June 2020 Issue
FW discusses distressed M&A with Jerry C. Dentinger, Mark H. Malooly, James J. Loughlin, Jr, Anthony I. Alfonso and Bob Snape at BDO.
FW: Could you provide an overview of how current upheaval and uncertainty around the world is shaping the distressed M&A market? How would you describe activity levels and investor appetite?
Dentinger: Activity has already started and continues to gain momentum in the obvious industry segments most severely impacted, including energy and consumer discretionary income-driven industries, such as restaurants. As companies work through applying for stimulus funds, negotiating forbearances with lenders, implementing furlough programmes and negotiating with customers and vendors, distressed deals have just begun to emerge but appear poised to ramp up during Q2 and thereafter. A significant influx of companies is expected to enter the distressed M&A marketplace, given that the current crisis impacts every sector in the economy. Investor appetite has already surfaced, and interest is expected to become increasingly robust as both distressed investors and well-capitalised market leaders look for opportunities to expand footprints and capabilities.
Malooly: From a tax perspective, even in the absence of deal flow, this is a time for companies to take a close look at their tax profile. There may be opportunities to not only reduce their current tax expense, but also possibly obtain cash tax refunds as a result of recent changes in the tax law. Likewise, companies should also be cognisant of tax costs associated with any debt workouts to the company and its investors. This is an appropriate time to review such considerations, because value can often be found in the tax attributes of distressed companies, and deal activity is expected to bounce back during the coming weeks and months.
Loughlin: The current upheaval and uncertainty have had a chilling effect on the M&A markets in the US. Numerous transactions have been cancelled or deferred. Investors currently are unable to completely assess the impact of coronavirus (COVID-19) on the target’s revenue, profitability and cash flow. As one would expect, this makes valuation nearly impossible. At the same time, many of the lenders that have been financing leveraged M&A transactions are essentially closed for business. Many firms and their lenders are assessing their own portfolio companies’ issues as well as the capital required to support their operations. For the past few weeks, the focus has been on ‘triage’ as opposed to entering into new transactions. Activity in the US has been largely limited to distressed investing to support ‘asset-rich’ but troubled corporations, such as airlines, cruise lines and other similar business.
Alfonso: Distressed deals are getting done, but investors are being cautious. Do not expect investors to jump right in. Some are sitting on the sidelines for the right deal to come in. And as the economic outlook becomes clearer, deal activity will rebound.
Snape: The upheaval is unlike anything we have faced in the past. Just prior to the pandemic, most businesses in the US were not in jeopardy. Within a few weeks, demand for their products and services ceased, and many businesses immediately became distressed. To be clear, some companies are now more challenged than others, while some are doing even better because they produce and sell essential products and services. Right now, we are in an assessment phase, wherein distressed companies are trying to project near- and medium-term financial performance. This is very hard to do because it is unclear when, and to what degree, customers will return as the COVID-19 threat dissipates. Clarity regarding projected performance will be important before distressed investors can begin to invest in abundance. As such, distressed M&A investing is currently in the early stages, but it is likely to begin ramping up very soon.
“So far, it is proving to be more difficult to value distressed assets as overall economic challenges mount. The reliability of well-established valuation techniques is in question.”
FW: Which sectors and industries are currently experiencing hardship, and likely to present opportunities for acquirers to pick up distressed assets as markets continue to deteriorate?
Snape: There are certainly sectors and industries that have been hit harder than others. Some of those sectors have been under pressure for quite a while too, well before the pandemic. Brick-and-mortar retail is an example of this. Most retail storefronts in the US are now closed, and there is talk of numerous large retailers getting ready to file for bankruptcy. Energy is another industry under extreme pressure. Consumer demand for fuel is currently at a crawl and US freeways are empty, even during rush hour periods. US manufacturing is also under stress. Manufacturing is a capital-intensive sector and, absent demand, manufacturers quickly began to face liquidity challenges in early March. There will likely be substantial opportunity for distressed investors to make attractive returns in manufacturing, especially as the economy opens and as US companies begin to accelerate the onshoring of supply chains to reduce future disruptions.
