If you’re looking at a distressed M&A deal, what should you consider in this unusual market?
State-driven economic shutdowns have hit some businesses hard; this unusual market presents compelling distressed merger and acquisition (M&A) opportunities for well-positioned companies and investors. Robust due diligence efforts are especially critical for evaluation of distressed M&A deals.
Distressed versus healthy deals
Distressed deals, especially in the current environment, have many key differences from typical “healthy” deals:
- The speed to close a transaction due to an impending liquidity event or milestones that need to be met in a bankruptcy proceeding might constrain the due diligence process.
- Stakeholders might now include secured creditors such as lenders, and unsecured creditors, including trade creditors, subordinated lenders, bondholders, unions, and governmental agencies, all of whom might need to come to a consensus to allow a sale.
- Turnover of key management and finance team employees might constrain accuracy and financial information flow to potential purchasers.
- Net working capital abnormalities due to cash constraints might skew averages used for working capital pegs.
- Valuations might be impacted significantly.
The current distressed M&A market is changing the way deals are getting done. Typically, in a healthy deal environment, sellers control the sale process, and deal structures are cleaner, with minimal if any earn-out provisions. In the current distressed M&A market, for out-of-court sales transactions, more earn-out structures are being attached to stock deals.
In addition, asset sale deals are increasing. These generally are used when buyers don’t want to assume certain liabilities, including unknown and contingent liabilities, and when the time frame to perform a thorough due diligence is compressed. Asset sales also can be the result of a company divesting certain plants, products, or divisions. Purchasing a distressed company through a stock deal offers certain advantages, which mainly are tax driven. However, this often is much less of a factor in a distressed environment where valuations are lower and gains are less likely.
Distressed companies also are bought and sold through the bankruptcy court (Section 363 sale). These transactions often are negotiated before a company files for Chapter 11 bankruptcy. The goal of such a prepackaged bankruptcy is the speed of a prenegotiated transaction and a quick exit from bankruptcy to maximize value for stakeholders.
Alternatively, in other Chapter 11 bankruptcy situations, companies are sold through a formal sale process through the bankruptcy court, with a compressed timeline. Typically, a stalking horse bidder is chosen, and that bidder’s purchase agreement is used as the benchmark for subsequent bids on the company. Additionally, that bidder often is granted a break-up fee if it does not end up with the highest bid.
An advantage of buying a company through the bankruptcy process is that the buyer purchases the assets of the bankrupt company free and clear of any liens and encumbrances, while leaving behind the liabilities not assumed.
Distressed investors also might acquire distressed businesses through loan-to-own transactions or debt-to-equity swaps, where distressed investors purchase the debt of a company, usually below par value, from the incumbent lenders. If the company violates its loan covenants, then the distressed investor forecloses on its collateral to take control of the business. In many instances, these transactions can result in a bankruptcy filing where the distressed lender credit bids its secured debt amount in the Section 363 bankruptcy sale process.
Considerations for EBITDA
A number of issues when purchasing (or selling) a distressed company, regardless of the sale type, might affect reported and prospective EBITDA. These include:
- Loss of major customers or decrease in customer fulfillment rates
- Increase in sales discounts to maintain revenue levels
- Questions about supply chain and whether the company’s main vendors will continue to provide product and payment terms
- Declining volumes on vendor purchase rebates
- Avoidance of repairs and maintenance, research and development, and other expenses
- Postponement of capital improvements
- Compensation normalization to account for workforce attrition
- Severance payments
- Retention bonuses
- Professional fees related to the restructuring and sale
- Litigation costs
- Sale of divisions or assets
- Plant or division closing costs
- COVID-19-related costs from temporary shutdowns, cleaning, and employee health checks
Additionally, purchasers (or sellers) should consider a number of issues when analyzing the net working capital trends of a distressed business for purposes of setting a working capital peg:
- Declining terms with certain vendors, or requirement of prepayments from vendors
- Increasing days in accounts payable for nonessential trade vendors
- Acceptance of less creditworthy customers to increase sales
- Inability to purchase inventory
- Delayed payments from customers
- Discounted accounts receivable to collect faster
Getting financial due diligence right is extremely important for a distressed transaction, especially because buyers often will have a compressed time frame to make decisions. Buyers need to utilize experienced accountants, attorneys, and investment bankers with deep distressed M&A experience to help navigate through the murky waters in an expedient manner, to focus on key issues, and to identify deal risks.