Distressed mergers and acquisitions (M&A) involve companies in financial or operational distress, potentially on the brink of insolvency or already grappling with significant debt burdens.
These transactions are typically characterized by the urgent need to prevent the target company from entering formal restructuring or bankruptcy, preserving as much value as possible for stakeholders. The urgency and complexity of these deals stem from various triggers of financial distress, ranging from macroeconomic factors like recessions or market saturation to microeconomic issues, such as poor strategic management decisions or ethical failures. Recognizing these triggers is crucial for potential buyers to accurately assess risks and form effective acquisition strategies.
Unlike traditional M&A, distressed M&A transactions require a strategic approach tailored to the target company’s precarious financial state. This scenario offers potential buyers the opportunity to acquire valuable assets at reduced prices but introduces complexities and risks that demand skilled navigation by experienced legal counsel.
Let’s look at the legal issues and challenges of distressed M&A transactions and how experienced transactional attorneys can help.
In-depth analysis of distressed M&A processes
A thorough understanding of the processes involved in distressed M&A is essential for success. These processes include the following:
- Pre-transfer liquidations: Sometimes the healthier segments of a distressed business are sold and the proceeds are used to address creditor demands. This process requires careful planning to ensure asset prices are justified, typically necessitating an independent appraisal.
- Reconstruction and administration: In cases where the distressed company can still be salvaged, assets might be sold under the supervision of appointed administrators or reconstructors to ensure creditors are treated fairly.
- Bankruptcy proceedings: If recovery is unfeasible, the company may undergo bankruptcy, where assets are sold under the management of a trustee. This process aims to maximize creditor returns and efficiently wind down the company’s operations.
Different legal challenges can arise in each of these scenarios.
What legal and business challenges are associated with distressed M&A?
Engaging in distressed M&A requires swift and decisive action, often under considerable time constraints and with limited information. This urgency can complicate the valuation and due diligence processes, making it difficult for buyers to fully understand the target’s financial health and operational viability.
Valuation
Valuing a distressed company is more complicated than valuing a healthy company. Accurate evaluation of the target company’s level of distress and its potential impact on the deal can help buyers make informed decisions about the transaction’s timing and structure. This includes assessing liquidity, debt obligations, replacement cost, and cash flow projections.
Unlike valuations of healthy companies, valuations of distressed companies should be forward-looking. The key is to identify what caused the company’s financial distress, determine whether the problem can be fixed, and develop a picture of the company’s future earnings after the M&A deal has been completed. Income-based methods, such as discounted cash flow analysis, as well as valuation techniques, such as liquidation value and replacement cost, are typically the best methods to value troubled companies.
Transaction timing and structure
Timing and structuring the transaction are essential components of distressed M&A. Buyers must act quickly to capitalize on opportunities before the target’s situation worsens, potentially leading to a less favorable outcome. As for structuring the deal, many buyers opt for asset purchases instead of share acquisitions to isolate potential liabilities. This approach allows for the acquisition of valuable assets while minimizing exposure to the distressed company’s existing obligations.
When it comes to distressed M&A transactions, buyers should also consider strategies for flexible pricing, such as earnouts, contingent payments, and equity stakes. Buyers in distressed M&A deals generally use the same types of acquisition financing as buyers in traditional M&A transactions. The type of financing used is likely to be dictated by deal size and the execution timeline. Purchase agreements in distressed M&A transactions typically calculate the purchase price on a cash-free, debt-free basis and may include a net working capital adjustment mechanism. However, if the seller does not agree to an escrow or holdback, there is a risk that the seller will not be able to pay any adjustment to the buyer. Although earnout provisions may help to align parties with differing valuations of a business, there may be disadvantages if the seller has immediate liquidity needs.
Due diligence
Given the time pressures, buyers must prioritize key focus areas in due diligence, such as identifying unencumbered assets, identifying counterparties, evaluating the enforceability of critical contracts, and assessing potential succession liabilities. Hidden risks and liabilities in distressed transactions may include undisclosed environmental liabilities, pending litigation, or potential successor liability claims.
The role of legal expertise in distressed M&A
Despite the expedited nature of distressed M&A, comprehensive due diligence is crucial. Legal teams help identify key risks, such as undisclosed liabilities or issues with asset valuation, that are pivotal in deciding whether to proceed with a transaction. For example, sellers in distressed M&A deals may be unable to provide adequate representations and warranties or indemnification provisions. This leaves buyers with limited recourse if issues arise following closing.
Skilled lawyers are also essential for negotiating terms that protect the buyer’s interests, particularly in structuring the acquisition to include adequate safeguards against potential liabilities. Buyers must also be prepared for the possibility that the distressed seller may file for bankruptcy and for fraudulent conveyance claims, which might arise if the transaction is deemed to have been made at an undervalue or with the intent to defraud creditors.
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