Dentinger: While severity will be industry specific, the existing crisis will touch every sector in the economy, causing a significant influx of companies to enter the distressed M&A marketplace in the near future. Consumer discretionary sectors will lead, such as hospitality and leisure, restaurants, auto dealers and airlines. Equally important will be the impact on middle market and small business manufacturers that compose the underlying supply chains for these industries, with the expectation for considerable consolidation in the coming years across manufacturing.
Alfonso: Hospitality, airlines, cruise lines, retail, healthcare, oil & gas and restaurants are some of the hardest-hit industries. Overall, it is hard to find an industry that has not been impacted by the COVID-19 pandemic. This raises significant opportunities for acquirers to identify targets at favourable valuations.
Loughlin: Virtually all industries and businesses have been impacted in one way or another by COVID-19. With the exception of essential service providers, such as healthcare services and products and food stores, for the most part all other businesses have felt the impact of lower or zero revenue. With that in mind, there will likely be many opportunities for investors to pick up businesses at valuations that are significantly lower than a few months ago. It is unclear how long it will be until we are able to properly assess the business recovery and the resultant impact on future financial performance at many businesses. In addition, the availability and cost of capital will be important to assess as we move forward into the transition from COVID-19 to the new normal for most businesses operating in the US.
FW: What essential advice would you offer to a distressed investor evaluating prospects in the current market?
Dentinger: Manage the process with the expectation of owning the asset, and then design the diligence and integration plans accordingly. Validating the investment thesis and quantifying the COVID-19-related earnings before interest, tax, depreciation and amortisation (EBITDA) impact will be the means to refining the operating plan. Operational diligence will be needed to assess any impact on suppliers and the overall supply chain. Financial diligence will expand from working capital pegs to assessing cash flow needs, as well as the review of forecasts and business plans. The 13-week cash flow analyses traditionally reserved for turnaround situations are expected to become commonplace and the cornerstone for the post-close 100-day plan.
Malooly: Investors should make sure they have a good understanding of the value of the tax attributes of a company they are buying. They should particularly understand any limitations that may arise as a result of the transaction on the company’s net operating losses and amortisable assets. This is especially important when purchasing a distressed company, as these limitations can be significant.
Loughlin: My advice would be to focus on performing complete due diligence. The challenges are greater to ‘get it right’ in the current operating environment. Revenue and profitability will be very difficult to accurately forecast, given the lack of visibility on the timing to accomplish an economic recovery in the US. An in-depth assessment of operations will be critically important, including the effectiveness of the supply chain, access to raw materials and the ability to return to normal in the workplace, as well as employees, labour force, customers and suppliers. The assessment of current liquidity and the working capital needed to ramp back up are also likely to be important areas of diligence that investors will need to focus on.
Snape: Unlike many recessionary periods of the past, the current challenges for the newly distressed companies in the US involve a quick loss of demand, which in turn has led to significant liquidity challenges. This is the root cause. For the most part, it has not been about other common challenges, such as weak management teams, poor strategy execution, competitor threats or a variety of other issues that often plague troubled companies. So, distressed investors will need to understand when and in what manner demand will return, and then stress test those assumptions against the appropriate capital plan needed. In each case, a foundational understanding of the industry in question will be required, along with enough time and information to conduct extensive due diligence. It can be hard to do the proper diligence needed in the context of a 363 sale, so risk in those situations will be higher and, as a result, bids should be lowered to account for unknowns.
Alfonso: Do not jump right in due to dips in the market. Take a careful look at the entity-specific factors of the potential investment. Industries may be distressed in general, but investors need to look at the true value play within the industry.
“It is hard to find an industry that has not been impacted by the COVID-19 pandemic. This raises significant opportunities for acquirers to identify targets at favourable valuations.”
FW: Could you outline some of the latest techniques and metrics used to value distressed assets? Are current market conditions likely to make this process more difficult?
Malooly: For distressed companies, there is often potential value in their tax attributes, such as net operating loss and credit carryforwards, as well as tax basis. Any transaction undertaken with a distressed company can have an impact on these attributes, and it is important to take steps to quantify them, protect them and use them to the fullest extent possible. That is why tax needs to be integrated into the models for valuing distressed assets.
