Distressed M&A – Same same, but different

Although the Covid-19 pandemic caused the worst economic downturn since the global financial crisis of 2008/9, a significant wave of insolvencies and restructuring situations has not yet hit the German market. This might change, however, in the short to medium term since there is still a great need for a fundamental transformation of business models in many sectors – e.g. automotive, industrial and retail. The transformation process requires a considerable amount of investment and liquidity that not every company is able to secure. Moreover, leverage ratios have increased especially in connection with Covid-19 rescue financings, which will considerably hamper the refinancing prospects for many businesses in the near term. The number of distressed M&A transactions is therefore likely to increase. The question arises: is the market adequately prepared for this, given that distressed transactions differ significantly from "ordinary" M&A transactions?

Transactions under time pressure

In general, distressed M&A transactions are not initiated proactively, but are instead the result of extraordinary circumstances such as financial distress or insolvency events. In structuring the process, sellers hardly ever have much time to prepare, leading to many distressed M&A processes being started on the basis of incomplete information. In this context, the challenge is often to identify the value drivers for potential acquirers quickly so that not only the equity story, but also a sound restructuring concept can be promoted during the marketing phase of the transaction.

Compared to the classic two-step M&A process, another challenge is the lack of time and flexibility in structuring the process. In the first phase of a classic M&A process, bidders are initially approached using preliminary information, and full-scale due diligence is performed with a smaller group of bidders in the second stage. By contrast, a distressed M&A process often only consists of one stage, where potential bidders are identified during a brief bidder eligibility check and the due diligence is started early on in the process. In addition to the sale of the entire company, the sale of individual business units frequently also needs to be pursued in parallel.

Moreover, stakeholder management is complex: while ordinary M&A processes are often "controlled" solely by the shareholder, distressed M&A transactions require additional coordination, specifically among lenders, suppliers and customers. They are also subject to stricter transparency requirements.

Buyer dynamics and value drivers

In distressed M&A transactions, approaching a long list of bidders is the starting point for ensuring transaction security and a maximum purchase price in a manner that is objectively verifiable (e.g. to a creditor committee). In this context, the approach of strategic buyers differs from that of specialised financial investors. The latter group, specialising in turnaround situations and familiar with structuring options, can use their experience to put a price tag on levels of risk and are used to meeting tight deadlines. Strategic investors, by contrast, often require more time to assess and execute distressed M&A transactions, and they frequently apply the same acquisition criteria as for "healthy" acquisitions.

This particular bidder environment brings opportunities to promote competition. Acquiring companies in distress offers strategic buyers the opportunity to increase the transaction's synergy potential significantly as the organisational structure of the target can be modified, for example through insolvency proceedings, even before the transaction is closed. This increases the pricing pressure on financial investors. On the other hand, the speed at which distressed M&A transactions can be executed by financial investors places added pressure on strategic investors, who might otherwise miss out on making a transformative acquisition.

Apart from securing the highest possible purchase price, it is crucial to identify alternative value drivers. Depending on the structure of the transaction, the "transaction value" can be increased significantly for the seller by minimising post-closing risks and implementing potential earn-out mechanisms.

Purchase agreements follow their own rules

Purchase agreements in distressed M&A transactions follow their own rules. Sellers frequently take a clean-cut approach – especially in cases where the seller "pays" the buyer a dowry in the form of a negative purchase price. In such instances, sellers demand that risks associated with the target's past business operations be allocated exclusively to the buyer and that there be as few representations and warranties as possible, which under different circumstances would be considered aggressive. Usually, agreements for the purchase of distressed targets also include provisions addressing the seller's liability risks that might materialise in an insolvency after closing, especially if the intended restructuring fails. In this context, liability risks associated with intra-group financing measures (e.g. loans granted during the crisis), intra-group transactions and pre-closing carve-outs are of paramount importance – particularly when considering risks posed by insolvency avoidance actions (Insolvenzanfechtung).

The linchpin of the contractual defence mechanism is found in provisions stipulating that the buyer is obliged to indemnify the seller against any and all claims asserted by third parties, such as creditors or an insolvency administrator, in the event of the target's insolvency, also known as "insolvency indemnity". Mirroring that indemnity, purchase agreements frequently provide for positive covenants, specifically so-called "solvency covenants", under which the buyer undertakes to provide the target with ongoing financing for a certain period of time. Closely connected with such covenants are ring-fencing provisions. These prohibit the buyer from taking certain measures with respect to the target for a specific period of time post-closing, e.g. withdrawing company funds in the form of dividends or management fees. In the event that the seller is unable to obtain reliable buyer commitments, the seller may seek to protect itself against certain insolvency risks by having the transaction implemented on the basis of a restructuring opinion prepared by an independent expert. In bidder processes, great care and skill are especially required when it comes to the restructuring opinion: it needs to be based on the business plan of the successful bidder validated by the opinion provider, although the selection of the successful bidder depends to a large extent on the business case presented by the bidder.

Exercising great care and skill when acquiring insolvent companies

Buyers also require specific expertise on insolvency if a restructuring has failed and the target has already filed for insolvency. In that event, the buyer may opt for buying either the insolvent company by way of an asset deal (übertragende Sanierung), or shares in the insolvent entity by way of an insolvency or restructuring plan. While both options generally permit the settlement of existing liabilities, they differ quite considerably in other respects and must be weighed up by taking the facts of the individual case into account. Finally, buyers of insolvent companies benefit from transaction experience: only buyers who are familiar with the demands of an insolvency administrator, and who manage to steer clear of the no-nos under insolvency law, will succeed in competitive bidding processes.

Due to the many unique characteristics of distressed M&A transactions, such processes are not carried out via a standardised approach. Distressed M&A transactions require not only a holistic approach when preparing and executing the transaction, but also the experience that is necessary to be able to respond with flexibility in extremely dynamic processes and special circumstances. In view of the expected increase in deal volume in the short and medium term, market participants are well advised to familiarise themselves with the special aspects of transactions involving distressed companies in order to be able to successfully execute accretive acquisitions as well as value-maximising sales that also safeguard jobs. Distressed transactions are usually perceived as carrying a high inherent risk at the time of execution. Accordingly, only those sellers and investors who are well-prepared and well-positioned when entering these processes will be able to achieve a high selling price / an attractive and predictable long-term investment return.

A version of this article has been published also in M&A Review.