Buy Distressed Companies
3. Take Steps To Protect Against a Fraudulent Transfer Challenge. If assets from a distressed target are purchased prior to a Chapter 11 filing, a significant risk the entrepreneur buyer faces is a subsequent fraudulent transfer challenge. Under federal law, state law and/or the Bankruptcy Code, the sale can be avoided (i.e., set aside) upon a showing by dissatisfied creditors or by a bankruptcy trustee subsequent to a bankruptcy filing that there was "actual" fraud (i.e., the sale was actually intended to hinder, delay or defraud creditors) or, more likely, "constructive" fraud (i.e., the sale was made for less than fair consideration or reasonably equivalent value and the target was insolvent at the time of, or rendered insolvent by, the sale). Indeed, this was precisely the ruling in the recent Tousa Inc. case in federal court in Florida (see The Wall Street Journal article ">here). Moreover, Section 544 of the Bankruptcy Code permits a bankruptcy trustee to utilize applicable state law to avoid such transfers for "reach-back" periods of six years or more. To minimize this risk, a buyer must do two things: (i) build the best possible record that "fair consideration" or "reasonably equivalent value" was paid (e.g., by obtaining a fairness opinion from a reputable investment bank); and (ii) require that (A) the sale proceeds stay with (or be used for the benefit of) the target and not be distributed to the target's stockholders and/or (B) adequate arrangements are made to pay-off the target's creditors.
buy distressed companies
4. Sign and Close Simultaneously. Another significant risk the entrepreneur buyer faces when acquiring a distressed business in the non-bankruptcy context is the possibility of the target's Chapter 11 filing after the purchase agreement has been executed, but prior to closing. In such event, the target would have the right to "reject" the purchase agreement, and the buyer would merely have an unsecured, pre-petition claim against the target for its damages (often worth pennies on the dollar). Conversely, the target would also have the right to "assume" the purchase agreement thereby locking the buyer into a deal that, perhaps, may not look so good after weeks/months of the deterioration of the target's business. (Not to mention the possibility of a significant time delay in waiting for the target's decision of rejection/assumption.) The best way to eliminate this risk is to sign and close the acquisition simultaneously.
5. "Hold-back" or Escrow a Significant Portion of the Purchase Price. If the distressed target files for bankruptcy after the closing of the acquisition of its assets, the buyer's claim for a purchase price adjustment and/or indemnification under the purchase agreement will be treated as an unsecured, pre-petition claim (again, often worth pennies on the dollar). Indeed, certain indemnification claims may be disallowed if they are contingent at the end of the Chapter 11 case. Absent a guarantee from a creditworthy affiliate or stockholder of the target (which will obviously be difficult to obtain), the best way a buyer can protect against this risk is to hold-back or escrow a significant portion of the purchase price. An escrow/holdback is often used in connection with the acquisition of a healthy private company (typically 10-15% of the purchase price); however, if the company is distressed, the buyer should consider a greater amount.
Earlier in the pandemic, our team identified the economic crisis caused by COVID-19 as a growth opportunity for businesses with the vision and the resources to take advantage. One such opportunity is the chance to diversify or grow by acquiring distressed competitors, suppliers, or customers.
States across America are beginning to re-open and restart their economies. Unfortunately, not all businesses will have survived COVID-19 and its impact on the economy. Some businesses have been unable to generate their pre-pandemic revenue for nearly a year and may be struggling to meet their fixed cost obligations. At the same time, federal lending programs, such as the Main Street Lending Program and the Paycheck Protection Program, have made available large amounts of low-interest financing. This creates an opportunity for businesses that have or have access to liquidity to purchase distressed businesses at bargain prices.
A distressed business is a business that cannot or is struggling to pay its financial obligations. Rather than purchasing the equity of a distressed business, it is advisable to structure the deal as an asset purchase. This allows the buyer to limit its exposure to risks related to both known and unknown liabilities, while assuming only the desired assets.
