Distressed or insolvent M&A: navigating the pitfalls and opportunities
07 April 2021
One of the surprising features of the pandemic, given the damage it has caused to businesses in many sectors, is how little M&A activity we have seen so far involving distressed or insolvent businesses.
The expectation at the outset of the crisis was that distressed M&A would almost immediately be a very busy area of the market.
With the exception of some high-profile retail deals and activity in the tourism, hospitality and automotive sectors, distressed activity to date has been relatively limited.
There are various contributing factors including:
- government employment and financial support schemes have allowed companies to put off what may still be the inevitable
- the temporary suspension in some jurisdictions, such as Germany, of insolvency filing obligations, has given troubled businesses time to breathe
As support schemes end and usual of insolvency rules are reapplied, we are likely to see a sharp uptick in deals targeting distressed or insolvent companies. Some market watchers expect to see a surge in such deals in the second half of 2021.
For buyers contemplating acquiring a distressed or insolvent business, there are many issues that distinguish such deals from normal M&A transactions.
- deals usually need to be executed at high speed
- opportunities to carry out deep due diligence may be curtailed
- normal contractual protections that buyers are used to, such as warranty cover, may be limited
Understanding the pitfalls and the opportunities, and being able to identify “red flag” issues from the outset, can often be the key to success.
Questions to ask upfront
Is it a controlling shareholder, the company itself or an insolvency practitioner?
What state is the target company in?
Is the target facing difficult times, in the twilight zone immediately ahead of becoming insolvent, or already embroiled in formal insolvency proceedings?
Are there cross-border considerations?
This could dictate where insolvency proceedings may be commenced and how parts of the business are sold.
How can the seller’s concerns be met?
Buyers should be mindful of the requirements of directors of distressed, but not yet insolvent, businesses to continue to meet their ongoing duties to stakeholders and their need to avoid personal liability.
What about integration?
Failure to think in advance about how two businesses will be integrated can lead to big problems later on and an inability to realise the true value from the deal.
Where the target business is a “going concern”, buyers also need to establish what kind of sale process is most appropriate and what conditions may attach.
For example, cherry-picking selected assets might be a better bet than acquiring the shares of the company (and inheriting all its liabilities).
Negotiation of the sale on an exclusive basis may be possible. Alternatively, there could be a race to complete the sale, with the seller talking to other prospective buyers.
Understanding risk is crucial. In particular, the buyer should consider whether there is any danger of the sale agreement being set aside (or an order made for the payment of additional consideration) as a result of the transaction avoidance provisions that can apply in an insolvency proceeding. These provisions are in relation to transactions entered into in the period immediately before the commencement of the insolvency proceedings.
Moreover, because information about the company may be restricted, limiting the ability of the purchaser to carry out full due diligence, the buyer must assess the likelihood of recovering any amounts in respect of breach of warranty and any other red flags raised in assessing the target.
Some of these issues will have a direct bearing on the terms of the deal.
Potential red flag issues
Certain assets will be treated very differently in an insolvent sale compared with a solvent transaction, raising a further range of potential concerns.
For instance, special issues may arise in a management-sponsored buyout. There could be constraints on continuing to use the company’s name and substantial property transaction considerations, while confidentiality issues may arise in respect of the seller and the management team.
Retaining all or part of the company’s workforce could also land the buyer with significant potential liabilities. Careful scrutiny of relevant employment laws is vital.
Relevant pensions regulators may have the power to intervene. If so, it may be worth seeking confirmation that the regulator does not intend to take action.
Where property assets are involved, the onus is on the buyer to carry out the best investigation possible in a limited timescale.
Other issues to look out for include:
- ensuring the release of security over shares and assets being acquired
- suppliers’ retention of title claims over stock
- book debts and ongoing access to books and records
- consents and approvals required in different jurisdictions
- continued performance of contracts and change of control provisions
- ownership of intellectual property
Changes afoot in UK for pre-packaged sales
The term “pre-pack” is used to describe the sale of an insolvent business agreed before a company enters formal proceedings.
The proposed insolvency practitioner will be involved in determining the terms of a sale in advance so that a deal can be completed quickly once, or shortly after, proceedings start.
Although not part of UK insolvency law, pre-pack sales are a mechanism that has commonly been used in practice in the UK, despite the fact that, until the practitioner is formally appointed, any commitment to sell is theoretical rather than actual.
Although popular, the mechanism is controversial, seen as lacking in transparency and denying unsecured creditors and customers a role in deciding the future of the business.
In response, the UK government laid regulations before Parliament in February 2021 which, if implemented, could either:
- require creditor consent for pre-pack sales (something that, for the reasons set out in our recent publication on pre-pack administration regulations, we think is unlikely to be used much in practice); or
- require connected parties to provide the administrator with an independent opinion of the deal terms, most crucially on the issue of price
The new regulations would probably push up the cost of the transaction for purchasers and we expect that they will come into force in relation to administrations commencing on or after 30 April 2021.
However, they may also, finally, quieten long-running criticism of pre-pack deals.