Distressed M&A

Distressed M&A (mergers and acquisitions) refers to a process that involves entities buying assets owned by companies confronted with financial challenges at bargain prices. It offers great opportunities for the purchasers to inject necessary liquidity relief via M&A transactions.

This procedure occurs on a tight schedule and involves a due diligence process. The latter is for offering peace of mind to the bidders. For these two reasons, M&A should accumulate lower prices than a regular auction procedure. Such a procedure is useful for sellers to acquire short-term liquidity and remain solvent.

• Distressed M&A refers to a procedure that involves acquiring a target having a significant over-indebtedness risk, high illiquidity, or dealing with a bankruptcy or insolvency proceeding.
• The distressed M&A due diligence is conducted by companies on multiple aspects, such as the cause of the financial turmoil, working capital efficiency, financial needs, transaction risks, etc.
• There are different types of risks associated with distressed mergers and acquisitions. Two of them are successor and execution risks.
• The COVID-19 pandemic’s long-term effects can provide various opportunities in distressed M&A. This would enable companies to acquire organizations with impressive fundamentals.

Distressed M&A refers to a complicated, fast-paced sales procedure that gives qualified bidders a chance to purchase assets of businesses in distress at appealing prices. This process enables the selling companies to improve their liquidity position over the short term and remain operational. The procedure consists of tight deadlines and intricacies; typically, this type of M&A may last for many months. In essence, the process is a race against time to salvage the maximum value while saving various job positions and avoiding factory closures.

The distressed M&A due diligence procedure may vary considerably. While time is short, the management team may have access to very limited information. Hence, experience is crucial for investors to spot the most relevant red flags, problems, and deal breakers.

Typically, acquirers carry out due diligence on the following:

• Current credit metrics and financial condition.
• Financing requirements and working capital efficiency
• Relationships with vendors, customers, and other prepetition stakeholders
• Transaction risks, such as fraudulent conveyance
• The reason why the company is in distress

Considering the limited time available, potential acquirers must perform the due diligence on the basis of priority. Moreover, they must concentrate on the aspects with maximum perceived risk.

One must also note that a strong legal background is pivotal to safeguarding investors from purchasing legacy legal liabilities.

Once the sale is complete, the acquirer starts a tedious procedure to bring the organization back on track. This may occur via an insolvency process and an executed restructuring plan that is closely formulated. In many cases, the acquirer or purchaser utilizes their creditworthiness to engage in negotiations with the lenders and restructure the debt of the organization. These actions can restore a business’s sustainable financial health in combination with strict measures to enhance operational efficiency.

Let us look at a few distressed M&A examples to understand the concept better. 

Example #1

Suppose ABC Inc. is in financial turmoil. It wants to improve its liquidity position. So, it approached certain qualified bidders with the proposal of a distressed M&A. The bidders conducted their due diligence and placed bids based on their estimated valuation of ABC. XYZ Inc., the highest bidder, acquired the company’s assets as it had placed the highest bid. As a result of this purchase, ABC’s liquidity position improved significantly.

Example #2

Amidst the severe instability in the U.S. lending sector following the Silicon Valley Bank’s collapse, First Republic Bank, or FRC, is evaluating multiple strategic alternatives to power through the difficult times. After getting a ‘junk’ status from Fitch Ratings and S&P Global Ratings, the bank is looking at different options to secure its financial position.

David Chiaverini, a Wedbush analyst, downgraded FRC to a neutral rating from an outperform. Moreover, he lowered the price target for the stock. The analyst’s concern with this bank is because of the potential distressed M&A sale. This could leave behind very little residual value for the common equity holders as the financial institution’s tangible book value is negative.

Certain sectors, for example, travel, hospitality, and retail were severely impacted owing to the pandemic-related limitations during a period when such industries were already burdened with tremendous pressure.

That said, unlike the past cycles where certain industries, such as oil and gas, forestry, etc., were distressed targets, COVID-19’s long-term market effect may impact organizations throughout the spectrum as employers make changes to their work arrangements. The alterations made will establish various opportunities in distressed M&A. In other words, entities will have opportunities to make distressed investments in companies with stellar fundamentals but needing financial and operational restructuring to carry out operations in the economic environment following the pandemic.

The risks associated with such a process are as follows:

• In this case, one of the most noteworthy risks for sellers is execution risk. When the selling company is in financial turmoil and the proposed sale fails, it must file for bankruptcy. That said if a selling company has already announced bankruptcy, selling assets might be an ideal way to ensure maximum recoveries for creditors.
• Successor risk is another key risk that comes with such M&As. It may lead to a buyer being considered the successor to the business of the seller, although the provisions in the purchase agreement are of the opposite nature. This risk is higher in the case of transactions that include distressed assets because of the concepts of de facto merger and fraudulent conveyance or transfer.
• Another significant risk to purchasers, in this case, is that the seller might be in distress for a certain reason, for example, an outdated business model, poor industry environment, or significant liability exposure. Such issues may travel with the seller’s assets as the buyer acquires the company. The risk may increase if the seller has an immediate cash requirement, resulting in a compressed due diligence procedure and timeline. This can make it even more difficult to identify the material risks that the purchaser might have to bear.

People new to the world of finance often think that distressed and conventional mergers and acquisitions are the same thing. However, they are not, as these concepts have some critical differences that one must know. So, this table highlights their distinct characteristics.

This article has been a guide to Distressed M&A and its meaning. Here, we explain its examples, opportunities, risks, and comparison with conventional M&A. You may also find some useful articles here -

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• Merger Arbitrage
• Horizontal Merger