This is the next in our continuing series of notes examining how the COVID-19 pandemic has affected mergers and acquisitions.
Here we focus on distressed M&A, particularly pre-appointment transactions, i.e. deals where the seller is undergoing some level of financial distress but is still trading under the control of its directors. The main issues we find in these transactions are:
- The transaction usually takes place in a very compressed timeframe. This significantly changes both the due diligence process (very limited) and the deal terms (meaning the business is sold ‘as is where is’ and for a fixed price).
- Distressed M&A is generally covenant light with sellers looking for a clean exit (meaning there are limited warranties and indemnities).
- There are additional legal complexities, particularly (for the seller) directors’ duties issues and (for the buyer) the risk the transaction may be later unwound. Distressed M&A is also a highly tactical process and encourages innovative transaction structures.
Background | The current environment
Some of the current trends in the M&A market include:
- Significant issues and difficulties in conducting business valuations – for example, BGH recently extended its exclusivity due diligence period in its bid for Village Roadshow, with the parties acknowledging that COVID-19 ramifications are making work slower. The value of the Village shares has been jolted by the pandemic and the significant brake on tourism and leisure, and BGH modified its pre-COVID-19 indicative offer of $4 per share to its maximum current bid of $2.40. In contrast, Mittleman Brothers (the largest independent shareholder of Village) argues that the shares should have a higher value as the current dint in revenue is temporary.
- Focus on domestic deals – there have been some recent changes to the FIRB regulations, which have slowed down cross-border transactions, which are already affected by differing global responses to the pandemic.
- Increasing volumes of small to medium sized deals (<$500 million).
- Increased activity in particular sectors including those particularly subject to trading interruptions from the pandemic, but including also digital and innovative technologies.
- Numerous transactions involving businesses restructure restructuring their supply chains and key logistics for operational efficiency and resilience.
We are seeing increasing numbers of transactions within this environment from ‘distressed’ sellers. At one extreme, we work with businesses experiencing trading slowdown that are looking to streamline or restructure their less profitable operations to focus on core business, while remaining overall solvent and profitable. In the middle ground, we see businesses that are under significant financial stress and are effectively forced to divest assets to pay creditors and preserve liquidity. In many cases these companies may be already insolvent while still trading. At the other extreme is companies that have been placed into formal insolvency administration, i.e. where an administrator or liquidator has been appointed.
Traditional transactions typically involve the business owner(s) agreeing to sell the whole box and dice, i.e. all the assets and liabilities of the target business. These transactions can commonly involve the following steps:
- Some form of vendor due diligence, including in some cases a pre-sale restructure to ensure the business is in saleable form;
- an orderly sale, for example an auction or tender process;
- a data room and opportunities for buyer(s) to conduct their own due diligence and management interviews;
- long form and negotiated transaction documentation, including warranties and indemnities for identified risks;
- some form of completion adjustment e.g. cash free/debt free or a working capital adjustment;
- in some cases, deferred payment terms such as earn outs or retentions against warranty claims.
Because distressed M&A is typically undertaken in a compressed timeframe, there is considerably less opportunity for due diligence. This means buyers and their advisors need to focus on key DD issues without the luxury of extended enquiries. Some key due diligence issues include: (1) supply chain logistics; (2) employment issues including compliance with workplace laws; (3) diligencing other key business counterparties.
Unconditional, convenant light transactions
Distressed sellers typically want to eliminate conditionality from a sale transaction. Conversely, buyers are more cautious and want an exit opportunity where the business undergoes a material adverse change. Buyers may also attempt to negotiate ‘subject to finance’ conditions.
Sellers are looking for fixed price transactions, with the entire purchase price payable on completion. The nature of a distressed sale is the seller is looking for immediate liquidity. Traditional completion adjustments and post-completion retentions (e.g. earn outs) are unpopular with distressed sellers for another reason, being the difficulty in agreeing earn out metrics in the present trading environment.
In some cases, sellers will even look to buyers to provide pre-completion funding (i.e. a loan) to ensure the sale businesses continue to trade through the pre-closing period.
Distressed transactions are usually warranty light. This is because the seller (1) sells the business ‘as is where is’; and (2) the seller may not have sufficient asset backing to support any warranties that are given. A buyer can address this second issue by retaining part of the purchase price or placing it in escrow. This amount is then held back for an agreed period of time and only released where there is no warranty claim.
However as above distressed sellers are often unwilling to agree to retentions. In such cases a buyer may look to obtain warranty protection by purchasing W&I insurance policy from a third party insurer. However, insurers are typically only willing to underwrite where there has been a customary due diligence and disclosure process. The absence of a formal due diligence process from distressed M&A limits the availability of W&I insurance.
Alternatively, buyers can reduce risk by looking to purchase identified assets rather than the whole business including its liabilities. An asset or business sale is attractive to the buyer because no liabilities are transferred without explicit agreement. On the other hand, sellers find asset sale less attractive because: (1) this structure is generally less tax effective; (2) the transaction documents are more complicated because the contract needs to identify each and every asset being sold; (3) asset sales take longer to complete because there are more consents needed to transfer the assets.
For example, Stockland has recently announced it is selling assets following on from Stockland’s prediction a month earlier that it will suffer a 10% fall in the book value of its portfolio, as a consequence of the pandemic. Stockland is selling two shopping centres: one in Victoria at a 16% discount to its June 2019 valuation, the other (at Caloundra) for $97 million, compared to its $125 million pre-COVID peak valuation. Haben, the buyer, is also acquiring for $8 million a residential block adjacent to the Caloundra shopping centre.
Unwind risk and tactical considerations
As we explained in our last article distressed M&A also involves additional legal complexity and risk.
Particularly, the directors of distressed sellers are often in an invidious position. Directors have a duty of care and diligence to the company, which extends to sale transactions. In broad terms, this means that directors need to be satisfied that (1) a sale process of part or all of the company’s business is in its best interests; and (2) the sale price and terms are supportable, i.e. a reasonable person in the director’s position would have agreed to them. This is particularly problematic for a distressed sale, which by its nature is undertaken rapidly and without it necessarily being possible to fully test the market.
Buyers also face risks. Because a distressed seller will often be insolvent (i.e. unable to pay its debts as and when they fall due), it becomes more likely the seller will be placed into some form of insolvency administration not too long after the sale completes. If a liquidator is later appointed, it has considerable powers to unwind transactions that are uncommercial or unreasonable. In this case, the assets can be clawed back. Some of the ways in which this risk can be mitigated include:
- for a buyer to undertake a ‘loan to own’ transaction. This involves a potential buyer first purchasing the target’s secured debt. First, this gives the bidder access to the company’s directors and valuable business information. It also gives the buyer a tactical advantage in negotiating to buy the business’ assets and gives the bidder control over the timing and manner of the sale process.
- as we have described elsewhere, buyers can also mitigate the unwind risk by obtaining an independent valuation or insisting on a market testing process before the sale is undertaken.
We are seeing increased volumes of distressed M&A transactions, of the kind described above. Keypoint Law is currently advising clients involved in transactions of the kind outlined above.
Due to its nature, distressed M&A will lead to a re-examination of traditional transaction structures to look at other ways to change control. Some buyers may even prefer to wait until the company is placed into administration and purchase assets directly from the administrator to eliminate this risk altogether. This is the subject of our next article.
Stockland also announced it has recently struck a $52.5 million capital investment in residential development in Melbourne, with a Thai-listed partner. See https://www.afr.com/property/residential/stockland-secures-53-million-thai-residential-investment-20200719-p55ddq
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please also note that the law may have changed since the date of this article.