Part 1:

INTRODUCTION - M&A OPPORTUNITIES AMIDST DISTRESS

Covid-19 and its economic fallout is leading to otherwise successful and attractive businesses facing distress. This in turn is leading to opportunities for PE.

The dynamics of buying a distressed business are quite different from the norms of a PE investment or acquisition.

This guide describes the key considerations of which PE should be aware when considering distressed M&A.

Part 2:

THE LIFECYCLE OF A DISTRESSED BUSINESS AND WHAT M&A MIGHT LOOK LIKE AT EACH STAGE OF THE CYCLE

Sale at underperformance stage:

• Not yet reached formal distress.
• Seller will often be considering refinancing with lenders or raising capital to improve performance together with early engagement with any regulators.
• Any sale will likely operate in line with traditional M&A practices, pricing and costs.

Sale at distress/crisis stage:

• Not yet entered into formal insolvency process but creditors likely circling and threatening to place company into a process.
• Timescales will be more pressured due to creditor pressure, cash flow, funding issues and potential regulatory action.
• Likely that sale will take place involving an insolvency, potentially using a pre-pack administration where insolvency practitioners are lined up, the sale is negotiated in advance, administrators are appointed and sale is completed immediately afterwards.
• The consent of certain regulators may be required to place the company into insolvency / the regulators may have an opportunity to participate in the process.
• Consideration would be given to any regulatory requirements for the buyer.
  Risks for buyers as businesses and/or assets sold as seen and without warranties but maximum discount available.

Sale at failure stage (out of an insolvency process)

• Creditors or board of directors have placed company into insolvency process with possible regulator involvement.
• Administrator sells business and assets of insolvent company during appointment again with possible regulator involvement.
• Appointment of administrator and ongoing administration process may erode confidence of stakeholders including customers and employees, which may impact on value.
• Consideration would be given to any regulatory requirements for the buyer.
• As with a pre-pack sale at distress/crisis stage, risks for buyers as businesses and/or assets sold as seen and without warranties but maximum discount available.

Part 3:

KEY CONSIDERATIONS FOR PE WHEN CONTEMPLATING BUYING DISTRESSED BUSINESSES AND ASSETS

It’s all about the price

Because the circumstances in which a distressed or insolvent business is sold are exceptional, any buyer and particularly PE must be satisfied the price is sufficiently attractive to take account of the inherent uncertainties, risks and lack of contractual protection.

Funding

• Clear evidence that an offer is fully funded will need to be provided at an early stage. PE buyers will need to provide sufficient comfort in respect of their fund drawdown process and are likely to be required to drawdown in advance of completed legals.
• As acquisition finance processes take time and increase diligence requirements, PE buyers should be prepared to fund the acquisition from equity initially and then refinance post completion.

Transaction principles

• Buyer beware: the sale will be on the basis that the seller/insolvency practitioner will only sell whatever right, title and interest (if any) the seller has to the business and assets.
• Exclusivity unlikely: as likely to conflict with insolvency practitioners' duties, but may be available in return for non-refundable deposit.
• No conditionality: the acquisition of the business and assets must complete one single, clean transaction without requiring any conditions subsequent to be fulfilled. Important that PE buyers conduct a merger control and antitrust analysis at an early stage.
• Wide indemnities from the buyer: sellers/insolvency practitioners will look to avoid any continuing liability either for themselves or the insolvent company, after completion of the sale. They will therefore require indemnities from the buyer.
• No warranties from seller/administrators: administrators will not want to wait for a warranty period to expire after the sale, as they will need to distribute the sale proceeds to creditors. In addition, they will not know more about the business than the buyer could find out through its own investigations.
• No warranties from management: PE buyers should note warranties are generally not available from the management team at the time of the transaction and there is also no real scope for W&I cover.
• Traditional M&A consideration structures, such as earn outs, will be unworkable when dealing with an insolvency practitioner. An insolvency practitioner will also generally resist deferred consideration structures.
• Delayed management incentivisation: it is unusual to issue sweet equity to management at the closing of a distressed M&A transaction – this typically happens at a later date, which has the advantage of allowing a PE buyer to “get to know” management before committing to the structure and quantum of management sweet equity.

Time is of the essence

• Sellers in distress will be looking for a quick sale in order to release liquidity to settle debts and avoid defaults. Often the extent of the seller’s distress will dictate the speed of the transaction.
• When the target is in the hands of an insolvency practitioner (e.g. an administrator or liquidator), the longer the process, the greater the risk of its deterioration (debtors become disinclined to pay, creditors may refuse further credit, key employees may leave).
• PE buyers therefore need to ensure they can move quickly and should consider a truncated or front loaded IC process. Fund documentation should be checked to ensure this flexibility exists.
• Early engagement with management and key customers/suppliers in an appropriate and orderly fashion is key.

Limited and focussed due diligence

• Focussed due diligence is key given time constraints and crucial given distressed deal transaction principles.
• Diligence is likely to be “messy” and patchy. A data room may not be prepared, or may be limited and not up-to-date.
• PE buyers are in our experience more likely, therefore, to successfully execute a distressed transaction in a business sector they are familiar with. Portfolio company bolt ons may present better opportunities than new platform deals.

Day 1 arrangements in place (particularly where a new area is being invested into)

It’s important to have Day 1 operational matters in place and ready to go, for example VAT registration, bank accounts and insurance. Where a bolt on investment is being made, often these arrangements will be in place. However, this may not be the case if an investment is being made as a stand alone or new platform deal. It may be worth considering having purchase vehicles readily incorporated, with operational arrangements in place as far as possible in order to be able to move quickly and be ready for completion.

Sector specific requirements

It’s also important to plan ahead for any Day 1 requirements that may apply in specific sectors, for example merchant processing services for retail/trading, licensing for particular licensed sectors (such as leisure, waste, or healthcare), and authorisations for regulated sectors (for example FCA approvals for businesses carrying on FCA regulated activities). Many of these arrangements will need to be put in place afresh for the buyer: (a) because the transaction will be structured as a business and assets sale and therefore the seller entity holding the arrangements will be different to the buyer entity carrying on the business after completion; and (b) because many of these arrangements will fall upon the insolvency of the seller.

Get in touch to find out more about any of the points covered in this guide.