Distressed M&A: Flipping the switch from risk to opportunity

Distressed M&A opportunities are expected to rise in the Australian market, with inflationary pressures weighing even heavier on businesses as a result of macroeconomic factors. In this article, we discuss what distressed M&A comprises and the key issues to consider from a buyer’s perspective. 

In brief 

• Distressed M&A generally falls into one of two categories – “solvent” sales or sales within a formal insolvency process – both have different considerations to navigate. 
• Distressed sales processes are often not binary, with processes commencing as ‘solvent sales’ often tipping into insolvency processes mid-stream. It is important for bidders to always have a ‘plan B’.
• Speed and certainty are critical in a distressed sale, and buyers will need to navigate the more limited due diligence as well as the potential need for interim funding.
• Transaction structuring can provide significant protection against the buyer taking on liabilities.

What is distressed M&A?

Distressed M&A generally refers to M&A undertaken when sale assets are subject to some degree of financial distress. It includes sales undertaken by administrators or receivers within formal insolvency processes as well as ‘solvent’ transactions where the seller pursues a transaction to address financial difficulties. In some cases, distressed sales can involve a ‘good asset’ being sold by a distressed seller in order to quickly raise cash, but more commonly the target business itself is under pressure.

Solvent or insolvent? 

Distressed sale processes often commence on the assumption that a solvent transaction is achievable. Sellers may initially believe there is sufficient equity value to support a sale that repays creditors in full (or avoids formal insolvency), particularly where there is a viable core business or a “good asset” is being sold to address short term liquidity pressure.

Companies invariably seek to avoid the impression of a distressed sale despite underlying financial stress. It is not always even clear whether a sale process is actually underway (and if so, who is running such process) as the process may be conducted quietly to avoid adverse attention. Strategic reviews or refinancing processes may also operate as stalking horses, generating unsolicited approaches from interested parties.

In practice, whether a solvent sale is achievable often only becomes clear as the process unfolds. Buyer feedback on price and terms may expose a gap between the seller’s expectations and what a buyer is prepared to pay once the risks, limited diligence and funding requirements inherent in a distressed transaction are priced in. That gap may widen further if trading deteriorates, key contracts or customers are lost, or interim funding is required to keep the business operating.

As a result, sale processes that commence on a solvent footing can tip into insolvency mid stream. 

For buyers, it is important to recognise that the solvent versus insolvent question is not binary. Price, conditions and any interim funding arrangements should be structured on the basis that the seller’s financial position and approach to sale may evolve rapidly, and that a “plan B” may be required.

The insolvent option

Where it becomes apparent that there is no solvent pathway, the board of the target entity will typically appoint administrators. Financiers with “all asset” security will often respond by appointing receivers (or taking steps to preserve their ability to do so outside the decision period). 

These processes can play out in a variety of ways depending on the specific circumstances and stakeholders. 

For buyers, insolvency processes present both advantages and challenges. On the one hand, they can offer greater certainty around liability containment (which can reduce the need to diligence those liabilities), provide access to statutory mechanisms to effect the transfer of assets or shares, and give buyers protection against clawback risk. On the other hand, insolvency is often regarded as damaging to the business, heightening risk of contract terminations and loss of key customers and suppliers (notwithstanding the ipso facto stay), with the potential for increased cost or execution uncertainty. 

Structuring

The type of transaction structure in a distressed M&A deal will typically depend on whether the seller/business is in a formal insolvency process, and the priorities of the parties (ie speed, deal certainty, process familiarity and / or cash runway). 

Below is an overview of the more common structures used to deliver control to a buyer in a distressed context.  

• Asset sale: where the buyer can ‘cherry pick’ profitable or desirable assets while leaving behind obligations and liabilities (and/or unwanted assets). If undertaken in a formal insolvency process, this can be done without a creditors’ vote (if the administrator is comfortable); 
• DOCA: if the company is in administration, a deed of company arrangement (where approved by the requisite majority of creditors) can compromise creditor claims and involve a sale of assets and/or a transfer of the equity. In practice, a DOCA allows for a share sale style transaction within an insolvency process, as debts can be compromised so as to return the entity to solvency;
• Hive down/carve-out: where the seller transfers specific assets and/or liabilities into a new company that is then sold to the buyer. This transaction structure takes on components of an asset sale and share sale, and shields the buyer from unknown liabilities that are not transferred; and 
• Debt for equity swap: where a creditor converts debt owed to it by a company into equity in that company in exchange for the cancellation (or reduction) of the debt. 

Creditors’ schemes of arrangement are also used in distressed scenarios but usually in ‘de-levering’ restructurings to reduce the finance debt rather than to deliver control of the company to a buyer (although this can sometimes occur in creditors’ schemes that involve a debt for equity swap).

Key issues 

Speed and certainty

The hallmark of a distressed sale is the need to transact quickly and a seller’s strong preference for certainty. 

Timing will be driven by the cash flow runway of the seller/business (including any options to extend that runway through additional funding), the rate of deterioration in the business while uncertainty prevails (the ‘burning platform’), and the time required to obtain any consents. 

Certainty in pricing and execution (ie no or limited conditionality) will also be prioritised by a seller. Consideration structures that involve a deferred or conditional component (eg earn-outs) are less likely to be attractive because of a distressed seller’s more immediate need for funds. Sellers / insolvency practitioners in a distressed M&A scenario will want a ‘clean’ exit.

‘As is where is’ and limited recourse  

Distressed assets are typically sold on an ‘as is where is’ basis with limited warranties. This means that where issues are discovered post-completion, a buyer has no or limited recourse to cover their loss. Even where a seller does agree to provide substantive warranties or indemnities those protections may offer limited protection in practice – in a distressed transaction the sale proceeds received by the seller will usually be paid out to creditors at or shortly following completion leaving little or nothing behind (whether or not the transaction is effectuated through an insolvency process).

