Compared to the 2007-08 financial crisis, the COVID-19 crisis is likely to produce a broader array of asset classes that become available at distressed prices. Here we examine the issues that arise when pursuing a distressed transaction in the US.
What does “distressed M&A” mean?
Distressed M&A is any sale where the seller is facing challenging headwinds, is under pressure or being forced to sell or—at the very end of the spectrum—is in a formal insolvency process.
Sellers tend to accept a lower price for a sale process that can be relatively quick and with few strings attached. Buyers trade some protections and process advantages they normally receive in non-distressed scenarios for the prospect of paying a lower price for the assets.
While it may have the same structural components of a regular M&A deal, the dynamics, assumptions and risks in a distressed transaction are very different. That said, when buying assets from a distressed seller, some of the risks are known and quantifiable and can therefore be reduced or even eliminated.
The three standard distressed M&A processes
The three main distressed asset disposition/acquisition processes are:
- sales conducted by the bankrupt entity via Section 363 of the US Bankruptcy Code;
- sales conducted via a plan of reorganization (POR) in a Chapter 11 case; and
- loan-to-own and debt-for-equity conversions
Section 363 sales
Due diligence is essential in Section 363 sales because:
- representations and warranties typically do not survive closing;
- indemnities are extremely limited; and
- asset purchase agreements (APAs) include limited, if any, diligence or other customary closing conditions.
From the buyer’s perspective, being the stalking horse bidder is crucial. Stalking horses are bidders that make the opening bid, which means that they have already completed their due diligence. Stalking horse bidders have “first mover” advantage; they are the successful purchaser approximately 70% of the time. Tactically, stalking horse bidders can (and should) have an outsized influence on the solicitation process, bidding and auction procedures, sale structure and time frame.
Being a strategic buyer is also an advantage, as they are generally considered as more attractive than financial buyers by sellers and their advisers.
Buyers must show they have the funding in place to complete the sale, as sellers will not normally allow for financing. A buyer that is also the provider of debtor in possession (DIP) financing will also have an advantage because the DIP provider has significant leverage in a Chapter 11 case.
For sellers, a Section 363 sale allows bidders to participate freely, which should help maximize value. For buyers, the break-up and topping fees and other sale procedures provide the stalking horse with some measure of protection. But other bidders may still win the auction if they are prepared to bid enough to overcome the stalking horse’s bid amount plus the break-up fee.
Note that all bidders must negotiate a form of APA and must submit a final and irrevocable draft with their bid.
As a bankruptcy court approves the sale, the seller avoids any risk of being “second guessed” as to the adequacy of the process and consideration received, and the buyer takes title free and clear of liens and fraudulent conveyance risk, with minimal successor liability risk.
Sales via a plan of reorganization
With POR sales, the seller negotiates with its creditors and a buyer to sell assets or the business as a whole. Sale proceeds are distributed to creditors and other parties in interest, and the assets conveyed to the buyer.
POR transactions are most likely if no other credible bidders have materialized prior to or during the course of the Chapter 11 case. Under these circumstances, the seller may insist on a POR rather than a Section 363 sale as a means of wrapping up the entire Chapter 11 case.
Buyers often prefer a POR sale as there is no real auction of the assets, thereby reducing the likelihood of a bidding war. Conversely, sellers and their creditors may prefer a Section 363 sale as they hope to receive competing bids and therefore a higher price. But the desirability or scarcity of the assets may also help dictate which path to take.
As with all distressed transactions, there is a cost to someone. POR sales generally take longer than Section 363 sales because the seller must negotiate the POR with its creditors and have it approved by a bankruptcy court, in many cases over the objections of creditors. The process can take as little as two months if parties (including the court) are cooperative but eight months or more if hurdles arise.
Many recent Chapter 11 cases have been prearranged, i.e., where the parties have agreed to the substantive terms before the Chapter 11 case commences. Indeed, a good number have been prepackaged cases where the creditor negotiations and vote on the POR occurs before the case begins. In these circumstances, approval by the court may be obtained in a matter of days in what has become known as the “super speedy prepack.”
