2012, it filed a Chapter 11 petition. In part, Kodak was able to obtain debtor-in-possession financing because of the strength of its intellectual property rights. The outcome of the Kodak bankruptcy remains to be seen. The deadline for Kodak to file a plan of reorganisation comes up in February 2013. Retail operations with a recognised brand name are another industry segment worthy of examination. Going back to 2006, the Alberstons retail chain and operations were acquired by multiple investors including Cerberus, CVS and Supervalu. Its name and presence made it a viable candidate. Still, acquisitions may beget their own problems. In 2012, Supervalu announced that it was conducting a review of its own operations.

FW: Are financing markets supporting distressed M&A transactions? How are investors funding their deals?

Gereghty: As US high yield issuance has continued to increase over the last two years, purpose of use has expanded from refinancing to include general corporate purposes, dividends and M&A. During October 2012, M&A accounted for more than 21 percent of all issuance usage in the US, a number that is similar to the 2011 level of 22 percent. In Europe, the preponderance of high yield issuance has been the refinancing of existing debt. Equity markets in the US and UK have improved, creating an additional form of currency to fund acquisitions. Finally, capital in the private equity market has also funded distressed M&A, as many of the deals require substantial equity cushions in order to entice debt funding. Strategic partners are also funding acquisitions out of rising balance sheet cash positions as the search for margin expansion and return on equity leads to consolidation of competition.

Asimacopoulos: There are ample funds available for distressed transactions. We are principally seeing a combination of all equity funds, and debt (bond and bank) and equity funds.

Cyganowski: Given the transaction costs and the flight to quality in the broader market, distressed M&A is an expensive proposition. It requires an appetite for risk that money-centre banks are not showing these days, and given the current regulatory environment, this reluctance is understandable. Still, the financing of distressed M&A does take place, but the sources tend to be non-traditional lenders. This means that the lender will likely want favourable loan covenants, sufficient collateral and, where possible, guarantees and additional protection. It goes without saying that actual and projected revenue streams will matter to the lender. In the absence of a favourable revenue stream, a would-be lender will likely balk at acquiring a distressed company.

van Dommelen: There is a significant difference in market conditions between middle market deals and larger market deals. We see that in the low to middle market space there is still appetite, for the right credit and deal structures, but for the larger deals financing is difficult. Non-bank funding such as high yield bonds, insurance companies, private investors and sovereign wealth funds could provide the solutions in these cases. These non-bank funders may be complementary to the traditional credit providers or could be the alternative financing source.

FW: To what extent are distressed investors becoming more sophisticated and employing innovative strategies and techniques to get deals done?

Asimacopoulos: It has become necessary for investors to be prepared for, support, and employ creative and legally unprecedented tools to get deals done. In Europe, the combination of each jurisdiction having its own legal regime and finance documents governed by law of a particular jurisdiction gives rise to unique challenges which have, this cycle, been overcome to good commercial effect.

Cyganowski: Distressed investors appear to be employing a two-track strategy. First, there is the out-of-court route. Bankruptcy is an expensive process that can make a distressed acquisition unaffordable, except in the case of larger companies, which reflect a significant amount of assets on their balance sheets. Consequently, many distressed companies look to work with potential sources of capital outside of a Chapter 11. On the other hand, Section 363 of the Bankruptcy Code offers a path for distressed companies that possess sufficient resources, or, where the distressed deal requires greater certainty in terms of eliminating future unknown obligations. The Chrysler and General Motors bankruptcies and the use of Section 363 have demonstrated that under the right circumstances Section 363 can become the right vehicle for salvaging a distressed company.

van Dommelen: Over the last year we have seen a lot of investors lining up resources focusing specifically on distressed opportunities to come. In particular, US hedge funds and private equity firms like Apollo, Oaktree Capital and Avenue Capital have set up offices and raised funds to prepare for opportunities in Europe. This has created a level playing field not seen before in Europe.

