The COVID-19 crisis is accompanied by fallout on personal, local, community, and global levels. Among the countless, unwelcome side effects is a greater level of financial distress for companies — and with it, risk to the potential acquirers of distressed assets.
According to the Wall Street Journal, a growing number of property investors are readying for what they view as a once-in-a-generation chance to secure real estate assets at fire sale prices. Meanwhile, a prominent US debt investor earlier this month noted that he envisions defaults based on price markdowns, ratings downgrades, and portfolio asset defaults.
While the scale of opportunities today from this black swan event may be nearly unprecedented, the land mines that accompany buying distressed assets are not. Sellers under financial duress are often in a hurry to sell quickly at the same time that potential buyers often remain unable to secure the same detailed seller representations and warranties typical of a non-distressed asset M&A transaction.
- In the case of a liquidation, a seller (such an insolvency practitioner) may have little insight into the past performance of the target asset, focused instead on a quick sale and minimizing personal liability.
- A leading law firm recently noted that in the case of Section 363 sales in Chapter 11 cases, “for a buyer, even where it is a ‘stalking horse’ purchaser with a breakup fee and other bidding protections, a Section 363 auction may invite competition for the seller’s assets that the buyer would prefer to avoid.”
These and other hurdles notwithstanding, it remains essential for acquirers to understand as much as possible about a firm’s legal and corporate structure, liabilities, pending civil litigation, track record, political exposure, and regulatory red flags. Adherence to intelligent and thorough due diligence policies and procedures is vital for a good long-term outcome, regardless of the structure (asset sale versus share sale, for example) of the deal.
Distressed Asset Due Diligence ABCs
Mitigating M&A transaction risk requires special considerations on the due diligence front. Here are some that are especially useful to keep front of mind:
- Identify, as fully as possible, the assets that come with the purchase. These can include patents, trademarks, copyrights, client contracts, machinery and tools, premises, and vehicles. Who owns them? Where are they physically located? Are they encumbered? Can they be legally or physically transferred?
- Review client contracts with care. This vital element of diligence will inform potential acquirers if any key contracts have been voided by insolvency or breached by nonperformance.
- Ensure ‘fair value’ for any asset. This is essential if the buyer is to avoid the pitfalls of creating a “transaction at an undervalue.” Legal experts are specifically cautioning directors about their duties in this regard, warning about claims that could be brought against them in the event of insolvency. In the UK, for example, a transaction can be deemed “an undervalue” under select circumstances and any transaction that takes place within two years of insolvency will be open to challenge.
- Hunt for hidden treasures. Careful research and investigation into business units that might perform if they were carved out can reap handsome dividends for the future. In the same vein, gaming out — and thinking through — the desired involvement of the existing management team in such carve-outs is best considered early on in that treasure hunt.
- Know the management team — and know them well. The backgrounds of key management who will stay employed must be carefully assessed. What does their experience, track record, and risk appetite look like? Are they politically exposed? Do they have any other known or undeclared business interests? All these questions are significant considerations when it comes to minimizing opportunities for breaches of noncompete agreements and ensuring business continuity.
- Understand and appreciate the geopolitical risk surrounding the transaction. As with any cross-border M&A transaction, attentiveness to FCPA successor liability is vital, just for starters. Some jurisdictions where political interference, local protectionism, and poor adherence to the rule of law raise obvious red flags (such as China, Indonesia, and Russia). But for virtually every overseas jurisdiction, it’s essential to be savvy about local conditions that may impact hiring and firing decisions, the risk of asset transfer blocks, or other regulatory issues that might trigger legal challenges by creditors or predatory parties.
We Have the Experience to Help
Our leadership team and researchers have amassed extensive experience in the distressed asset due diligence transaction space. Only just recently , for example, we were involved in assisting with a complex managed buyout transaction involving a formerly state-owned enterprise in Asia that had been cut loose from government funding.
- That particular case stands out for us because it embodied so many of the elements noted above: sorting out the wheat from the chaff from the purchased assets, dissecting the potential liabilities growing out of a woefully underfunded pension fund, successor liability connected to environmental degradation associating with the product’s manufacturing, local government sensitivities and potential interference with plans for workforce layoffs, and screening of the management team in a jurisdiction with opaque public records.
We would be honored and pleased to put our expertise to work for you to help ensure your transaction due diligence success. Please reach out to us so we can talk about how we can be of help.