Possibilities and pitfalls: navigating distressed M&A

August 2024  |  FEATURE | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

August 2024 Issue

Distressed mergers and acquisitions (M&A) transactions are a subset of M&A that presents parties with a unique set of risks and opportunities. Distress may range from a company needing to engage in early-stage discussions with lenders and financiers, to restructuring negotiations, to an urgent need to appoint insolvency specialists.

In the current climate, where economic instability abounds, companies are encountering challenges in staying financially viable, resulting in a rise in both accelerated and distressed sales. Since distressed M&A occurs when a company is in financial turmoil, usually facing insolvency, the acquisition process can be far more intricate, stressful and demanding on parties compared to a traditional transaction.

Trash or treasure?

Though 2023 saw a decline in overall M&A activity, distressed dealmaking experienced an uptick. Financial sector acquisitions driven by banking failures featured prominently in the first half of last year.

There are many factors driving distressed dealmaking. For example, companies that borrowed with the expectation of higher returns may find themselves struggling to repay debts due to lower-than-expected growth.

“While a wide range of sectors are under stress, there are some, including commercial real estate, retail, hospitality and certain other emerging industries that have exposure to multiple pressures, leading to growing financial burdens and, in some cases, existential questions about their ability to continue as a going concern,” suggests Angela Blake, a partner at Bennett Jones LLP. “The increase in distressed businesses creates significant opportunities for investors, particularly those that can see potential in current valuations and have capital to deploy.”

Indeed, there have been heightened levels of distress across a number of regions, including Australia.  “According to insolvency statistics published by the Australian Securities and Investments Commission, in the nine-month period from 1 July 2023 to 31 March 2024 there was a 36.2 percent increase in the number of companies entering external administration, as compared to the previous corresponding nine-month period,” says Peter Bowden, a partner at Gilbert and Tobin. “The industries which we see as being particularly challenged right now are retail, construction, health and property.

“A far more assertive and proactive Australian Tax Office (ATO) is putting increased pressure on many businesses which may, up until recently, have avoided the need to proactively address financial difficulties on the basis that large and influential creditors such as the ATO and retail banks have not been actively taking enforcement steps,” he adds.

To a degree, the conditions that may compound adversity for businesses also amplify the risks for potential acquirers. “Uncertainty and volatility remain defining characteristics of the current market, where macroeconomic challenges, such as higher-for-longer interest rates, geopolitical tensions, inflationary pressure, increasing regulatory scrutiny and lingering effects of the pandemic, continue to put a damper on M&A activity,” says Ms Blake. “Ongoing valuation gaps and the fact that predicted lower interest rates have not yet materialised have unexpectedly kept many buyers and sellers on the sidelines.

“Financial sponsors are facing additional headwinds from demands for distributions by their limited partners, pressure to deploy capital, and, for a significant number, rapidly approaching end of life maturity walls, all of which are creating pressure to transact under suboptimal circumstances,” she adds.

Yet, acquirers seeking opportunities in the current market may benefit from potential significant discounts – if they look for assets in industries that they understand, engage with external administrators early and can transact quickly. “In distressed M&A, the selling counterparty is typically insolvent and will usually not be able or prepared to give the types of contractual protections – in the form of representations and warranties – that ordinary buyers may be used to and may expect in a solvent scenario,” says Mr Bowden. “In addition, vendors will typically be looking to transact on a compressed timetable which limits the opportunity for extensive diligence. This can, however, provide an opportunity for those investors who are already familiar with the insolvent business, as they will be far more advanced than other bidders which may allow them to transact with more speed.”

Deal structuring – challenges and considerations

While all M&A transactions present unique challenges, distressed deals can be far more intricate, stressful and demanding for the parties involved. There are areas of increased risk compared to traditional M&A.

Among the areas which must be considered when structuring a deal, valuation is typically the most pertinent. “Often the vendors will look for guidance as to value from interested parties, so bidders need to assess value early in the sale process and may be able to leverage certain factors, such as there being a limited market for the business or assets being sold, to their advantage,” suggests Mr Bowden. “In addition to value or consideration, investors can also differentiate themselves from other bidders by offering contractual protections over and above the usual representations and warranties, which can provide additional deal certainty to the seller.

“This can be particularly valuable when the seller is operating the business within tight funding constraints. For example, the ability to offer parent company guarantees, to provide compelling proof of funds, to limit the number and complexity of any conditions precedent, or to offer additional upfront consideration rather than deferred consideration, will often weigh heavily in favour of a bidder,” he adds.

In terms of valuations, the current valuation gap may increase post-closing litigation risk for companies on the brink of insolvency, according to Ms Blake. “In these circumstances there is increased stakeholder scrutiny and pressure on parties to demonstrate that the purchase price is reasonable – but it may be difficult to source a supporting third-party valuation,” she points out. “This can potentially be mitigated by a robust marketing process that provides evidence of what interested buyers are actually willing to pay.

