Although the economy is slowly recovering, businesses across many industries are continuing to struggle and, in many cases, fail. While some sectors are improving more rapidly than others, times are still tough for mid-market companies.
The rapid changes and continuing uncertainty in health care are putting significant pressure on health care providers, as they are not prepared to adapt as conditions change and access to capital remains difficult, says Stephen M. Gross, Detroit managing member of McDonald Hopkins PLC.
Similarly, although the automotive industry is posting record profits, this is primarily limited to OEMs and very large suppliers that reduced debt in chapter 11 and that have access to capital. But for the small to mid-market automotive supplier, the battle continues.
“Owners of companies need to be conscious of the events impacting their businesses, be ready to accept reality and be willing to employ different strategies if they are going to preserve value in these unique times,” says Gross. “They cannot refuse to acknowledge the business’s situation until alternatives no longer exist. Early intervention is the key to making the best of a bad situation. They need to understand and analyze their financial and legal situations to determine which strategies are most beneficial for their constituents.”
Smart Business spoke with Gross about how to preserve the value of your business in a still-struggling economy.
What are the issues facing small and mid-market businesses?
Three factors are present in financially distressed situations. First is change, whether it is the loss of a customer, a rapid increase in material costs, or a gradual reduction in sales. Second, and perhaps most important, is the inability of management to quickly acknowledge the change, realize that doing business as usual will not work, and implement financial and legal strategies. Third is a lack of access to capital, whether to bridge the gap, fund a ramp-up or consolidation, or acquire competitors. This does not mean getting capital to fund losses; it means funding for a strategy that is well thought out and likely to succeed with minimum risk.
What strategies are available to businesses in distress?
That depends on where the business stands in terms of product, market, liquidity and debt level, as well as when it recognizes the need to address an issue. For example, an auto supplier needs to understand that the supply base will continue to shrink and suppliers that provide commodities will have a difficult time due to price pressure. If the supplier has access to capital, this is a good time to acquire other suppliers, especially those with a market niche that can be purchased on favorable terms due to their distress.
However, if the supplier lacks access to capital, it is time to consider selling the business while it still has value as a going concern. Too many managers think only in terms of keeping the business going, instead of preserving value for owners and other constituents. While most business operators intuitively opt to restructure and survive, this is easier said than done, especially after losses have continued for any length of time.
In these cases, the lender has lost faith in management and begun to limit funding, suppliers are reducing credit and, in automotive cases, customers do not want to risk production, so they demand a sale or resourcing.
Consequently, unless undertaken early, restructuring is usually not successful and, due to the losses incurred during the process, may be worse for the owners than a wind-down. As a result, management must strongly consider whether its best option is a sale or wind-down.
What are some key issues with distressed acquisitions?
The major benefit of distressed acquisitions is adding revenue and/or capacity at a good price. Typically, distressed sellers have lenders that are willing to accept a discount on debt and in chapter 11 ‘363 sales’ or UCC Article 9 sales, the business can be acquired free of its trade debt, as well. And this is one area where funding seems to be available because private equity firms are seeking opportunities to deploy capital.
There are risks. If the seller has a problem, and the problem is too much debt, the structure of the transaction may eliminate it. However, if the issues are more fundamental, the acquisition could jeopardize the buyer, so buyers need to make sure they understand the seller’s business and what is causing the losses. Additionally, the acquisition needs to be structured so that if losses continue, the risks to the buyer from the seller’s operations and losses are isolated from the buyer.
Finally, there are risks that are not present in other acquisitions, such as that the time involved in negotiating with lenders, trade creditors or customers will cause the seller to continue to consume cash, impacting the potential return and driving up the price.
What are ‘363 sales’ and Article 9 sales?
363 sales are sales in bankruptcy. Historically, buyers required distressed sellers to go into chapter 11 to take advantage of this code section, as it enables buyers to get a court order stating the purchase is free and clear from most claims against the seller. However, because the cost is high, and the bankruptcy code requires competitive bidding, the benefit of a 363 sale may be outweighed.
Recently, distressed transactions are being done under Article 9 of the UCC, allowing a secured lender to sell personal property free and clear of claims against the distressed borrower. Article 9 sales can be done quickly, with limited notice, and can be structured as a surrender of assets to the lender and a simultaneous sale to the buyer, or by having the buyer purchase the secured debt and then foreclose on the assets.
However, real estate cannot be sold under Article 9, so creative structuring is required to do a transaction in which the seller owns real estate that is needed in the business.
Stephen M. Gross is the Detroit managing member of McDonald Hopkins PLC. Reach him at email@example.com or (248) 646-5070.