The main concern when purchasing the performing assets of a distressed business is that the seller may then declare bankruptcy and creditors will attempt to avoid the sale as a fraudulent transfer. The trustee can avoid any transfer occurring within two years of the seller filing bankruptcy if there is (1) actual fraud or if (2) the transfer is for less than the assets are worth when the seller was insolvent or was made insolvent by the sale. Obtaining a fairness opinion from an investment bank that demonstrates the transaction was for fair consideration can help a buyer avoid this pitfall.
Another way to reduce the risk of buying a distressed business is to require a large portion of the purchase price to remain in escrow. This allows the buyer to more easily recoup costs stemming from a post-closing issue and to cover indemnification agreements. The indemnification agreement should cover any breaches of traditional representations and warranties, as well as any costs that stem from creditors seeking to void the conveyance. Without a significant holdback, it will be difficult to seek repayment because the entity holding the remaining assets may be worth only pennies on the dollar.
Purchasing any business comes with risks and rewards. Those same risks and rewards are magnified when purchasing a distressed business or purchasing a business out of Chapter 11 bankruptcy. You will want an experienced team on your side to help assess and minimize any risks associated with the transaction.
We understand from our ongoing engagement with UK corporates that stakeholders are considering options available to either protect their financial involvement or implement a strategy that maximizes realizations. As a first step, stakeholders, including lenders, investors and management teams, who cannot see how they can continue with a financially troubled business often look to implement what has become known as a distressed accelerated merger and acquisition (AMA) strategy.
The value of a distressed business tends to diminish slowly at first, but more quickly the longer the process continues. Often, in distressed situations, the value breaks in the debt stack and an AMA strategy is encouraged by concerned stakeholders who may have a different view of value. Usually, with the approval of the concerned stakeholder, a restructuring professional will be retained by a company to handle a time-critical disposal. At the first meeting, the appointed advisor will seek to obtain as much information as possible to formulate the most appropriate AMA strategy. The key questions they will ask are:
With any level of distress comes an equal level of opportunity. Distressed businesses can offer great value, but, as a buyer, if you make a mistake along the way, a distressed acquisition could cost you more than you bargained for.
With the current environment of high inflation, rising interest rates, major geopolitical concerns, volatile stock markets, supply chain disruptions, and other economic headwinds, we should expect to see an uptick in distressed M&A activity in the near-term as prospective buyers seek to take advantage of reduced valuations and opportunities to acquire businesses that may be facing financial or operational challenges. Of note, Bloomberg reported recently that approximately $246.6 billion of dollar-denominated corporate bonds and loans in the Americas are trading at distressed levels (i.e., below 70 cents on the dollar), growing to a size not seen since November 2020, with the telecommunications, retail, software, health care services, and pharmaceuticals sectors having the greatest amount of that debt. In addition, the Economist recently reported that funds have raised approximately $500 billion in anticipation of distressed investment opportunities.
Distressed businesses may be unable to obtain payment deferrals, engage in refinancings to pay off maturing debt (particularly where rates have increased dramatically from historic lows), or access the capital markets efficiently and, as a result, they may be forced to engage in M&A transactions. Prospective buyers should be prepared to capitalize on an opportunistic strategic transaction, as there often is an advantage to moving fast in a distressed situation.
In any M&A transaction involving a distressed business, however, it is important to analyze the potential benefits and risks of working with a company that might end up in bankruptcy and to be in the best position to evaluate when and how to engage with the target company, whether through an out-of-court transaction, a transaction executed pursuant to the U.S. Bankruptcy Code, or otherwise.
Financing contingencies put prospective buyers of distressed businesses at a severe disadvantage. Accordingly, if a prospective buyer needs financing to consummate the transaction, it is paramount to secure committed financing at the outset.
One of the first things a prospective buyer of a distressed business needs to decide is the nature and structure of the transaction. These transactions can be effectuated with or without a bankruptcy of the target company. Understanding the key benefits and detriments of an out-of-court acquisition versus an acquisition executed through bankruptcy is imperative and case-specific. Key considerations include price, potential liability, timing, the risk of competitive bids, and keeping the supply, customer, and employee bases intact. 041b061a72