As competition for attractive assets becomes ever more intense, a wider range of investors are looking for businesses that are "distressed". This normally means the asset is priced at below market value, often because the owner of the asset is having difficulty dealing with its liabilities, needs to raise cash or strategically wants to eliminate management distractions from non-core businesses. However, the dynamics of buying distressed assets can be quite different to a 'normal' transaction, for example:
- How do you determine if a cheap asset is really a pot of gold and not a can of worms?
- How do you mitigate the risk of the asset's owner being or becoming insolvent?
- What can you expect if the asset enters insolvency before the transaction closes?
This article looks at these (and other) crucial questions to ask before you make those calls. With special thanks to Paul Durban from the MJH Turnaround team who provided expert input for this article.
1. Do your diligence
Even if a buyer is familiar with the underlying business and wants to move quickly, thorough due diligence is necessary when acquiring a distressed asset. As a distressed sale usually means that protection offered by indemnities and warranties is limited, a buyer will need a complete picture of the assets being bought.
Financial books and records must be examined to determine what, if any, liabilities may or may not follow the asset purchase. This is especially important as a seller of a distressed asset may have conducted its business in a manner which means certain liabilities impact a buyer, such as adverse litigation judgements or product liability claims. Key contracts relating to the asset will need to be reviewed to ensure that the seller has not breached their terms.
As part of the diligence process, a potential purchaser must work out what debt currently encumbers the asset. For instance, is there a loan or security affecting the individual asset? If careful attention is not paid to this, a creditor that owns the debt might have superior rights to the asset even after it has been acquired.
2. Valuations add value
Due diligence will help determine if anyone else can lay claim to the asset and assess any other risks associated with the target and its operations, but if the value of the asset is not what you thought or if there are underlying issues, it is better left untouched. It may therefore be helpful for a buyer to seek a solvency or valuation opinion from a third-party expert who can provide a range of possible outcomes deriving from market data and other methodologies.
In a significant asset sale that might be susceptible to challenge for having undermined the solvency of the company or been made at an undervalue, such an opinion may be useful in building the best possible record that fair consideration was paid, thereby reducing the risk that the transaction will be set aside.
3. Exercise caution if seller insolvency is looming
If an asset's owner enters insolvency after signing but before closing of the transaction, investors are subject to risk that the insolvency office holder may choose to reject ("disclaim") the transaction or (if possible) cherry pick between parts of a transaction by rejecting some agreements and assuming others. Upon rejection, the owner will have no further obligations under the agreement and the purchaser generally will have an unsecured claim for any damages incurred from losing the transaction.
If the transaction closes and an owner then enters insolvency, a buyer could for example be left with relatively worthless representations and warranties in relation to the asset, since any claims for breach against an insolvency company will tend to be unsecured claims. In addition, payments received by the purchaser post-closing but pre-insolvency may be avoidable by the company as a preference (and might need to be reversed) if it can be proved that the purpose of the transaction was to put assets out of the reach of creditors, or if the transaction otherwise prejudiced creditors' interests.
Clearly the best way to eliminate the risk of seller insolvency is to sign and close the acquisition swiftly, and simultaneously! But if that is not possible, transaction documents can be drafted to include express language evidencing the parties' intention to integrate the agreements into the seller's estate, and thereby reduce both the insolvency office holder's scope to disclaim contracts or cherry pick different transaction agreements. This would also mitigate the risk of subsequent challenge (and reversal) for being a transaction which caused or accelerated the insolvency of the target (commonly known as an "antecedent transaction"). Absent a guarantee from a creditworthy subsidiary of the company (which will be difficult to obtain), other potential protections for a purchaser include the granting of security over other assets of the seller or including a hold-back or escrow of a significant portion of the purchase price.
4. Silver lining? Buying out of insolvency can increase certainty...
Perhaps it's not all bad news though; if a buyer does find itself dealing with an insolvency practitioner, rather than a seller, then the transaction is less likely to be the subject of a challenge under insolvency legislation. The buyer will be part of a regulated process and will not be as vulnerable to the whims of the seller as in a regular sale. Dealing with a formal insolvency process can also mean less uncertainty. And in the case of a pre-pack administration process which facilitates a sale of assets, the process can often be conducted swiftly.
5. ...but that comes at a price
But don't think that buying an asset from a target which is the subject of insolvency proceedings always means a cheaper price. In most jurisdictions the insolvency practitioner is under a duty to achieve the best possible price for the company and its creditors so it can often drive a hard bargain to protect that position.
Moreover, an insolvency office holder is unlikely to be able to provide any protections in the form of warranties, indemnities or other covenants. When buying out of insolvency, the principle of 'buyer beware' will prevail. The pressure faced by an insolvency practitioner to deal with the assets expeditiously can also mean that, although the potential risks connected with the target are higher, the timeframe for due diligence is significantly reduced. Other local competition laws may also apply, depending on the home and trading jurisdictions of the buyer and the target business.
Acquiring distressed assets can be a lucrative way to expand and diversify an investor's portfolio, but before taking this step, a buyer should undertake a requisite amount of due diligence to determine whether the acquisition will not only be profitable but will also be relatively risk free. Whether the acquisition is outside or inside insolvency, an understanding of insolvency law and knowledge of the ways in which those laws can be implemented is required to maximise the chances of achieving a successful acquisition. A prospective buyer is always encouraged to consult competent and effective counsel and other professional advisors as early as possible to ensure time, effort and cost are deployed efficiently.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.