“Whether a target can be sold as a going concern can also significantly impact valuation and the determination of what transaction structure is most appropriate,” she continues. “Strong corporate governance, coupled with sales processes managed by seasoned restructuring advisers, are key to reducing post-closing litigation and business transition risk.”

Also important is due diligence. Buyers need to identify which aspects of the business are material to their objectives and whether there are financial consequences that may impact valuation – for example environmental liabilities or bribery concerns.

However, given the shortened timescale of a distressed deal, investors may be unable to conduct extensive due diligence on the company or assets they are acquiring. Typically, little or no due diligence is carried out. “Buyers may be faced with highly compressed diligence periods and completion timelines, lower quality information and fewer deal protections, with many transactions carried out on an ‘as is where is’ basis,” says Ms Blake.

Buyers should then focus any limited due diligence on matters of specific material importance to them. These could be financial or legal, perhaps environmental, social and governance (ESG), or may involve assessing key employees of the business.

“The transaction will almost always be on an ‘as is where is’ basis, so this needs to be considered and factored into the legal documentation,” says Mr Bowden. “There are also complex legal systems in place that underpin restructuring and insolvency situations – these can drive the objectives of the counterparties and need to be fully understood. Typically, there is also a need for transaction speed and certainty, particularly from an external administrator’s perspective.

“Both sides are incentivised to move quickly, particularly in the context of a sale of a going-concern business, and this can create opportunities for bidders to trade value or consideration for speed and certainty,” he continues. “Conversely, the need for post-completion support from the external administrator – such as the provision of certain services on a transitional basis – may weigh against a bidder.”

Transaction certainty is also a fundamental concern when structuring a deal, according to Ms Blake. “For sellers, speed to closing becomes increasingly important as their financial position deteriorates, when there is less time to triage avenues to restore financial health before facing an insolvency scenario,” she observes. “A drawn-out process could force a seller into an untenable position financially, while a failed process could indelibly taint it, making it no longer attractive to other purchasers.

“A company in the early stages of financial distress will have more optionality, including the potential to run a traditional sale process that may lead to a higher valuation and superior stakeholder recoveries,” she adds.

As with any transaction, various stakeholder groups must be considered, and their interests factored into the deal. “When faced with a range of stakeholders with myriad and often conflicting interests, emotional intelligence and consensus building can be vital to getting a deal done in what is often a zero-sum game where everyone wants the best result they can get,” says Ms Blake. “Investors and their advisers should seek to build relationships with sellers and their advisers that can be leveraged to gain insight into the disparate personalities, desires and dealbreakers of these groups, as well as their respective levels of influence on the transaction.

“While some will clearly be critical from a financial perspective, such as large, secured creditors that may or may not be willing to sell their debt at a discount, there may be less obvious players that wield significant influence among others, or that are ready and able to use social media or other public forums to loudly voice their discontent, leading to potential deal delays and value destruction. A strategic approach that prioritises open dialogue and transparency can build trust and credibility, allowing investors to win the hearts and minds of key allies needed to get to a successful close,” she adds.

Regulatory scrutiny can also present complications for certain distressed deals. “Outside of matters within the control of the parties, recent increased scrutiny and intervention by regulators globally is adding another layer of complexity and uncertainty, particularly for cross-border transactions,” notes Ms Blake. “Early engagement of skilled restructuring advisers can help address legal and business issues as they arise to avoid future roadblocks to closing.”

To reach close, dealmakers have many options for creativity when structuring distressed transactions. In Canada, for example, the country’s corporate laws provide for balance sheet restructuring tools that can be used before resorting to formal insolvency or bankruptcy proceedings.

For Mr Bowden, given the range of potential challenges, investors must be prepared to consider ‘outside the box’ structuring ideas. “This may include loan to own or credit bidding, or super priority funding of external administrators,” he says. “Investors might also consider buying debt in order to obtain a front-row seat at the table. Unusual or alternative transaction structures can also enable an external administrator to satisfy some of its prescribed statutory objectives through the use of tools such as – in Australia – bespoke deed of company arrangements, for example, to facilitate returns to certain classes of creditors.”

Outlook

Economic and geopolitical uncertainty are likely to continue for the foreseeable future. “The market is busy, and we expect activity levels to increase significantly over the next 18 months,” predicts Mr Bowden. “We expect that in the immediate future, the retail, construction, health and property markets will continue to face strong headwinds.”

Ms Blake is also seeing a significant uptick in formal bankruptcy and insolvency proceedings. “However, many creditors are opting to temporarily waive defaults and entertain customary forbearance agreements, particularly when they see long-term upside for the business or general sector recovery, or where they are facing their own financial challenges and want to avoid engaging in lengthy and costly formal proceedings, or taking a write down on assets that will weaken their balance sheet.

“Notwithstanding ongoing turbulence, expectations remain optimistic that pent up buy-side demand will continue to bring dealmakers to the table at an accelerating cadence, leading to an increase in both distressed and traditional M&A activity as we move through the second half of 2024 and into next year,” she concludes.

© Financier Worldwide

BY

Richard Summerfield