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Distressed M&A Primer

Guide to Understanding Distressed M&A (Section 363)

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Distressed M&A Primer

Distressed M&A Primer: Asset Sales in Restructuring (Section 363)

The distressed sale process is completed under a compressed time frame, which often causes there to be less diligence done by the buyer.

Therefore, it is critical for purchasers of distressed assets to understand the legal risks associated with out-of-court sales, as well as the protective measures offered during in-court Chapter 11 sales.

For sellers, on the other hand, distressed M&A represents a method to obtain short-term liquidity to remain solvent. For instance, the rationale for the divestiture of a non-core asset could be to use the sale proceeds to meet near-term debt obligations.

Or, the seller may partake in the outright sale of its entire business, which is usually done in an effort to avoid the onerous restructuring process.

Yet the circumstances regarding the seller such as being under Chapter 11 bankruptcy protection bring meaningful implications to the process.

Out-of-Court vs. In-Court Distressed M&A Transactions

Akin to the findings in our post on out-of-court and in-court restructuring, the protective measures of the Court can bring more structure to the process and remove much of the uncertainty and risks.

But before we delve more into distressed M&A, the table below summarizes the advantages/disadvantages of out-of-court vs in-court deals:

Distressed M&A Out of Court vs. In-Court Transaction

Distressed M&A Transaction Considerations

Buyer vs. Seller Negotiating Leverage

Simply put, distressed M&A is a buyer’s market – the participants are aware the seller is vulnerable, the list of potential buyers is limited, and the need for liquidity will soon force a sale. And the most distinct trait of distressed M&A is that the seller is in a state of financial distress.

The transaction consists of an unbalanced buyer/seller relationship because rather than prioritizing a maximum sale price, the seller is just attempting to have enough proceeds to remain afloat.

To make matters worse for the seller, the list of potential buyers is likely limited, which diminishes the negotiating leverage of the seller even more.

The seller is negotiating from a position of weakness and is willing to accept a lower valuation to avoid a long, drawn-out process because of the urgent need for cash.

Timing Constraints

The value of a company under distress continues to diminish over time; hence, the timing of the sale is critical to preserve the residual firm value.

In distressed sale processes, time is of the essence as the liquidity needs of the seller are urgent.

Therefore, distressed purchasers are forced to make decisions quickly, which can be risky.

Additionally, if the target’s business is declining at a rapid pace or payment dates are coming up soon, the seller will be more incentivized to close quickly to preserve its firm value.

Whereas conventional M&A can extend several months or even years, distressed sellers need to complete the divestiture or exit in a span of a couple of weeks or a couple of months at most.

But while the restricted time can hurt the seller in being unable to shop around more to find the highest offer, conversely the buyer can be put under pressure by having to decide in the same time frame (i.e., not as much time to complete in-depth diligence).

The accelerated timing poses two negative possible outcomes:

  1. A higher potential bid was excluded from the buyer list (i.e., “left money on the table”)
  2. Certain risk-averse buyers might pass to avoid having to make an abrupt decision

Sell-Side Marketing Limitations

As a result of the time pressure, the ability of the M&A advisors to depict the seller in a better light and maximize the valuation in the sell-side marketing process is greatly diminished. In effect, the information provided to the buyer will be limited in scope, but enough depth is still given to include all the material information required to make an informed decision.

That said, the form of delivery tends to be of lower quality due to the accelerated timetable, which puts more pressure on the buyer to perform thorough diligence quickly. Under the compressed timeline, many of the transaction steps are carried out at the same time, which can create a frantic, rushed environment for both the seller and buyer(s). But if the company is pre-petition and not subject to imminent insolvency in the near term, then the sale process can be run closer to a traditional auction process (e.g., more time spent putting together high-quality marketing documents, more networking, and pitches/presentations).

Purchase Consideration and Sale Process

  • Purchase Consideration: In distressed M&A, the purchase consideration used in virtually all cases is an all-cash transaction – clearly showing the priority of the seller: liquidity. Hence, many sale processes are rushed to facilitate expedited deals, often at the expense of potentially higher sale prices. The need for the seller to raise capital quickly to remain solvent grants the buyer with more negotiating leverage – theoretically resulting in a reduced valuation.
  • Sale Process: The auction sale process has become the norm to fulfill the requirement of selling at a fair valuation for the sale – in what is called the “robust auction requirement.” If a proposed in-court sale is found to have not conducted a robust sale process, the sale could be overturned. As a result, the typical sale process used for distressed sales is an auction because it establishes the valuation in a systematic structure in which the highest bid sets the value – putting all differing opinions on the valuation aside.

