Process – deal evaluation process and strategy
Time is of the essence in a distressed M&A transaction.
There are often urgent liquidity needs to be met on the part of the seller/target especially in circumstances where the value of the target business and assets is rapidly deteriorating. There is frequently time pressure to commence and complete a deal before the seller/target runs out of cash and formal insolvency proceedings are initiated. The seller/target also needs to factor in the compressed timelines mandatorily imposed by creditors and/or the courts (for instance, in pre-insolvency proceedings).
As a result, the deal evaluation process must be well-calibrated and focused. In Part 1 of this series, we covered the typical structures utilised in a distressed acquisition which involves the acquisition of shares, assets, debt or a combination thereof.
A buyer/investor needs to adjust its deal evaluation process to take into account the proposed deal structure:
- Assets: The evaluation of individual assets is typically the most straightforward. The buyer will often have pre-identified the assets it wishes to acquire and will thus focus its efforts on acquiring good and marketable title to these assets. The buyer’s evaluation and due diligence efforts should be structured to focus on related aspects of the asset acquisition, such as whether there are ancillary arrangements which would help these assets realise their full value. For example, if the buyer of a commodities business is principally interested in the physical storage facilities, it will be critically important to understand the ownership of the tanks/warehouses and the bankability of any long term storage contracts that underpin the related revenue streams.
- Debt: If the buyer’s strategy involves the acquisition of debt, it will need to understand the value of such debt and its contractual underpinnings in the context of insolvency and pre-insolvency proceedings. The buyer must also form a view as to the recoverability of such debt, taking into account its rank in the creditor hierarchy. Accordingly, the buyer’s deal evaluation strategy should focus on examining the level of indebtedness owing to the different classes of creditors (e.g., secured lenders, unsecured lenders and trade creditors), the existing security arrangements, the extent to which the to-be-acquired debt is recoverable and the leverage such debt will afford the buyer/investor in pushing through a favourable deal.
- Shares: An acquisition of shares will involve a due diligence process that is similar to that of a non-distressed M&A transaction albeit with a compressed timeline. One key difference, however, is that the buyer/investor will also need to look very closely at the target’s ability to continue as a going concern post-closing. This means that, apart from the usual due diligence a buyer/investor would be expected to undertake, the evaluation approach used for a debt acquisition, which is mentioned above, would also be applicable here to understand the level of indebtedness and the different classes of creditors. This will help the incoming buyer/investor ascertain the extent of rescue financing that may be required to sustain the target post-completion, and in parallel, allow it to make restructuring proposals favourable to its objectives.
Auction process
From the seller/target perspective, an auction process can be an attractive means of obtaining the best possible price for the subject matter of the transaction within a short timeframe. The competitive nature of the auction process helps to address the risk of a transaction being challenged as an undervalue transaction and becoming subject to statutory claw-back rights in a winding-up. If managed properly, an auction should also help expedite the process of securing a buyer/investor within the shortest possible time.
The seller/target needs to carefully balance the desire to cast the net wide in order to solicit as many bids as possible (always being mindful of the risk of competitors using the auction process as a fishing expedition for their own commercial benefit) against the time constraints available to put together and complete a viable deal. Getting this balance right is difficult and we have seen recent instances in Singapore and Southeast Asia where the desire to attract as many bids as possible has caused significant and costly delays to the deal process.
Protection – for prospective buyers/investors
It is not uncommon for distressed M&A transactions to be conducted on a purely ‘as is, where is’ basis. Given that the seller/target is in distress and sale proceeds are likely to be required to repay indebtedness (rather than being retained by the seller/target), the seller/target is unlikely to be in a financial position to give the buyer/investor any meaningful deal protections, such as the usual warranties or indemnities a buyer/investor would expect in a non-distressed M&A transaction. The trade-off for the buyer/investor is, of course, the expectation that the transaction is priced accordingly and often at a deep discount to reflect the risk that the buyer/investor assumes in not obtaining the usual deal protections.