Gereghty: Activist lenders have continued to use 363 sales, UCC 9 dispositions and credit bidding as techniques to control, and ultimately take over, a process or sale of a company or business through bankruptcy. In addition, challenges to valuation assumptions in a plan of reorganisation have distributed ownership stakes across lender groups, ultimately transferring or diminishing control. All of these techniques have contributed to the increasing volume of M&A activity in the US. Stalking horse protections in the US have assisted potential suitors in the quest to acquire assets through the ability to direct the process on favourable terms. In Europe, untested changes to bankruptcy laws in Germany, Italy and Spain have contributed to unforeseen errors and longer, more difficult processes. As such, strategic partners and financial sponsors have increased their levels of sophistication to improve the likelihood of successful outcomes and potential sellers have tried to avoid missteps that could lead to insolvency proceedings. Finally, the use of litigation strategies in contentious insolvency proceedings has increased as distressed investors attempt to affect a desired outcome.

FW: Could you outline some of the major legal issues that come into play when acquiring distressed assets?

van Dommelen: Like in any M&A deal, you want to minimise the risks attached to the assets. Particularly for distressed M&A, diligence is focused on understanding what the key assets are you want to acquire, and carving out the liabilities to the extent possible. But for the European market this can be complicated to do, as bankruptcy laws differ from country to country.

Gereghty: Untested changes to the legal frameworks in Germany, Italy and Spain are among the largest legal risks in distressed M&A in those countries, but as time passes and the new frameworks are interpreted, these risks are expected to dissipate. Fiduciary responsibilities in certain jurisdictions complicate potential activities as directors may bear personal liability to stakeholders for actions taken on their watch. This can confuse the process as directors have a fiduciary duty to maximise recoveries to all constituents but must also be cognisant of stakeholders’ rights in these jurisdictions to seek remedies against personal property. Finally, in the US, successor liability is a significant issue in the case of an acquisition of an entire organisation or if the purchase and sale agreement explicitly includes the purchaser’s assumption of certain liabilities.

Asimacopoulos: The pressure on directors to file for insolvency in times of distress is something that needs to be carefully managed. In addition, the ease of being able to acquire the assets clear of encumbrances and out of the money liabilities often requires consent of relevant stakeholders or a restructuring/insolvency process that can be value destructive if not managed carefully. Also, the positions of other stakeholders should be taken into account, including their ability to adversely impact the transaction and how to work around them. Finally, the level of diligence is often less than desirable, so understanding the risk appetite is key.

FW: What challenges tend to surface when valuing distressed assets and negotiating a purchase price?

van Dommelen: When valuing the distressed asset the difficulty lies in understanding the company’s potential performance after the business has been restructured, and the time and investment it takes to get there. Obviously, this leads to higher levels of risk surrounding the investment decision. A thorough understanding of what went wrong, what needs to be done from an operational perspective to restructure the business, and the chances of making the firm competitive again as well as the growth potential going forward needs to be assessed. From a technical perspective, it is important to rely on meaningful multiples including transactions of other distressed businesses, but cross-checks with your DCF calculations and sensitivities are even more important.

Gereghty: Access to reliable data to assess an acquisition is paramount in distressed M&A. Many acquisitions involve businesses that are part of larger organisations, and reliable independent information on these targets may not exist or may be incomplete. If the target business is not a public organisation, pricing can be complicated as third parties may be hired to determine a range of value; however, if the range is based on uncertain data, the valuation may be imperfect and subject to disagreement. Both assets and liabilities may not be easily identifiable, which may lead to prolonged discussions over the definition of what is actually for sale. Finally, accounting standards may differ across countries and organisations, which can further complicate the negotiations.