Dentinger: The current conditions necessitate a granular approach focused on cash generation and optimisation. Discounted cash flow (DCF) models can be built leveraging the 13-week cash flow model to design a roadmap for valuation ranges and hurdle rates. Diligence findings need to be baked into the models, and government programmes need to be considered. Various valuation approaches will be applied, but, like market multiples, risk premiums and growth rates will have wide ranges for the immediate future.
Alfonso: Instead of the typical base-, best- and worst-case financial modelling, there has been a lot of discussion regarding modelling for V-, W-, U- and L-shaped weighted recovery models. The challenge is what weightings to assign to each recovery. Also, the weightings can change on an almost daily basis.
Snape: So far, it is proving to be more difficult to value distressed assets as overall economic challenges mount. The reliability of well-established valuation techniques is in question. Discounting projected cash flows is hard to do for two reasons. Near- and medium-term demand is uncertain because we do not, as of this point, know how and when the economy will reopen. Then there is the challenge of picking an appropriate discount rate. Another technique, using publicly traded guideline companies, is also challenging given current market volatility, unclear performance guidance and the significant influence of Federal Reserve monetary policy on stock prices. Assuming a subject company is viewed as a going concern, using the cost approach on an in-place basis may be the most reliable as a baseline technique, subject to adjustment for the competitive tension of the distressed sale bidding process. This approach would favour strategic buyers, which often have synergies to apply.
“When structuring and financing distressed deals, tax plays a mission-critical role. Even small changes in how a transaction is structured can have significant tax implications.”
FW: How important is it to plan in advance and outline clear strategies to generate future returns? What considerations need to be made when structuring and financing distressed deals?
Snape: Clearly outlining strategies for return generation is critical to successfully invest in distressed assets. It is elemental to valuation and a key part of bid development. It should be based on detailed due diligence, as time permits, and include sensitivities for a range of possible trajectories. It should also reflect the reasonable requirements of the many constituencies typically involved in distressed situations – the judge, the debtor or trustee, debt holders, creditors and management – who can influence a closing. Such a plan benefits the structuring and arrangement of new financing too, as loan and investment committees look for clarity and an acceptable degree of confidence before providing funding approvals.
Dentinger: An approach that works backward from owning the asset is needed in compressed timelines. Build a strategy and, more importantly, an operating plan with specific tactics and metrics around capturing financial value. Credit markets will be tight for the remainder of this year, and any new leverage is already more costly and with fewer turns available. While well-capitalised strategic acquirers may be able to complete an all-cash deal, such structures are unlikely, given the uncertainty around their own future liquidity requirements. Financial sponsors may also be in a position to enter such structures, but these are likely to be related to add-on acquisitions as opposed to platform acquisitions, due to the current economic uncertainty. Structural options such as earnouts, seller notes and warrants may be an option to bridge concerns around valuation and access to debt, but such instruments are not always available within a distressed acquisition.
Malooly: When structuring and financing distressed deals, tax plays a mission-critical role. Even small changes in how a transaction is structured can have significant tax implications. Therefore, it is important to include tax advice in the structuring and financing from the outset. You do not want to find out at the end of the process that you have structured your way into a significant tax exposure, or that some of the tax benefits you were counting on will not materialise.
FW: With a narrow window for due diligence in distressed M&A, what can acquirers do to optimise transactional risk management and avoid potential pitfalls?
Loughlin: It is critically important that investors know the industry space they are assessing, including likely future operating scenarios and resultant revenue growth when the economy normalises. In addition, asset valuation is an increasingly important component to fully understand as part of the due diligence process. With future cash flows more difficult to fully assess, the hard assets underlying the business are likely to become a more important component relative to valuation in distressed transactions. Obviously, the value proposition for these types of transactions lies in the ability to pick up assets at low valuations. To the extent that the buyer fully understands the business and industry, and can properly assess asset value, that will help to get these distressed investment transactions across the finish line and avoid negative surprises.
