Some potential buyers of distressed companies may be sitting on the sidelines, waiting for the economic cycle to shift to growth mode so they can return to acquisitions, but some of the most recognized names and most prized assets in the nation have landed in bankruptcy during 2009 due to liquidity constraints, too much leverage, operational issues, etc. While buyers are unable to obtain the leverage of previous years, the discounted valuations of companies in distress or near or in bankruptcy can set buyers up for profit-taking once the economy strengthens. Now is the time to purchase blue-chip assets at bargain prices.
Knowledgeable buyers are best able to make a determination as to whether the purchase of distressed assets makes sense. With that buyer in mind, this article summarizes some of the key features of acquisitions in chapter 11, the practical business advantages of buying assets in chapter 11 and the related business issues encountered.
Chapter 11 Acquisitions
The following are some of the key features of chapter 11 acquisitions.
- Buying assets “free and clear of any interest” under §363 of the Bankruptcy Code. Under §363 and subject to bankruptcy court approval, a buyer can purchase a debtor’s assets free and clear of prior liens and claims, including claims that may remain unpaid after the sale is completed. In addition to asset sales under §363, assets can also be sold under a chapter 11 plan (presently the plan tool is not used to sell substantially all of a debtor’s assets as frequently as a 363 process).
- Competitive bidding. The goal of the bankruptcy sale process is to find the highest or best bid for the assets being sold. All prospective bidders must comply with court-approved bidding procedures, which are initially agreed upon and/or laid out by the debtor but are often negotiated with the creditors’ committee, lenders and other parties-in-interest. The bidding procedures usually contain tight timelines for marketing assets.
- A stalking-horse bidder. Outside of a plan, a bidder often is identified as a “stalking horse” and an asset-purchase agreement is executed, subject to an auction and court approval. The stalking horse creates interest in the debtor’s assets and sets a price floor for potential bidders during any auction. The stalking-horse bidder can obtain break-up protection and fees, reimbursement for due-diligence costs and establishment of the terms of the transaction and the purchase agreement that will be the baseline for all other bids. With the ability to negotiate the purchase agreement, the stalking horse can potentially set up requirements for the other bidders with respect to due diligence and closing. However, if these requirements are too strict, the court might not approve the stalking horse’s purchase agreement due to the perception that it will chill bidding.
Key Aspects of a Distressed Purchase Agreement
Purchase agreements are generally similar for bankruptcy and nonbankruptcy sales with the exception of the following in a bankruptcy agreement: (1) closing conditions are scrutinized, given the time pressure to consummate a sale and could result in reductions of a bid’s value; (2) post-closing purchase price adjustments are typically avoided because the potential for downward adjustments complicates the ability to determine the highest or best bid; (3) representations and warranties are generally more limited; and (4) indemnification protection is usually not included.
- Credit bidding. In a 363 sale context, a secured creditor that has liens on the assets to be sold can bid up to the face value of its claim. Credit bidding is an important right for distressed investors that have purchased secured debt as a leverage security. It should be noted that plan processes have been used recently as an environment that insulates a stalking bid from competitive pressure by a credit bidder and with some success.
- Ability to choose executory contracts and assume liabilities. The purchaser has the right to choose the contracts and leases it would like to keep when buying the business, generally without the need for approval by the counterparty, as long as notice is provided, prepetition defaults are cured and adequate assurance of future performance is provided. Parenthetically, as the General Motors and Chrysler cases demonstrate, this power and the right to assume contracts, and the related ability to assume key creditor liabilities, enable a debtor to support a 363 sale by accomplishing rehabilitation through purchaser decision-making outside of a plan.
Advantages of Purchasing Distressed Assets in Bankruptcy
There are a number of important advantages to purchasing distressed assets, including:
- Ability to carefully select assets. The stalking-horse bidder has the opportunity to select specifically the assets it needs from a distressed business without having to purchase the entire company (out of bankruptcy, anti-assignment provisions in contracts, shareholder/bondholder approvals might preclude such selectivity).
- Reduce business costs. By selecting the contracts and leases that the buyer believes are beneficial to the business and leaving behind those that are not needed, the buyer can reduce the relevant business cost structure.
- Opportunity for outsized returns. By acquiring the “best” assets, leaving behind burdensome liabilities and costs, and paying distressed prices, a buyer can achieve significant returns in a bankruptcy distressed context.
Addressing Obstacles
There are a number of obstacles that a buyer must address, including:
- Closing risk. Purchasers can mitigate closing risk by positioning as the stalking horse, protecting invested opportunity cost through appropriate auction procedures and milestones.
- Concern about damage to the business. It is often the seller’s relationships with customers, suppliers and employees, established from years of doing business that enable a distressed business to continue as a going-concern, providing an acquisition opportunity in the first place. Therefore, the seller and its advisors must identify the gatekeeper(s) of those relationships within the company and enlist their support in the sale process. Good information about the nature of stakeholder relations must be obtained by prospective buyers from sellers at the beginning of the process.
- Legacy issues. Legacy operational issues, such as inefficient processes, late deliveries, proliferation of products/services and low customer satisfaction as well as dysfunctional corporate cultures, are not as easy to pinpoint in due diligence as other issues. Furthermore, once these issues have been identified, it can be difficult to determine whether the operations can be turned around and/or the culture changed cost- and time-effectively. Buyers can address these concerns by retaining a turnaround consulting firm during the due-diligence process to cover these key issues, verify whether they can be overcome and assist the buyer in stabilizing and/or turning around the business post-closing, thereby reducing the risk of a mistake.
- Integration issues. The risk of a failed acquisition is high: 70 percent of acquisitions fail to achieve the buyer’s goals. A buyer’s ability to understand the opportunities and pitfalls, build the right team and develop an effective integration plan with metrics are critical to success in an add-on acquisition. Distressed buyers must recognize the potential asset leverage for their portfolio company (e.g., sales growth, value-chain integration, etc.), cost efficiencies (e.g., productivity gains, headcount reductions) and new opportunities (e.g., customers, products and markets) in order to set up the appropriate post-merger structure that will achieve expected synergies.