Cyganowski: In acquiring distressed assets, both the prospective seller and buyer confront the initial issue of whether to acquire the company or its assets inside or outside the Chapter 11 process. Bankruptcy presents advantages such as the protection of Section 363 and disadvantages, particularly that of up-front costs and the potential need for DIP financing. Regardless of the selected path, a buyer faces the issues of successor liability. Here, bankruptcy may offer additional protection by cutting-off successor liability or paving the way for a release of the debtor’s liability. Distressed asset M&A frequently brings with it the need to redefine and address the challenges and competing interests presented in the target business’ capital structure. Bankruptcy is a tidier method for achieving capital and legal restructuring, but it is not always worth it, particularly at the mid-market point. Bankruptcy presents a distinct advantage where there is a large community of creditors whose distinct interests may block restructuring, in large part because the court has the decision-making authority to resolve issues which the parties could not resolve amicably. In particular, in situations like these, court-supervised mediation may be an advantage that is otherwise unavailable outside of the Chapter 11 process. Getting two parties to a table is difficult enough. Bringing multiple parties together is made easier by court-mandated mediation with its attendant force of legal sanction. Court-supervised mediation is codified in many jurisdictions, including the Southern District of New York.

FW: Due diligence is key to managing risk and uncovering potential liabilities, but made more difficult given the time constraints of a distressed transaction. How can investors overcome this problem?

Gereghty: Due diligence is always important in assessing the viability of a distressed M&A transaction, but sometimes time constrains the ability of the acquirer to perform an in-depth analysis. It is in these circumstances that a buyer must assess the expected return and evaluate the risk in order to determine whether or not to proceed. If time is of concern, asset purchases, as opposed to the acquisition of an entire organisation or business entity, can minimise the issue of unforeseen liabilities. This strategy allows the buyer to focus on identifying and evaluating the assets, leaving the seller with the liabilities. A careful drafting of the purchase and sale agreement can further alleviate the stress of unforeseen liabilities as the document can outline the liabilities the buyer is willing to acquire or those for which the seller is willing to indemnify the buyer. While there is often a way to reflect certain risks in the purchase price, ultimately you have to know when to just walk away from a deal.

Asimacopoulos: Try to front load your understanding of the company such that, when it comes time to execute the transaction, you are already ahead of the curve and ahead of other competitors. Also, try to obtain additional protection in documents such as indemnities and warranties.

Cyganowski: Tight schedules certainly complicate due diligence and, as the question implies, there is no neat comprehensive solution. In the face of a compressed due diligence schedule, parties should avail themselves of electronic databases, internal corporate records and interviews with key personnel of the intended target. Additionally, the distressed company’s existing creditors serve as a valuable information source. The question is, without a court-mandated process, how much cooperation can an investor expect to receive from this particular community? Within a Chapter 11, due diligence may be aided by a first-day order that enumerates deadlines and provide an opportunity for diligence and inspection. Again and not surprisingly, a court supervised process tends to provide for greater transparency, and, when time is of the essence, easier access to needed information is highly valuable.

van Dommelen: It is true that due diligence of distressed assets is very much driven by the time that is left to do a deal. At a minimum the due diligence is focused on short and long-term liquidity requirements the business has, but, given that representation and warranties are often limited, the sponsor and the banks may require more detailed analysis of what led to the company’s past problems. In the end it comes down to the trade off between gaining more time to perform diligence by stabilising the business and the appetite for risk that investors have.

FW: What is the outlook for non-performing loans and distressed investing going into 2013?

Asimacopoulos: Many companies are struggling and will fail to recover in 2013. This is due to a variety of factors, including the macroeconomic environment, and the debt owed by these companies will simply be unable to be paid in full. As a result, the outlook is that there will be increased distressed activity. However, due to the maturity wall being pushed out and bond market activity, we do not believe the levels of activity will be greater than in 2012 or 2011.