Snape: Narrow windows for due diligence come with buying assets in bankruptcy. In these cases, an investor needs to use what time is afforded to conduct as much due diligence as possible, with a disciplined focus on identifying key risks and the issues that led to the distress. Insight into these issues will inform an investor’s bid and return potential. Such bids need to reflect the added risk of limited access though, to avoid overbidding and ultimately making a bad investment. Alternatively, the investor might also consider pursuing the role of stalking horse, which affords the opportunity for more extensive diligence in advance of the sale process, as well as influence over the bidding procedures, including the determination of break-up fees and other important financial safety nets. That role also provides for greater access to various constituencies involved in the process and transaction, which provides a significant advantage over other bidders.
Dentinger: Diligence should be designed with ownership in mind. Short time frames will bring laser focus on quantifying the COVID-19-related EBITDA impact and assessing the damage to the target’s operating model, including whether the loss in value renders the pursuit a non-starter. Thereafter, diligence resources should be allocated to the workstreams validating the key assumptions of the investment thesis.
Malooly: It is important to work with an experienced tax adviser early in the process, even before the letter of intent is signed. This gives the tax adviser more time to better focus tax diligence on the most significant items. In addition, as the structure of the transaction is often set forth in the letter of intent, acquirers should consider the tax implications of the structure before the letter of intent is negotiated and signed.
“Short time frames will bring laser focus on quantifying the COVID-19-related EBITDA impact and assessing the damage to the target’s operating model, including whether the loss in value renders the pursuit a non-starter.”
FW: What kinds of challenges can acquirers expect to face when negotiating with various stakeholder groups in a distressed scenario? In general, what steps do they need to take to overcome these challenges and close the deal?
Dentinger: Acquirers should work to understand which stakeholders have the most influence, if that is not immediately apparent in available documents around the company’s capital and debt structure. Establish communication plans to respond to the inevitable diligence trifecta: quality of information, access to management and compressed timelines.
Malooly: Each stakeholder is going to have a different tax profile, and often it is the case that what leads to a good tax result for one side will be less than optimal for the other side. The classic example is that buyers will often want to purchase assets to get a step-up in basis, whereas sellers will want to sell stock to avoid two levels of taxation, but there are many variations. Sometimes, these differing interests can be negotiated in a way that works for both sides, such as a gross-up payment from one side to the other for the tax cost of structuring the transaction a certain way. Tax modelling will be critical in this process.
Loughlin: Depending on how distressed the situation is, numerous stakeholders may have input into whether the transaction will move forward. To the extent creditors are going to be asked to settle their obligations at a discount, they will need to be consulted with, and approvals will need to be attained. Shareholder approval will be required for businesses where there may or may not be value available for equity holders. It may also be necessary for the company to go into bankruptcy, in order to implement a change in ownership or to get all creditors on board with a transaction. This obviously requires greater expense and time to complete a transaction. Creditors will have their say in court, and the bankruptcy judge will typically allow other potential buyers to present offers for consideration by the court. The bankruptcy process can become cumbersome and create issues for many buyers. We can expect to see many transactions accomplished in bankruptcy proceedings if the economy fails to recover quickly. Hiring experienced legal and financial professionals can help buyers successfully navigate through these processes.
Snape: There are many challenges, including aggressive and litigious secured and non-secured creditors, vendors and other constituents. Undisclosed liens, claims and unpaid bills can often be difficult to navigate. Falling sales, disgruntled customers and disenfranchised employees and management can also make pricing and negotiating a deal very difficult. Thorough financial and tax due diligence is essential to overcome these risk factors. In addition, carefully worded indemnification and insurance protections are critical to minimising exposure in the future. An asset purchase with specific excluded liabilities is necessary.
“There will likely be a significant volume of transactions in the distressed M&A space as companies struggle to service or refinance the debt that many of them have taken on over the past decade.”
FW: What are your predictions for the distressed M&A market over the coming months? What trends and developments do you expect to dominate this space?