In these circumstances, how then does a buyer get comfortable? 

• Targeted due diligence on the key risks is a buyer’s key protection; though there are limitations to the due diligence process (see further below).
• Transaction structuring can provide significant protection against the buyer taking on liabilities (known and unknown) or taking on undesirable contractual arrangements (see above).
• Depending on the nature of the asset and the timeframe, buy-side warranty and indemnity insurance may be available, though the cost and availability of such insurance can be limited.
• Ultimately, and particularly where time and reliable information is in short supply, a buyer’s best protection will be to simply factor the risk in when determining the purchase price it will offer for the asset.

Limited due diligence 

There are two key aspects of due diligence in a distressed M&A process that differ from a solvent sale:

• information flows are more likely to be limited; and
• a distressed seller is less likely to provide information warranties and, even if given, they  are often of uncertain value. 

Where the company is in an insolvency process, the insolvency practitioners (and their advisors) may have limited prior involvement with the business, and may not know about key matters relevant to a buyer, or have access to the relevant information. While this may be ameliorated to some extent where directors or management are working with the insolvency practitioner, distressed businesses often suffer from loss (or high turnover) of key staff. Finance teams in particular find themselves with limited bandwidth to manage the increased demands for information arising from a distressed sale process (and potentially other processes that may be running in parallel), alongside normal business operational requirements and general firefighting which is typical once liquidity pressures become acute.

Accordingly, buyers should not place undue reliance on answers to questions posed during the diligence process, particularly if those questions are not supported by documentary evidence.  

Given the above, distressed buyers need to take a pragmatic view when assessing and weighing risks, and seek to form a view early on as to what key contracts (and customers/counterparties), assets and employees it needs to secure for the acquisition to be viable and commercially attractive, and what it can provide or acquire itself (if necessary) whether at the time or at a later date. 

A buyer of a distressed business will almost invariably need to factor in a further investment budget to allow implementation of the repositioning and turnaround of the business post-acquisition, and to cover ongoing operational losses and working capital needs of the business until the business can fund these costs itself. In many cases such further investment may significantly exceed the purchase price being paid, and accordingly, it is important for the buyer to assess its total likely investment commitment holistically, including when seeking to price in certain risks. 

While these limitations apply to both solvent and insolvent sale processes, the due diligence process is often simplified when there is a formal insolvency process. Liabilities and risks that would typically require quantification in a solvent transaction can be ignored if the buyer is buying through an insolvency process where these liabilities are either compromised or ‘left behind’. Often there will be a subset of key contracts or other arrangements a buyer will want to understand more closely, as they impact both negotiations and implementation. 

Addressing a potential need for interim funding

By the time a seller has begun a distressed sale process, it may have insufficient funding to continue operations for the period until a sale actually completes. Increased publicity in relation to the company’s financial position may also lead to its liquidity deteriorating further. 

A distressed business will typically look first to existing shareholders and lenders for additional interim funding. Entry into administration or receivership may also provide some initial working capital relief, as the administrators and receivers are not required to pay most pre-appointment unsecured liabilities of the company, and can prioritise the use of trading receipts to pay obligations incurred during the insolvency period or which are otherwise critical to preserve the going concern business.

Nevertheless, these measures are frequently not sufficient, and sellers may look to a buyer for assistance in bridging the gap. This occurs in two scenarios:

• a seller’s liquidity position may be acute, meaning it needs immediate funding to keep operating even before it can agree a sale agreement. A funder will want to ensure that its funding has priority security over sufficient assets of the business so that its loan can be recovered if a sale (or other rescue transaction) does not occur and the business is liquidated. Depending on the circumstances, such funding can give the provider an advantage in acquiring the asset; and
• alternatively, even once the sale is agreed, there may be various conditions that prolong the period until the transaction can complete. This may include typical regulatory conditions (such as FIRB or ACCC), or conditions arising from the distressed nature of the transaction, such as secured creditor approval, creditor votes (for example to approve a deed of company arrangement or scheme of arrangement) and/or court approval (for example to approve a scheme of arrangement or transfer of shares pursuant to a deed of company arrangement). Depending on how long this period is, and how much funding is otherwise available within the target business, the seller may need to obtain interim funding from the buyer. For example, it is not uncommon for short-term bridge financing to be provided by a buyer as a condition of entering into a sale agreement. Similar to the above, a buyer will still need to consider how it will be repaid if the sale does not complete, including in situations where the buyer itself terminates, and whether it will have priority of repayment in that event.

Voidable transactions and claw back risks 

One additional point to consider is that unlike conventional M&A processes, distressed M&A transactions may be ‘voidable’ under the Corporations Act 2001 (Cth). An M&A transaction could be set aside, for example, if a reasonable person in the company’s circumstances would not have entered into the transaction and the company is insolvent (these are known as ‘uncommercial transactions’), or if the transaction was entered into for the purpose of defeating, delaying or interfering with the creditors’ rights. Where there are voidable transactions, it may be possible for the company’s assets to be ‘clawed back’ by a liquidator (if the company subsequently enters liquidation) who has the power to ‘unwind’ the transaction.

Accordingly, given the reality of companies in the distressed M&A context being at risk of insolvency, the voidable transaction risk is more present, creating increased uncertainty and is something that buyers need to be aware of when negotiating a sale.

Conclusion

Flipping the switch from risk to opportunity in distressed M&A requires a buyer to navigate the complexities of an often-changing landscape, particularly where the financial situation of the target is deteriorating throughout the process. The key issues and structuring tools that we have highlighted in this article will assist a buyer in framing their approach to any distressed M&A opportunity.