Cyganowski: For now, the outlook is to expect more of the same. Financial entities are sitting on large cash reserves and the current environment does not indicate that these reserves will be aggressively tapped any time soon. Still, market volatility may provide opportunities and entice players to get off the sidelines and back into the market. In assessing the demand for distressed debt, it is also worth remembering that distressed debt is no longer limited to corporations. There is also an ample market in distressed sovereign debt which means that the menu for distressed debt has grown and competition for investors’ dollars has increased. As always, prospective returns and yields will need to match the risks posed by these investments.

van Dommelen: Although there is an astronomical sum of distressed debt sitting on the balance sheets of banks, of which part needs to be trimmed off to increase capital buffers, the question is whether lenders will be pressured to clean up more next year. Over the last few years we have seen that regulators, banks and governments are manoeuvring prudently to sell the assets in an orderly fashion. So we expect banks only to sell what they can while limiting the damage. The necessity to sell will change, obviously, if interest rates rise, but this is presently not foreseen in our market. For Southern Europe this is different of course. For the distressed market as a whole we believe that the increase in transactions will continue, as the economy is not growing and consumption will fall, fuelling the likelihood that debt used to finance acquisitions or leveraged buyouts will need to be restructured.

Gereghty: Despite two significant flare-ups in Europe, a hotly debated budget crisis in the US, continued civil unrest in the Middle East and increasing tensions between Asian nations in the South China Sea, capital markets appear to have stabilised and, in many cases, improved since the summer of 2011. Actions out of the central banks throughout the developed world have eased fear in the markets and helped position institutions to survive the series of extreme events that have followed the global financial crisis. A continuation of central bank activism is priced into the markets for the foreseeable future, and we believe the recent stability will continue. Interest rates are expected to remain low and prices should adjust to this reality if they haven’t already done so. Despite these positive sentiments, we continue to exercise prudence as we evaluate distressed opportunities in the US and Europe. With default rates persisting at below long-term averages and significant capital dedicated to distressed investing, the market may be tempted to lower expected underwritten returns to access deal flow. We refuse to believe this is a prudent strategy and will continue to invest opportunistically in deals where we can assess a situation and create a risk adjusted return profile that is positively asymmetric, allowing for greater upside potential than downside risk.

Kon Asimacopoulos is a partner in the European Restructuring Group of Kirkland & Ellis International LLP. He acts for a range of stakeholders in national and international financial restructuring, insolvency and complex dispute resolution matters, for debtors and insolvency practitioners of national and multinational corporations in cross-border insolvencies and reorganisation transactions, and for debt and equity investors in par, stressed and distressed transactions. Mr Asimacopoulos is recognised as a leading corporate restructuring and insolvency lawyer.

Prior to joining Otterbourg, Steindler, Houston & Rosen, P.C., Melanie L. Cyganowski served for 14 years as a US Chief Bankruptcy Judge for the Eastern District of New York. Ms Cyganowski is a member of the executive committee of the Commercial & Federal Litigation Section of the New York State Bar Association, a member of the National Conference of Bankruptcy Judges, a Fellow of the American Bar Foundation and a director of the New York Institute of Credit

Rick van Dommelen is responsible for PwC’s Netherlands Delivering Deal Value team with a focus on Business Restructuring and Operational Consulting. He advises clients on operational and financial aspects of transactions, for example business restructurings, carve outs, business improvements, and synergy reviews, and provides merger advice.

James Gereghty is a managing director at Siguler Guff and is head of Distressed Investing for the firm. Mr Gereghty is responsible for investment selection and monitoring, asset allocation, due diligence and portfolio risk management. He is a member of the Investment Committees for the firm’s Distressed Opportunities Funds and Distressed Real Estate Opportunities Fund. Mr Gereghty has over 16 years of capital markets experience, 13 of which he has spent focusing on distressed debt and private equity.

THE PANELLISTS

Kon Asimacopoulos

Kirkland & Ellis International LLP

Melanie L. Cyganowski

Otterbourg, Steindler, Houston & Rosen, P.C.

Rick van Dommelen

PwC

James G. Gereghty

Siguler Guff & Company, L.P.