Asset purchasers that have actual or constructive knowledge of a competing interest yet fail to alert the bankruptcy court may be subjecting them to claims by competing interest holders in an otherwise free and clear sale.
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.
Below are some key considerations that prospective buyers, whether financial, family office, or strategic, should think about as they explore a distressed M&A opportunity.
Understand the Levels and Areas of Distress and Be Prepared to Act Quickly
In a distressed M&A scenario, the seller may need to act quickly due to liquidity problems and impending defaults under its debt obligations. To obtain any first-mover advantages, prospective buyers should quickly perform financial, operational, and legal due diligence to understand the extent of distress and how it impacts the target’s business, while simultaneously working with experienced distressed advisors to structure a transaction.
It will be important to analyze all the assets and potential liabilities of the target business in an efficient manner to decide which assets to acquire, including key contracts and intellectual property, and, just as importantly, which liabilities to exclude. In addition to the usual areas of diligence, understanding the supply chain risks a target business may be facing, the availability and cost of alternative sources of supply, and any issues related to the backlog of goods and components is crucial in the current environment.
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.
In- or Out-of-Court?
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.
Companies facing liquidity problems and impending debt defaults may be able to pursue non-bankruptcy solutions, such as asset sales, restructurings, foreclosure sales, and assignments for the benefit of creditors. While an out-of-court transaction may provide a prospective buyer with a fast and less expensive way to acquire a distressed business that minimizes the risks of a competitive process and potential reputational ramifications associated with the target company’s bankruptcy, there are challenges associated with this option. Out-of-court transactions often require creditor consensus and/or shareholder approval, and they carry with them the risk of a later judicial challenge as a fraudulent transfer (based on allegations that the target company was insolvent, or close to it, and the prospective buyer did not pay adequate consideration) and of successor liability, particularly with respect to taxes, torts arising out of the target business’ pre-acquisition conduct and products, and environmental and employee claims. Prospective buyers may want to consider obtaining third-party valuations of the business as a prophylactic measure to protect the transaction against a subsequent challenge.
Out-of-court transactions often result in the assets of the target business, rather than its equity, being acquired, as buyers seek to acquire only those assets and liabilities required to operate the ongoing business. However, contract-laden targets present challenges in out-of-court asset deals, as assignment often requires consent of the contractual counterparty. In addition, prospective buyers in an out-of-court transaction with a distressed target need to consider how to manage the risks that the target company might file for bankruptcy (a) between signing and closing of an acquisition, giving it the ability to reject the acquisition agreement and relieving it of any closing obligation, or (b) after closing, potentially making the buyer’s negotiated indemnity and other covenants (including any purchase price adjustment or transition support services) relatively worthless. Prospective buyers should consider using a holdback or an escrow to support these continuing obligations, having an agreement with the target company to assume the acquisition agreement (subject to bankruptcy court approval and bidding process), and pre-negotiating “stalking horse” protections if there is a bankruptcy to mitigate these post-signing or post-closing bankruptcy risks.
Target companies and prospective buyers alike, however, may decide that executing an M&A transaction through a bankruptcy of the target company is more aligned with their key objectives and will vest the buyer with only the assets and liabilities it wants. A transaction executed pursuant to the Bankruptcy Code can provide a prospective buyer with the benefits of binding non-consenting parties and rarely requires shareholder approval. A bankruptcy transaction can transfer assets free and clear of liens, claims, and encumbrances and result in the assignment of most contracts (so long as outstanding defaults are cured), notwithstanding consent rights or anti-assignment provisions running in favor of the non-debtor contractual counterparty. A bankruptcy transaction can also eliminate the risk of post-closing fraudulent transfer claims and minimize the risk of successor liability claims. Also, because bankruptcy courts are likely to require that a transaction to acquire the assets of a target business be subjected to a competitive bidding process (where, in addition to potential bids by third parties, the secured lenders can often “credit bid” their debt), a first-moving prospective buyer likely can obtain bidder protections for being the “stalking horse” against which other potential purchasers bid. Bidder protections generally include break-up fees, expense reimbursement, a defined initial overbid, and subsequent bidding increments. A key advantage to the “stalking horse” is that any competing bid generally would need to satisfy not only the initial overbid but also any break-up fee and expense reimbursement offered to the “stalking horse,” which makes a competing bid that much more expensive.
A bankruptcy process, however, is not without its challenges. It can be time consuming and expensive. Also, post-closing indemnification is often hard or impossible to get or relatively insignificant if obtained (although representation and warranty insurance may be available to the buyer to provide post-closing protection for breaches of a seller’s representations and warranties). Furthermore, as noted above, a competitive bidding process likely will be required, which may delay closing and increase the price a prospective buyer needs to pay. Finally, the transaction will be subject to public review, and creditors or their representatives likely will get involved in negotiating deal terms and process.
An M&A transaction executed through the bankruptcy process can take different forms. It can be a sale of assets under section 363 of the Bankruptcy Code or a transfer of assets or ownership of the business through confirmation of a plan of reorganization or liquidation. A section 363 sale may have certain benefits for a buyer, such as speed and the ability of the buyer to extricate itself from continued involvement in the bankruptcy case upon closing. A transaction implemented through confirmation of a plan for a target company is a more complicated process, as the sale transaction must be approved as a part of the debtor’s plan of reorganization or liquidation. However, it may provide a prospective buyer with the ability to structure what in essence is a stock transaction, preserving (to the extent otherwise allowed under the Internal Revenue Code) loss carryforwards and retaining any non-transferable intellectual property or permits. Whether a prospective buyer should pursue a section 363 sale or an acquisition executed through a plan will depend on the specific goals of the parties in the proposed transaction and the circumstances at the time.
Regardless of the determination to execute the M&A transaction in or out-of-court, prospective buyers need to be mindful of federal and state regulatory filings that may be required or should be made, including those under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 and with the Committee on Foreign Investment in the United States.
Bridge the Valuation Gap
Sellers may continue to be influenced by the heady valuations received in comparable transactions in the recent past even though they may no longer be representative of the current M&A market. A prospective buyer may need to navigate valuation challenges with shareholders in an out-of-court transaction or other stakeholders in a bankruptcy process. Prospective buyers can seek to bridge valuation gaps through a transaction structure that reduces the initial cash consideration a prospective buyer pays at closing—which may include an earn-out, true-up, or deferred consideration (e.g., royalty or milestone payments). These types of alternative structures may allow the seller to potentially obtain its desired aggregate purchase price, assuming the target business meets the agreed upon metrics or milestones. However, these alternatives typically create tension between the buyer and the seller (and, in certain cases, the seller’s creditors) — with the seller (and, in certain cases, the seller’s creditors) being concerned about how the applicable metrics or milestones can be affected by post-closing management and the buyer being concerned about restrictions on its ability to operate the business post-closing. For prospective corporate buyers, non-cash consideration, such as shares or convertible debt, should also be considered, although valuation challenges may be present, nonetheless.
Successfully executing on a distressed M&A transaction requires not only quick and efficient diligence of the target company but also an understanding of the benefits and limitations of an out-of-court acquisition versus a transaction executed through the bankruptcy court. Having professionals familiar with distressed M&A transactions to perform that diligence and strategize will maximize benefits for prospective buyers