These rapid prepackaged cases are popular with both buyers and sellers as they put the least amount of stress on the business. Buyers are also much more involved in the POR process compared to Section 363 sales because they often become the “plan sponsor.” This means they will be involved in developing and negotiating the POR and its terms, which may be time consuming but will help the buyer control the outcome.
As with a Section 363 sale, the buyer takes title free and clear of liens and fraudulent conveyance risk, with minimal risk of successor liability. Additionally, under a POR, certain transfer taxes may be avoided.
A loan-to-own strategy is perhaps the most intriguing of the three sale methods. This is because it takes an additional level of planning and tactics, but may yield the best return if properly executed.
A potential buyer first identifies the fulcrum debt, which is the debt in the capital stack where value "breaks," i.e., where a junior debt holder would recover nothing as the enterprise value is not enough even to pay all senior claims. Conversely, debt senior to the fulcrum security remains as senior debt in the reorganized entity.
Loan-to-own buyers need to carefully:
- analyze the enterprise value of a target in order to ascertain where the fulcrum lies; and
- review debt documents, intercreditor relationships, and the capital structure of the target in order to make an effective investment decision.
These are undoubtedly high-risk/high-reward ventures. In essence, a loan-to-own buyer is purchasing the fulcrum debt at a discount in sufficient amounts to be able to acquire either the assets or the business using the debt as currency in one of several methods, e.g. in a Chapter 11 scenario under a Section 363 sale or POR sale, or out of court via a private foreclosure or consensual turnover of assets (the Chapter 11 scenario is generally the more common method).
Buyers interested in implementing a loan-to-own strategy often begin to acquire debt of a distressed seller at discounted prices. They may also coordinate with other parties, some of whom may be existing debt holders or distressed debt investors.
Once buyers reach a certain threshold, they form ad hoc groups and begin to conduct negotiations with borrowers and other creditors. The goal is to amass, alone or in concert with others, enough of the seller’s fulcrum debt to meet the statutory requirements to approve a POR, i.e. more than 50% in number of creditors and 66 and 2/3rds in dollar amount.
With that power, the buyers can obtain control of a Chapter 11 case and can dictate how the debt-for-equity conversion will be implemented because they are, as a practical matter, the economic owner of the business.
Loan-to-own buyers may avail themselves of either a Section 363 credit bid strategy or a POR strategy. With the Section 363 sale, the purchase will be subject to higher and better offers in an auction process. However, the buyer will be able to “credit bid” the full amount of its secured debt position – regardless of whether the buyer paid less than par for the debt.
Alternatively, the buyer may wish to use a POR process to implement the conveyance (as a Section 363 sale is an auction, it will potentially allow other parties to bid). However, with enough debt in hand, the loan-to-own buyer can vote on the POR for full face value rather than the discounted price it paid, which affords it tremendous purchasing power. That dynamic effectively gives the loan-to-own buyer who bought at a discount a pronounced advantage to acquire the assets it seeks.
A loan-to-own strategy has been referred to as reverse M&A or “reluctant M&A” when par lenders are compelled to own a business that needs liquidity and their debt is unintentionally the fulcrum debt. In many cases, distressed buyers team up with the “reluctant” par lenders to acquire the business in the hopes of improving it, or waiting for the cycle to improve, before selling it again. Commodity businesses are very prone to loan-to-own acquisitions, and this is particularly true today in the energy sector.
As noted and under the right circumstances, secured debt holders can also effectuate a loan-to-own strategy on an out-of-court basis. For example, when a private equity sponsor acknowledges that it no longer has an economic interest in the asset or the borrower and wishes to cooperate, the lender and the equity will negotiate a voluntary turnover of the entire business, usually in exchange for a release and sometimes a small warrant position, which will be in the money after the lender recovers its original debt in full.
This type of transaction is referred to a consensual debt-for-equity conversion or a deed in lieu (in lieu of the lender exercising remedies). Here, the lender is acquiring the business subject to all liabilities and obligations, and it is effectively a change of ownership and not an operational restructuring, which can possibly occur later if needed.
Consensual turnovers work well where the liabilities are quantifiable and the borrower does not need to avail itself of a bankruptcy case to restructure or shed operational liabilities, such as unfavorable leases or contracts. It is the type of transaction that, under the right circumstances, can be a most efficient means of implementing a loan-to-own strategy with less cost and friction.