Private and public companies are potentially facing significant supply chain disruptions, store and office closures and reduced consumer spending. These issues, together with travel restrictions, market volatility and general economic uncertainty have had, and will continue to have, an impact on M&A transactions worldwide.
When faced with these realities, distressed companies can turn to M&A transactions as a means of generating capital and/or exiting from non-performing businesses. “Distress” in this context does not necessarily mean insolvent. Indicators of distress can include diminishing cash position, breaches of financial debt covenants, sluggish payment of trade creditors or seeking to obtain additional short term debt.
In this article, we consider key considerations in distressed M&A, including structure, due diligence and risk.
Timing is key. A seller and its advisors need to provide purchasers with sufficient time to undertake appropriate due diligence and talk to suppliers, landlords and other counterparties and to ensure that the seller receives appropriate value for the asset. Leave it too late and a seller may become desperate and sell at a significant discount.
Consider the most appropriate structure for the sale (e.g. asset vs share acquisition or a hive-down). A purchaser will usually prefer an asset purchase to minimise its risk.
A targeted, lean and efficient due diligence process should be undertaken by experienced practitioners to identify how clean title to the assets can be transferred.
The price payable for the asset is dependent on a range of factors, including the level of risk being borne by the purchaser in the transaction. Generally speaking, the higher the risk, the lower the price. The purchaser needs to balance risk with opportunity.
Purchasers need to carefully consider the likelihood of success in recovering against a seller for breaches of warranties and indemnities in a distressed sale. Other mechanisms to protect risk should be contemplated including reducing the purchase price, paying in instalments, escrow and warranty and indemnity insurance.
In such situations, purchasers’ preference is generally for M&A transactions to take the form of asset sales rather than share sales. By purchasing the assets of a distressed business, the purchaser is able to extricate and unburden the operating assets from the debts and liabilities of the distressed seller.
However, acquisitions of shares are generally simpler and quicker to execute. In an asset sale, the transferability of each class of asset will need to be considered and the consent of third parties (e.g. landlords, contract counterparties, regulatory authorities) may be required.
If the seller is undertaking a broader restructuring, a hive-down can be considered. This is where the seller transfers assets into a new company within its group and the shares in that new company are sold to the purchaser.
Fast-track due diligence
Depending on the nature of the financial pressures being faced by a distressed company, a sale process may need to move faster than a non-distressed transaction. The seller may want to complete the sale quickly to alleviate pressure and avoid any further slippage in terms of its trade. However, a seller will need to be mindful of spooking a purchaser or flagging to the market the extent of its distress.
A purchaser will want to ensure it has sufficient time to undertake appropriate legal, financial, tax and commercial due diligence. Given the time-frames involved, a purchaser may have to take a commercial view about the level of diligence it requires to undertake in order to ensure it will acquire clear and unencumbered title to the assets in sale. It is important for purchasers to work with advisers to ascertain and target key areas for due diligence. Much depends on the type of asset being purchased and the industry in which the seller operates.
Liability and risk
The provision of warranties and indemnities in a distressed transaction is typically more limited than that in a non-distressed sale.
A purchaser may consider that a seller is not a “good mark” for damages in the event that the purchaser has a claim for a breach of warranty or under an indemnity. A seller should also assess what warranties and indemnities are appropriate in circumstances where a purchaser is likely acquiring the assets at a discount on an “as-is, where-is” basis.
There are a number of mechanisms which can be used to bridge the gap between the seller’s and purchaser’s appetite for liability and risk in a distressed transaction, including:
obtaining security or a guarantee from a third party whose credit worthiness is not in doubt;
structuring the transaction so that there is a holdback or escrow of part of the purchase price; or
obtaining buy-side warranty and indemnity insurance against insurable warranties.
In order to obtain warranty and indemnity insurance, the insurer would likely require a reasonable level of diligence has been conducted on the areas the subject of the warranties. A holdback or escrow of the purchase price is not ideal for a seller in a distressed situation as it delays payment and potentially reduces the purchase price.
Companies seeking to undertake asset sales in a distressed scenario need to be mindful of the timing, cash position post-sale and long term impact of the proposed sale. While there are pitfalls to a distressed sale process, it does not always signal the beginning of the end for distressed companies. Decisive and timely actions, with the benefit of advice from experienced professionals, can begin a successful turnaround of the business that refocuses strategy and ultimately creates value for all stakeholders. Distressed sellers should also be encouraged that there is potential to recover funds via an asset sale, which may provide much needed relief from economic duress and a possible return to a better financial position.
Given the extensive personal liability regime under the Corporations Act 2001(Cth) for insolvent trading, directors must be mindful of the impact of the company’s financial circumstances on their personal liability position. During the sale process, especially if prolonged, directors must remain vigilant about the company’s creditor base and cash position. In the event the company becomes insolvent, directors will likely appoint voluntary administrators to protect themselves. This is an all too common outcome. As such, it is important to remain well-informed and well-advised of the risks during the course of the sale process.
About Hamilton Locke
Hamilton Locke is a corporate law firm specialising in complex corporate finance transactions, including mergers and acquisitions, private equity, finance and restructuring, litigation, property and fund establishment.
The Finance and Restructuring team has considerable restructuring and turnaround experience across all relevant areas including finance, debt-trading, loan to own transactions, distressed M&A, safe harbour, enforcement and insolvency.