The Covid-19 pandemic has brought about significant challenges for many businesses, and a heightened risk of financial difficulty and insolvency. While the number of formal insolvencies has been relatively low thus far, troubled businesses may be forced to pursue accelerated asset disposals, or may themselves present an attractive investment opportunity for new equity stakeholders capable of providing new capital. There are market indicators of a continuing appetite for acquisitions in 2021, particularly acquisitions of businesses that have been impacted by the Covid-19 crisis but are fundamentally sound.
Successfully executing an acquisition of a business from stress, distress, or insolvency requires skilful navigation of competing interests in a complex and rapidly evolving legal landscape. In this article, Latham considers the key issues that M&A deal teams must tackle, and how deal-making is likely to progress as this period of economic uncertainty continues.
Who is in the driving seat? Understanding the deal influencers
When considering a target asset in a stressed, distressed, or insolvency context, buyers must first assess the opportunity presented by identifying the decision makers in the sale process and structuring the bid to address the seller’s requirements. Often the status of the M&A opportunity is unclear, or evolving, as the sell-side seeks to avoid the detrimental value impact of a forced sale.
If the sale is part of a formal insolvency process, then, broadly speaking and allowing for differences across jurisdictions, the negotiating dynamics are likely to be simpler as the insolvency officeholders will deliver the deal, typically focused on a sale of assets (rather than the company), speed of execution, and maximisation of immediate value. However, some jurisdictions may prioritise sustainability of the business going forward and preservation of jobs over maximisation of value, meaning deal teams must remain alert to varying regimes and requirements. Additionally, senior secured creditors sitting behind the officeholders may exert influence directly through security rights or indirectly in negotiations, so it is important to understand their position.
The situation is less clear if the sale is being effected outside of a formal insolvency process, but from a position of stress or distress. There is a strategic imperative to understand where the ‘value breaks’, and which stakeholders are ‘in the money’, ‘out of the money’, or at the ‘fulcrum’. An out of the money shareholder may have less influence in determining the outcome of the process (other than through the value that comes from assisting in the sale by ‘handing over the keys’ in a solvent and consensual manner). On the other hand, senior secured lenders are likely to be the most influential stakeholders due to their contractual (ie change of control) and security rights, in addition to their status as the fulcrum creditors.
The target’s directors sit in the middle: they face the pressures of saving the business; the need to maximise value while trading in the ‘zone of insolvency’; the risk of personal liability owing to directors’ duties and regulators, as well as mandatory duties in certain jurisdictions (such as Germany) to file for insolvency combined with a criminal law liability if a filing is delayed; and their own uncertainty of future employment. Nevertheless, their expertise and that of other senior managers may be essential to the business’s success post-acquisition.
A successful buyer will need to understand these dynamics, whom to influence, and how to structure an offer to cater for the demands of the relevant stakeholders and to take into consideration the risk that the transaction be ‘clawed back’ (which varies across jurisdictions). To gain a competitive edge, it is also important for buyers to prepare a contingency plan to circumvent the need for support from a dissenting stakeholder, for example through a pre-packaged enforcement or insolvency process.
No second bite: buyer beware
A successful buyer will need to be ready to place little reliance on contractual protections, whether in the form of representations, warranties, indemnities, or post-closing price adjustments – but alternative solutions exist.
If the sale is from insolvency, the officeholders will be unlikely to offer any contractual protections and, in fact, will seek hold-harmless contractual protections from the buyer.
If the sale is outside of an insolvency process but from a situation of stress or distress, the seller is unlikely to receive much or any value, and will have no incentive to provide any contractual protection that risks residual liability for the seller.
The use of warranty and indemnity (W&I) insurance is also on the rise. Several W&I insurance structures allow business warranties to be provided with minimal or nil liability to the warrantors. While W&I is increasingly being used, certain particularities can apply with regard to distressed or stressed scenarios. W&I may not be feasible if time is of the essence, can be costly, and may exclude key risks.
Risk mitigation: understand it and price it
The limited scope for contractual protection brings the buyer’s due diligence into particular focus. Depending upon the degree of distress, diligence timetables can be accelerated. Understanding the sector and having expert advisers primed and ready will give a buyer a competitive edge.
If the sale is from insolvency, the scope of the due diligence will vary to reflect the situation of those jurisdictions where the sale is (almost) free and clear of liabilities and/or where various constraints restrict access to information. Outside of an insolvency process, the scope of due diligence will essentially be the same as for any M&A process, with the need to prioritise high-risk matters that could expose the target or buyer to significant or unexpected liabilities. Areas that required close attention on recent deals include regulatory and governmental controls and consents – including foreign investment controls, pensions, and financial regulations (where there is often little leniency, even if financial difficulties mean that there is a need for an expedited process) – and tax (as the transaction will usually involve steps, including debt releases, that are contrary to the target’s historic tax planning, which can have unexpected consequences). Further, in some jurisdictions (such as Germany) more significant clawback risks have to be evaluated when structuring a transaction.
Once liability is identified, a buyer can consider structuring options, such as consideration holdbacks and deferred payments. However, these can render the bid less competitive, so every effort should be made, with the benefit of robust advice from experienced advisers, to mitigate the risk and price it appropriately.
Move quickly, deliver deal certainty, and be creative in the bid structure
A seller from stress, distress, or insolvency is likely to place a significant premium on deal certainty and speed of execution. Delay can often lead to irreparable damage to a business through a crunch in liquidity, trading counterparties losing confidence and walking away, key employees leaving, and creating a permanent blight on the business through continued negative publicity.
A successful buyer needs to be creative in its deal structuring. This often requires a deep understanding of debt, equity, and hybrid structures, and, potentially, a readiness to acquire debt instruments to unlock a deal and execute quickly.
If a buyer or seller is publicly listed, depending on the type of transaction, specific shareholder consents and market information may be necessary, increasing deal timelines and completion risk. A listed target or seller must also be aware of its obligations to disclose inside information relating to its financial difficulties, which is likely to include an agreement on a sale. On the other hand, potential buyers, especially holders of listed notes or bonds, will need to refrain from trading while having access to material non-public information.
In an increasingly regulated world and depending on the nature of the transaction and the jurisdiction in which it is implemented, we are seeing buyers having to employ novel holding structures to deal with an unavoidable gap between signing and closing to obtain consents and clearances, including foreign investment, regulatory, and competition approvals.
During this period, the buyer needs sufficient control and confidence (without having full control through equity ownership) to finance the business. This requires advice from a broad range of experts in debt, equity, regulation, and restructuring, often across multiple jurisdictions. Legal advisers must be well acquainted with the tools available in order to provide novel and creative solutions to the many complexities and issues that a buyer from stress, distress, or insolvency may encounter.
Stress’ and ‘distress’: what’s the difference?
While ‘stress’ and ‘distress’ are not terms of art, they are often used to convey a spectrum of financial trouble.
The difference between the two terms lies in the degree of insolvency risk: a company in stress has sufficient liquidity and no imminent insolvency risk, allowing for a more orderly sale process (albeit on a more accelerated timeline than a typical M&A transaction), whereas a company in distress has a greater, more pressing liquidity or insolvency risk that requires a ‘fire sale’ on an accelerated timetable.
Distressed M&A: the spectrum
|Value breaks below the equity||Value breaks below the equity||Company in insolvency process|
|No immediate default on debt||Actual or imminent debt default||Sale (usually of assets) by officeholder|
|Sufficient liquidity for orderly sale||Uncertain liquidity for orderly sale|