Business gems Featured

7:00pm EDT January 26, 2010

Many people expected a dramatic increase in the number of businesses going bankrupt when the economy turned sour in late 2008. The general slowdown in the economy, which many thought would (and, in fact, did) cause loan defaults, coupled with a credit “crunch” that continues even today, was expected to lead to a wave of bankruptcies. The increase occurred, but was not nearly as large as expected. There have been more debt restructurings, out of court workouts and non-judicial sales of assets in order to avoid bankruptcy.

The lower than expected number of bankruptcies can be attributed to several factors, including the costs of bankruptcy (particularly when compared to other alternatives). A second cause is the so-called “amend, extend and pretend” practices of some lenders: amending loan documents to eliminate defaults and extend the date of reckoning. Many incumbent lenders, finding no new lender looking to refinance the borrower, and unwilling (or unable) to realize the loss resulting from a liquidation, have chosen to wait to see if the economy and/or credit environment will improve.

As a result many companies continue to struggle, unable to fix problems or find new lenders. There are many opportunities for purchasers to step in and purchase these distressed companies at fairly good prices to try and turn them around.

“There are a lot of bargains out there, and a well thought out acquisition of a distressed business creates a real opportunity to see a significant upside,” says Shawn M. Riley, managing member of the Cleveland office of McDonald Hopkins LLC. “But one has to be willing to take on the additional risk of turning around the business, and have the resources and knowledge to do this.”

Smart Business spoke with Riley about what makes a distressed merger and acquisition unique and key things to know if you want to undergo this type of transaction.

How are distressed mergers and acquisitions different from traditional ones?

A distressed business has some type of problem that still needs to be fixed. The company may have too much debt, or is not operating profitably. In a more traditional deal, profits are already being generated by the business. The buyer is looking to improve operations, increase profits, and then ultimately sell the business. There are typically no profits in a distressed deal — it mainly involves turning the business around to make it profitable and then selling it at a future date.

What are some of the risks and benefits of distressed mergers and acquisitions?

There is always the risk that the problem identified is not the actual problem, or that there are additional problems not identified. Another would be that the buyer miscalculates the amount of negotiation required with the other constituencies, such as the lender or trade creditors. That requires more time and perhaps even more cash to close the deal, thus increasing the overall cost and impacting the ultimate return.

On the positive side, these opportunities are much more available than traditional mergers and acquisitions because of the current business cycle and the lack of available credit.

How can you take advantage of these opportunities, and what should you know about distressed mergers and acquisitions?

There are two different types of potential purchasers. First, business owners in a particular industry ought to be out looking for additional businesses in that same industry that may be struggling and have lenders willing to accept a discount on their debt. That will allow the acquiring business to grow by adding sales and ultimately creating a much larger business. Second, it offers private equity firms an opportunity to deploy capital in a segment of the mergers and acquisitions market that is still active.

A buyer needs to be sensitive to the fact that these businesses are not going to be profitable immediately. There is a problem there that needs to be fixed, and a buyer has to approach due diligence with that in mind. Understand what the problem is, how to fix it, how long it will take and how much additional money might be needed, and then factor that into the deal price.

What preparation is needed for distressed mergers and acquisitions?

A buyer needs to identify and analyze the root of the problem with the business it is acquiring. A purchaser goes into the deal knowing that there is a problem that needs to be fixed, but has to identify that problem immediately, analyze the root of it, and determine how to fix it. That is very different than a traditional deal, where a purchaser goes into it assuming that the business is profitable and making money, and just needs to improve the operations or profitability.

There are also additional negotiations that need to occur with other interested parties that do not typically occur in traditional deals. In a traditional deal, a buyer is not terribly concerned about what trade creditors think, because the assumption is that they will be paid in full, and the business will continue to operate with no interruption. It is also assumed that the lender will be paid in full, and it is only a matter of bringing the lender in at the last moment to get the appropriate releases signed.

In a distressed transaction, the assumption is that one or both of those groups will not be paid in full. So the lender may be required to release its claims and security interests for less than 100 percent of what’s owed. It is also possible that the trade creditors to the business are going to be paid less than 100 percent, and therefore have to be brought into the negotiations, whether individually or as a group. These elements impact the way the deal is actually consummated. Is it a straight asset sale, with no judicial oversight, or is it a bankruptcy sale, done through the supervision of the bankruptcy court?

Shawn M. Riley is a managing member at the Cleveland office of McDonald Hopkins LLC (www.mcdonaldhopkins.com). Reach him at (216) 348-5773 or sriley@mcdonaldhopkins.com.