Should I buy a distressed business in bankruptcy or outside of it?

The ingredients are all there for a rise in distressed mergers and acquisitions. Inflation, rising rates, volatile stock markets, geopolitical issues, supply-chain disruptions. Headwinds such as these should result in more companies selling or seeking a merger to help mitigate the problems they’re facing. Buyers will go after lower prices and distressed targets. Bloomberg reported that about $246.6 billion of U.S. dollar-denominated corporate debt and loans in the Americas trade below 70 cents, the most since November 2020. Telecommunications, software, retail, pharmaceuticals and health-care services are among the issuers struggling the most. According to The Economist, distressed-investing funds raised about $500 billion.

Owners and operators who cannot defer payments to a future date, refinance maturing debt at much higher rates, or raise capital may be forced to sell or combine in an M&A deal. When interest rates rise, refinancing becomes harder. It makes owners vulnerable to buyers looking for opportunistic deals. If you are a buyer, remember that the first offer that checks out is often the one that wins.

Decide carefully whether to participate in a distressed M&A transaction. The risks, of course, include the target ending up in bankruptcy. Weigh the advantages and disadvantages of moving outside the Bankruptcy Code and inside the Code. You will have to do a lot of due diligence to decide whether and when to make an offer. When you decide to make an offer, the risks vary depending on whether you do it before or after a possible filing.

Here are some of the key points everyone — from financial buyers, to family offices, to strategic acquirers — should know about doing distressed deals.

The First Mover Advantage Is Real

A seller with cash-flow shortfalls or defaults looming needs to move quickly. A buyer should work with an experienced distressed advisor to perform a quick financial, operational, and legal due diligence and get the deal done. With speed, a buyer can shape the deal before others enter the auction.

Going into a distressed M&A deal, not only are you picking up the key assets like contracts and IP, you are leaving behind liabilities. When doing the diligence, remember that looking for what you don’t want is as important as what you do. Identify the assets (contracts, IP, etc.) that the business will sell to you, then decide which liabilities, if any, you are willing to take. One of the critical diligence issues in today’s market is supply chain risk. Look at backup suppliers and backlogs. Are suppliers at risk? What would happen if those suppliers shut down?

A buyer with a financing contingency is at a disadvantage. Sellers who are short on cash won’t have time to wait for you to put financing in place. This means you have to lock in the committed financing upfront.

Outside the Bankruptcy Arena or Through a Bankruptcy Case

The target does not have to file bankruptcy to get the deal done. It is essential for anyone who considers a distressed M&A deal to understand the tradeoffs between doing the deal outside the Bankruptcy Code, and doing the deal in a bankruptcy case. The decision depends upon many factors, including the purchase price, transfer liabilities, transaction timeline, competing bids, keeping customers and employees. There’s no one-size-fits-all answer here. Each deal is different.

You can get the deal done outside the Bankruptcy Code, in a quicker, cheaper, and less competitive process, with less publicity, through a foreclosure sale, asset sale, restructuring, or even an ABC (an assignment for the benefit of creditors). But getting creditors or shareholders to sign off on the deal can be a challenge. Buyer beware. A party must be careful if the seller is insolvent and the price is too low, because the transaction could be attacked later for being a fraudulent transfer. There is also successor liability for tax, tort, and environmental claims, and for employee claims. Even claims against products that the seller sold before you bought the company may wind up as your problem. A buyer may want a third-party valuation opinion before closing the deal.

A buyer doing a deal outside the bankruptcy court is usually buying assets, not stock. This may mean assigning contracts, and that often requires the counterparty to the contract to consent. Transfer risk increases with targets that depend on many key contracts. Get the contracts early in the diligence process so you can understand this risk early. You also need to keep in mind that, should the target file before the closing, the target can reject the deal. In a sale outside the bankruptcy court, if the target files a bankruptcy case after the closing, the indemnity, price adjustment and transition services can be nearly worthless. Even a target that agrees to assume the deal requires court approval of the assumption agreement and a bidding process. If you’re a buyer doing a distressed deal, try to get a holdback or escrow or an agreement to assume the deal or stalking horse terms in advance to minimize a possible rejection of the deal.

Then there are the bankruptcy advantages to making an offer. The deal binds holdout creditors who refuse to join. There is rarely a shareholder vote. Assets can be sold free of liens and claims. Even contracts that have anti-assignment clauses can be assigned. Of course, defaults must be cured. Doing the sale in bankruptcy also can remove the risk of a post-closing fraudulent transfer claim. Successor liability is cut. Courts usually require competitive bidding. Secured creditors can often credit bid their debt. If you want to bid on an asset in bankruptcy, you may be able to do so using your debt that is secured by that asset. This is called credit bidding. If you are the first to sign a contract and your offer requires a bidder to bid higher to beat you, then you have a stalking horse position. A stalking horse deal means the first buyer who signs the contract typically gets a break-up fee and reimbursement of expenses in the case another party outbids. The buyer can put an overbid amount and a bid increment amount into the contract, and any other bidders would have to bid enough to cover the overbid, plus the break-up fee and reimbursement of expenses. Being the stalking horse can make it costlier for other bidders to beat you. Be the stalking horse.

Doing a deal inside the Bankruptcy Code has its drawbacks too. The process is often time consuming and costly. Indemnity is rare and usually small. Sometimes the buyer can get a rep and warranty insurance policy to cover a seller’s breaches of reps and warranties after the deal closes. The process has risks, including that there are bidding delays and that can drive up the price. Everything plays out in public view. You’ll have to deal with creditors who will want to shape the terms of the deal. Weigh those cons against the pro of a clean title.

A bankruptcy sale can be done two ways: A 363 asset sale or a plan. A Section 363 sale typically offers a clean exit, and all the assets are sold free and clear after the sale closes. A plan sale is only part of the debtor’s confirmed reorganization or liquidation plan. A Section 363 sale can be quicker than a confirmed plan, too. The plan process is more complicated, needs approval of the plan, but the debtor can retain the tax loss (where the Internal Revenue Code allows), non-transferable IP, and permits. The plan route can be treated more like a stock deal. Which route makes more sense depends on the goals of the debtor and buyer and how quickly a deal can be done. Talk to advisors early in the process to figure out which option is best for you.

Whether you’re buying or selling, in or out of bankruptcy court, watch out for filings that may be required or advisable such as Hart-Scott-Rodino, which is an antitrust clearance, or CFIUS, which is a Committee on Foreign Investment in the U.S. clearance.

The Price Fight

Sellers can get anchored to old comparables that no longer hold up in today’s market. Buyers can bridge the gap with earn-outs, true-ups, and other deferred payments, including royalties and milestone payments. Instead of paying cash at the closing of the deal, buyers can agree to make payments in the future. These kinds of agreements can cause tension between buyers and sellers. Sellers or creditors may fear that new management will hurt performance metrics. Buyers may not like having to agree to operating constraints. Corporate acquirers may pay with stock or convertible debt. It is a delicate balance. Expect the price fight to continue.

There’s a lot of opportunity for the prepared buyer — in and out of bankruptcy court. The due diligence is key, and you have to do it quickly. Hire experienced distressed M&A advisors.