M&A in the COVID Era – Part I – Dealing with Distress: Strategies for Buyers of Distressed Targets in the Post–COVID-19 Era
As many traditional private company buyers take a “wait and see” approach to dealmaking, pausing or cancelling their active transactions, many are scanning the horizons for new opportunities outside of their traditional comfort zones. In addition to scoping targets in COVID-19–relevant industries, many are looking for unique value propositions and approaching historically healthy and stable targets that are experiencing distress during the pandemic. For buyers with a record of purchasing distressed assets, the pros and cons of buying assets out of a formal bankruptcy process and the strategies for success are well known. For buyers that are less experienced with acquiring distressed targets we have prepared the following primer on the pros and cons of purchasing distressed targets through a formal bankruptcy process, and several strategies for increasing your likelihood of success.
Background
Generally speaking, the United States Bankruptcy Code allows a “debtor in possession” in a Chapter 11 reorganization case and Chapter 7 trustee in a Chapter 7 liquidation case to sell assets outside of the ordinary course of business pursuant to Bankruptcy Code Section 363. These assets can generally be sold “free and clear” of any interests in such assets pursuant to a federal bankruptcy court order. The advantages to a buyer of such free and clear order are readily apparent when the target is undergoing a period of financial distress.
Deciding Whether to Purchase Assets Through A Formal Bankruptcy Process
The usual choreography for distressed acquisitions can involve a buyer identifying and approaching a target with an expression of interest, the target reciprocating such interest, and the buyer beginning a limited due diligence process. Given the distressed nature of the target, this dance is often on an abbreviated timeline and with limited engagement from the target’s management team, who tend to be nearly exclusively focused on keeping the lights on. Given the fast pace, buyers are forced to decide early in a process, often prior to completing substantial legal or financial diligence, whether to encourage the target into a formal bankruptcy process and to act as a “stalking horse bidder,” or to proceed with a more traditional acquisition process. Where a potential target may have multiple suitors, this decision is further complicated by the risk that another buyer may encourage the target to pursue a formal process, leaving you behind the stalking horse in the process (although it should be noted that there can be advantages to being a counter bidder to a “stalking horse bidder”).
When deciding whether to encourage a formal bankruptcy process and therefore to act as the stalking horse, buyers should be thoughtful of the following:
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Valuation |
Relative purchase prices are typically lower than non-bankruptcy sales. |
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Speed |
If the bankruptcy filing is done contemporaneously with the filing of the appropriate “Section 363 Sale Motion,” the process from filing to close can take as little as a few months, preserving asset value. Given the rapid decline of revenues at many targets during the pandemic, this speed to closing is of obvious appeal. |
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Third Party Consents |
Except for specific circumstances, contracts purchased through a bankruptcy are not subject to third party consent. During and after the pandemic, we expect contract counterparties (lenders, landlords, customers, etc.) to pursue all opportunities to renegotiate legacy contract terms that are now “off market,” and as such we see more “hold up risk” associated with third party consents post-pandemic. A formal bankruptcy process reduces that risk almost completely. |
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Operational Continuity |
During the pendency of a formal bankruptcy process, the target is protected from creditor pressures, including any efforts to foreclose or other otherwise employ creditor remedies. This creditor protection is particularly valuable in the current market, where distress is rampant and creditors are more actively and aggressively pursuing all avenues of recourse against debtors. |
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Pole Position |
The stalking horse in a bankruptcy process sits in the pole position – they are the first on the inside for management meetings and will have the most time for due diligence, giving them advantageous visibility into the operational viability of the target and its assets. |
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Deal Terms |
Stalking horses can help shape the deal structure, identifying the assets to purchase and limiting the assumed liabilities as they choose. They can also set the features of the sale, including timing, deposit requirements, and bidding protections such as expense reimbursement and break fees. |
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Competition |
The bankruptcy process and the public filings required in connection therewith open the transaction to competing buyers, who may outbid the stalking horse. |
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Cost/Timing |
While a formal bankruptcy process can move more quickly than a traditional acquisition, the cost and delay of negotiating bid procedures and stalking horse terms, including potential interference from “parties in interest” (e.g., unsecured creditors committees, secured lenders) can slow things down. However, the relative parameters of bid protections are fairly well established by custom and practice, and experienced counsel should be able to help buyers efficiently manage that process. |
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No-Exclusivity and Limited “Outs” |
Exclusivity and “no-shop” covenants are generally disfavored and, once the asset purchase agreement is signed, closing “outs” available to the buyer (financing, diligence, etc.) are very rare and can put the bidder at a disadvantage with respect to other bids that don’t have such contingencies. |
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Limited Indemnification |
To allow creditors to walk away with clean hands, asset purchase agreements in formal bankruptcy processes typically contain very limited seller representations and warranties, with very limited (often zero) survival. Post-closing risk can be mitigated to some extent by securing a representation and warranty insurance policy, but the buyer will nonetheless have to live with the limited disclosure and lack of recourse for known issues. |
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Approvals/Challenges |
Bargained-for bid protections are subject to objections from various parties in interest in the case, such as the Executive Office for United States Trustees (a branch of the Department of Justice that oversees bankruptcies) or an unsecured creditors committee that may be appointed in the case. The asset purchase agreement also requires court approval, but it’s that court approval that gives the buyer the powerful “free and clear” order largely preventing creditors of the target from chasing the buyer post closing. |
Strategies for Success
Buyers that ultimately find themselves in a competitive bankruptcy process, either as a stalking horse or as a completive bidder, can maximize their likelihood of success in several ways:
- Diligence — Given the limited opportunity and potential scope of due diligence, buyers should be prepared to quickly identify the diligence needs of the target and then deploy their legal and financial advisors as quickly and comprehensively as possible.
- Pre-Closing Financing — Buyers should include in their diligence a review of the target’s current operational capacity and needs. Understanding whether pre-closing financing is needed to keep the target operational is critical, and buyers in a position to provide needed bridge financing (often in the form of a debtor-in-possession financing or “DIP loan”) will distinguish themselves against the rest and in certain situations allow them to “credit bid” for the assets.
- Contingencies — As with traditional deals, bids with fewer closing conditions will stand out ahead of the rest, as courts and creditors will prioritize clear paths to closing.
- Cash Consideration — Cash is king, and sellers will prioritize return of capital over potential future upside. Cash consideration is almost always required in bankruptcy sales.
Ultimately buyers will need to decide whether the benefits of buying assets free and clear of almost all liabilities and third party consents outweigh the risks of the public filings and possible competition that result from formal bankruptcy processes. If the answer is yes, a formal bankruptcy processes may be the way to go for many acquisitions of distressed targets during and after the COVID-19 pandemic.
M&A in the COVID Era – Part II – Debt Financing Opportunities for Middle Market PE Funds
April 6, 2020| Advisory|
M&A in the COVID Era – Part III – A Dealmaker’s Guide to Post–COVID-19 Purchase and Sale Agreements
April 7, 2020| Advisory|
Authors
William W. Kannel
Member