Distressed M&A Deal Structuring: Asset vs. Stock Sales

For the vast majority of distressed sales, the transaction structure is in the form of asset sales.

Acquirers in distressed scenarios nearly always opt for asset purchases rather than stock because the specific assets to purchase can be chosen.

Only the assets the buyer wants to purchase are paid for, and there is less risk in assuming the contingent liabilities belonging to the distressed target.

Buyers can choose the assets that they want to purchase (i.e., “cherry-pick”) while not assuming all liabilities in asset sales.

The concern regarding unknown liabilities is also another reason that stock purchases are less common in distressed acquisitions, as the buyer does not have the time to be able to diligence the entirety of the seller’s operations in the short time frame before closure.

From the viewpoint of the buyer, the aim is to leave behind the liabilities that resulted in the company becoming distressed and/or could potentially become legal risks later.

Plus, if the acquisition is structured as an asset sale, the buyer’s time can be focused on the assets being acquired; whereas, in a stock purchase, diligence must be performed on the entire business.

Distressed Buyer Due Diligence Process

While distressed sales do tend to favor the buyer, such purchases do not come without their own set of risks and significant challenges. Under time pressure, the buyer must estimate the value of an underperforming asset with uncertain prospects and look into the risks to protect itself.

For example, before moving forward with a purchase, the buyer must perform diligence on:

  1. The Cause of Distress
  2. Current Financial Condition and Credit Metrics
  3. Working Capital Efficiency and Financing Needs
  4. Relationships with Prepetition Stakeholders (e.g., Customers, Suppliers/Vendors)
  5. Transactional Risks (e.g., Fraudulent Conveyance)

Given the limited time, a potential buyer needs to perform its diligence based on priority and focus on the areas where the perceived risk is the highest.

Section 363 Asset Sales in Chapter 11 Bankruptcy

Under Section 363 of the Bankruptcy Code, buyers can acquire the assets in the ordinary course of business of the debtor “free and clear of liens or other claims”.

The debtor benefits from Section 363 because the process aids in the marketability of the asset being sold – and more competition leads to increased valuations. Selling a debtor eroding in value is a tough task in itself. That said, the elimination of the liability risks increases the odds of receiving a higher bid.

For sales under Chapter 11, the existing claims, liens, and interests dictate the distribution of sale proceeds to creditors but do NOT remain attached to the post-sale asset(s).

The length of the sale process can last as little as a couple of months, or even less if the debtor has shown that its asset values are drastically dropping. On the other side, however, the Court and creditors typically want to avoid an overly-rushed process because more time spent on marketing and looking for potential buyers increases the chance of finding a higher bid.

For a Section 363 sale to receive Court confirmation, the following three tests must be passed:

Section 363 Sale Confirmation Requirements

Auction Process vs. POR Distressed Sale

In Chapter 11 bankruptcies, there are two methods of asset sales:

  1. Plan of Reorganization (“POR”): Lengthier and more expensive process as it requires a disclosure statement (and confirmation), voting procedures, and more Court hearings
  2. Auction Process under Section 363: Less time-consuming and not as onerous as a sale made under a POR

The drawback to distressed sales being part of the plan of reorganization (POR) is that the process of negotiating the documentation, planning out the sale, soliciting creditor votes, and receiving approval from the Court means more time spent in bankruptcy (and costs).

“Stalking Horse” Bidder in Distressed M&A

The “stalking horse” bidder enters a binding purchase agreement with the seller, which sets the initial “floor” valuation that other bidders are required to bid above.

Frequently associated with pre-packs or pre-arranged filings, a debtor can negotiate an asset purchase agreement (“APA”) with a stalking-horse bidder.

The role of the stalking horse bidder in Chapter 11 is to set the “floor” bid that must be exceeded by other buyers.

Based on that starting point, the price can only go up due to the participation of the stalking horse and negotiated formal purchase agreement. If a debtor files for bankruptcy with a stalking-horse bid and term sheet already on hand, this permits management to conduct the auction process quickly and with a confirmed purchaser already on deck.

In conjunction with the Court’s approval of the stalking horse bidder and APA, the deadline date is then set for interested bidders to submit a “qualified bid” and partake in the auction.