Snape: The volume of distressed M&A is likely to expand significantly in the coming months. Some good companies that have unfortunately been idled by the pandemic will be forced into distressed transactions, either outside of or through the bankruptcy process, and, with the opening of the economy, will begin to dig out. It is not clear how much economic damage will have been caused, but certain businesses will return more successfully than others. Key sectors – such as tech, healthcare and, more generally, businesses involved in providing essential services and products – will likely do better and improve more quickly. The well-established historical trends in down economies will favour these sectors and industries that provide for non-discretionary products and services. It can also be expected that, due to a recent loss of profits, there will be more capital raise transactions and, in particular, non-control equity transactions as good companies seek to fund opportunities for growth and competitive advantage as circumstances improve.
Malooly: There are going to be new developments in the tax law. Significant changes came out of the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March 2020, including carryback of net operating losses, new rules on interest deductibility and more. We expect more developments. In times of change, tax rules will change as well. We saw this in the 2008 financial crisis and with the 2017 tax reform. It will be important to keep up to date on these changes as they develop, as they will present new tax opportunities and pitfalls.
Dentinger: Fundamentals indicate a significant volume of companies will become distressed in the foreseeable future, and their entrance into the M&A market will evolve in waves as the recessionary economics ripple throughout supply chains of multiple industries. A natural progression will be supplier consolidation across manufacturing in the coming years, led by automotive and aerospace.
Loughlin: There will likely be a significant volume of transactions in the distressed M&A space as companies struggle to service or refinance the debt that many of them have taken on over the past decade. Valuations are likely to be lower as a result of declining revenue and profitability putting pressure on lending relationships. Many lenders will likely opt for borrowers to either pay down debt with an injection of capital from ownership or seek to refinance or sell the business. This is a typical workout strategy. As a result of this scenario, there will be numerous opportunities in the distressed acquisition arena for smart money with ‘dry powder’ to take advantage of these challenging economic times and pick up businesses at favourable valuations.
Jerry Dentinger brings 25 years of turnkey deal experience guiding senior executives through all phases of an M&A transaction. At BDO, he is focused on delivering financial due diligence to private equity investors, strategic acquirers and debt capital providers. His experience comes from a diverse background in investment banking, corporate finance, public accounting and financial advisory, including expatriate assignments. He can be contacted on +1 (312) 239 9191 or by email: jdentinger@bdo.com.
Mark Malooly has more than 20 years of experience in the field of tax. He has worked on complex US federal income tax matters for a diverse and sophisticated client base in various industries, including hospitality, governmental contracting, telecom and media, power and energy, high tech and professional services. He is the southwest regional leader of BDO’s transaction advisory services (TAS) tax practice, which provides tax structuring, due diligence and consulting services to corporate and private equity clients. He can be contacted on +1 (214) 243 2991 or by email: mmalooly@bdo.com.
Jim Loughlin is the US practice leader for BDO’s business restructuring & turnaround services practice. He has more than 30 years of experience advising companies, lender groups and investors on performance improvement strategies and restructuring transactions. He has worked on some of the largest US restructuring cases, including serving in senior management roles and providing leadership during complex operational and financial restructuring matters. He has experience in retail, consumer goods, media and telecommunications, transportation and logistics, and healthcare. He can be contacted on +1 (212) 885 8097 or by email: jloughlin@bdo-ba.com.
Anthony Alfonso co-leads the BDO US corporate finance practice, as well as the firm’s global and domestic valuation & business analytics practice. He has more than 25 years of financial services experience providing valuation and transaction advisory services to a wide range of organisations and industries. Formerly an equity trader and investment banker, he brings capital markets experience when working with clients to provide valuation advisory services that achieve a range of business and strategic objectives. He can be contacted on +1 (602) 293 2358 or by email: aalfonso@bdo.com.
Bob Snape has over 29 years of investment banking experience, including M&A, debt and equity. He has successfully executed hundreds of M&A advisory engagements for a variety of clients, including family-owned businesses, Fortune 500 corporations and leading private equity firms. He has experience in leveraged recapitalisations, corporate divestitures, go-private transactions, management buyouts and exclusive sales. He has completed cross-border transactions, private placements and fairness opinions and provided strategic advice on dividend policy and share repurchases. He can be contacted on +1 (617) 239 4177 or by email: bsnape@bdocap.com.
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