This having been said, some limited buyer/investor deal protection provisions may still be available in a distressed context and can be broadly categorised as follows:
- Pre-closing withdrawal and conditions: A buyer/investor will want to reserve for itself greater rights to walk away should there be further adverse developments affecting the seller/target. The buyer/investor can also insist that favourable restructuring proposals are completed before deal closing happens, such as a suitable debt ‘hair-cut’ for creditors to ensure the viability of the post-closing target/business. The list of conditions precedent to closing and pre-closing covenants must be carefully scrutinised and adapted to properly reflect the distressed nature of the transaction. For example, the buyer/investor will want to ensure that the seller/target does not apply for bankruptcy protection without the buyer/investor’s consent so as to avoid being unwillingly drawn into an unintended adverse situation.
- Price adjustments: The buyer/investor might also consider including specific price adjustments, involving an agreed reduction of the purchase price in the event of certain pre-agreed liabilities in order to compensate for the fact that the buyer/investor will be working under a compressed timeline and may not be able to complete customary due diligence. On the flipside, the creative use of earn-outs can be favourable for the seller/target in that the seller/target is able to secure a baseline pay-out to cover its immediate funding needs, while at the same time allowing for a potential upside when economic conditions improve and/or the buyer/investor is able to effect a successful turnaround of the target.
- Post-closing assurances: As mentioned above, the usual buyer/investor protections such as warranties or indemnities are likely to be limited in a distressed transaction. One strategy a buyer/investor can deploy to seek to address these risks is through warranty and indemnity (W&I) insurance. This is, however, not without its challenges given that insurers will typically expect that the buyer/investor has carried out thorough due diligence. Some insurers are willing to provide cover to the buyer/investor by insuring a suite of ‘synthetic’ warranties which are usually directly negotiated between the buyer/investor and the insurer and are particularly useful where the seller/target is unwilling or unable to negotiate warranties. Synthetic warranty based W&I cover is still a relatively novel device in the M&A toolkit in Southeast Asia. That being said, given the current deal climate, we foresee the potential for significant innovation in the Southeast Asian W&I space in the near term. It is worth noting that synthetic warranties tend to be priced at a higher premium compared to traditional W&I policies.
People – assembling the right team
Apart from a compressed timeline, the reality for any distressed M&A transaction is that there will be imperfect access to information. The financial statements of the target will often be qualified and therefore of limited comfort to a prospective buyer/investor. The buyer/investor would thus need financial advisers familiar with and well-equipped to value the target business/assets on an ‘as is, where is’ basis, and also ascertain the ‘burn rate’ (meaning the extent to which cash is depleted to keep the target viable) and provide financial projections for the target to continue as a going concern post-closing. Likewise, the legal advisers will also need to be familiar with the implications of pre-insolvency and insolvency scenarios and sensitive to various potential default situations and their consequences, such as whether there are security arrangements that have crystallised or are subject to certain withholding rights in favour of third parties and whether crown-jewel assets may potentially be subject to an insolvency-triggered call option.
A buyer/investor would thus be well advised to assemble, at the earliest possible instance, a team of professional advisers that are keenly aware of the implications of the distressed state of the seller/target and, in particular, the potential risks should the seller/target end up in a winding-up scenario. The buyer/investor should then be in a position to navigate and avoid the pitfalls which abound in a distressed M&A transaction, thereby greatly enhancing the likelihood of a successful deal.
Next segment
In Part 3 of this series on distressed M&A transactions, we will be sharing more on the current situation in the Singapore market in light of the COVID-19 pandemic. We also will consider the benefits of a formal pre-insolvency restructuring process, such as judicial management, and the additional factors when dealing with a prospective target which is a listed company.
Reed Smith LLP is licensed to operate as a foreign law practice in Singapore under the name and style, Reed Smith Pte Ltd (hereafter collectively, "Reed Smith"). Where advice on Singapore law is required, we will refer the matter to and work with Reed Smith's Formal Law Alliance partner in Singapore, Resource Law LLC, where necessary.
Client Alert 2020-493