Standard 363 Timeline

Court Protection of the “Stalking Horse” Bidder

The stalking-horse bidder has access to internal data from the debtor and spends considerable time doing diligence before other potential buyers. The management team often works closely with the buyer to increase the bid, as a higher amount can be a “positive signal.”

If the stalking horse bidder is outbid, the Court offers protection to compensate them for their time commitment and for setting the “floor bid”:

  • Expense Reimbursement: Out-of-pocket costs related to diligence and participating in the process will be reimbursed
  • Break-Up Fee: Similar to M&A break-up & termination fees, an incentive payment will be made if the deal fails to be completed (usually around 3% to 5% on the transaction value)
  • Incremental Bids: The bidder can often set the minimum increments in which bids can be placed so that the competing bids would need to bypass the original floor bid by a certain amount

Qualified Bidders in 363 Asset Sales

Financial Buyers vs. Strategic Acquirers vs. Credit Bidders

  • Financial Buyers: Financial buyers, such as distressed buyout firms, have the distinct advantage of specializing in distressed purchases – meaning, they are typically more knowledgeable in the Bankruptcy Code and 363 sale process. In addition, these firms are more experienced in rapid decision-making and assessing risk under pressure, and the level of risk that these firms can tolerate tends to be on the higher end since the distressed investment strategy is based around these opportunistic circumstances
  • Strategic Acquirers: Strategic acquirers (i.e., competitors) have a distinct advantage in possessing industry knowledge, which can expedite the diligence process due to their familiarity with the risks (and the competitive landscape). Coming in with an understanding of the customer types, products/services, market trends, suppliers and vendors, and regulatory risks can be very advantageous. Strategics can also benefit from synergies from the transaction, which can enable them to place higher bids, whereas financial buyers are restricted by their minimum threshold for the required return from an investment.
  • Credit Bidders: In 363 sales, the “credit bidding” practice permits secured creditors to use their claims as a form of currency to place bids on the assets of the debtor. Secured creditors with liens can “credit bid” using the face value of their debt holdings (as opposed to the market value). Without having to contribute cash, secured creditors can set a valuation floor to prevent the winning bid to be unreasonably low. Each holder of the secured debt can have differing motivations – for example, a corporate lender is unlikely to actively pursue asset ownership since it is not in their business model, whereas distressed investors could seek to take over the debtor (or assets). By utilizing the credit bid, credit bidders can prevent the debtor from selling collateral at too much of a discount. If the credit bidder is successful, it can acquire assets at a bargain price using the debt discount, as it reduces the actual cash outflow required as part of the purchase price. But even in the case that the credit bidder ends up being outbid, the outcome is favorable because the bidder was able to push up the price of the asset and prevent a low sale price, which ultimately ends up benefiting the interests of all creditors.
Financial Buyers Strategic Acquirers Credit Bidders
  • Experienced in participating in distressed asset sale processes (i.e., can make quick decisions, process familiarity)
  • Strategic acquirers have pre-existing industry knowledge and may have a relationship with the debtor
  • Only secured creditors with liens can participate in placing bids with the claim being the form of currency
  • Usually comes with more certainty of closure due to reputational risk (i.e., will not participate if not serious)
  • Unlike financial buyers, strategic acquirers can benefit from post-acquisition synergies (and can bid higher)
  • Can set the floor valuation – regardless of the bidder (e.g., corporate banks, investment firms), preventing low sale prices is a shared priority
  • The investment strategy of distressed funds consists of much higher tolerance for risk
  • Can complete due diligence faster due to already knowing the “ins-and-outs” of this business (e.g., customers, suppliers/vendors, trends)
  • Since the senior creditor is not bidding with cash, it can often bid more than competitors (i.e., pushing up the price)

Fraudulent Conveyance Risk in Distressed M&A Sales

The recurring theme throughout this primer has been that out-of-court sales add more risk considerations for the buyer and complexities to the M&A diligence process. Purchases of distressed assets must be made with caution because all out-of-court M&A transactions bear the risk of potential litigation.

For example, a company can file for bankruptcy and creditors could make an accusation of a fraudulent transfer, which occurs if:

  1. The seller was insolvent at the time of the transaction (or became insolvent post-transaction)
  2. The sale price was completed for “less than reasonably equivalent value”
  3. The transfer was made with the intent to harm the creditors
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