March 01, 2010
The government's extraordinary efforts to stabilize the financial markets and overall economy over the past two years have created an environment where the pricing of many asset classes, including leveraged and distressed debt, has increased beyond their underlying fundamentals. While the “traders” have had a great run the past twelve months taking advantage of the Fed’s low interest rates, middle market companies are not getting the same benefits.
Although the Federal Reserve has expanded the monetary base by over $1 trillion since the Fall of 2008, commercial credit continues to shrink. The monetary expansion has been offset by an even greater decrease in the velocity of money. In effect banks are holding this cash on their balance sheets instead of creating new loans.
The fact is that we are in a structural deleveraging cycle which will take years to work off. On both the commercial and consumer side of the world, the past decade witnessed significant malinvestment biased by artificially low interest rates, poorly drafted legislation that enabled gaming of the financial system and the creation of systemic risk, and the general psyche that assets values would continue to increase. The reality is that banks and consumers now have to save to offset the destruction in value that has occurred. Sovereign governments are not immune to these problems, swelling their deficits to ease the pain of this deflationary cycle, but risking a long term crowding out effect and inflationary forces. The net result is that economic growth will likely remain tepid for the foreseeable future and unemployment will stay unusually high.
The primary reasons why commercial lending continues to shrink are that banks continue to have poor balance sheets and significant unrealized future losses, underwriting standards and federal guidelines have become more stringent, and the fundamentals of the underlying borrowers have eroded. The net result is that for the average middle market company it is harder to get a loan today than one year ago, although the pundits, regulators, and experts claim that the recession is over.
As opposed to creating new loans, most commercial banks are “amending and extending” existing loans to prevent further short term losses. The FDIC troubled bank list as of January 2010 was 575 institutions; some industry experts have projected 700-1,000 regional banks will fail over the next five years. Over 30% of bank owned loans (not securitized) are commercial and leveraged loans. The majority of these loans mature between 2012-2014; however, current market pricing implies a 20% to 40% discount from where most of these loans were made. The banks will need to replace hundreds of billions of dollar reserves in order to absorb these future losses.
For middle market distressed businesses, the ability to refinance out of court or obtain debtor in possession (“DIP”) financing in bankruptcy has been significantly constrained. Most historical DIP lenders have vacated the space. The deals getting done are generally defensive in nature where the existing lender is protecting its interests or are “loan to own” strategies. As a result of the limited financing alternatives, bankruptcy sales processes have become much more prevalent compared to emergent strategies.
While the above lengthy introduction may seem bleak, it has created an opportune environment for those with long term horizons and available capital to acquire distressed middle market businesses or business assets at a discount to their intrinsic value. The reduced competition from financial buyers, lower EBITDAs, reduced multiples, and lower asset appraisals have created an attractive value proposition. However, buying distressed business assets is much different from standard M&A and is fraught with their own unique risks and perils. It is not enough to just get a great price, the balance sheet needs to be restructured/recapitalized and the operations need to have a turnaround orchestrated.
Opportunities can be broken into two categories: overleveraged good companies available at a discount, and structurally flawed businesses whose bundle of assets can be put to more productive means by an outside party. The likely transaction structure ranges from a bankruptcy 363 sale, a “loan to own” structure, and out of court sale. Distressed M&A is inherently a different animal requiring a different approach and mentality as a result of the level of crisis of the target company, dealing with imperfect information, and the influence of multiple stakeholders on the process.
From a valuation perspective, what is most important to understand - regardless of the quality of the target - is that in the presence of a liquidity crisis, the business is not viable, conventional valuation methodologies have limited applicability, and the starting floor price in the absence of multiple bidders is liquidation value.
Once a debtor has reached the zone of insolvency, the fiduciary responsibilities of management and the board of directors transfers from the equity to that of the creditors. While this inherently creates potential conflicts of interest, the result is that the creditors will have significant influence on any proposed transaction. It is critical to understand the dynamics of the target’s bank borrowing arrangements and the economic interests of each of the constituents in a syndicated lender group. In today’s climate many lender groups are fractured and include secondary market position that can make it difficult for them to reach consensus and make decisions. It is possible that some participants in a loan are employing credit default swaps in which they are actually betting for the debtor to fail.
As a result of the limited availability of DIP financing and the overall cost of professional fees in an extended bankruptcy, today the majority of middle market filings result in a Section 363 transaction which allows the court to transfer the assets of a debtor to a buyer free and clear of liens and encumbrances. With the ability to extinguish historical liabilities and cherry pick executory contracts, 363 sales have become a preferred method for distressed transactions. Prospective buyers must understand that such transactions generally are “as is, where is” in nature and have very limited representations, warranties or recourse.
Often companies file bankruptcy with a stalking horse bidder already in place with the intent of running an accelerated sales process. Generally all bankruptcy sales are subject to an auction process so as to prove “highest and best” offer. However, stalking horses often are able to negotiate preferable treatment as well as break-up fees that can effectively limit competition. It should be noted that Secured Creditors can “credit bid” their debt, thus requiring prospective buyers to reach agreement with the lender when the price is less than the outstanding secured debt. However if the debtor is not sustainable on a standalone basis and the liquidation value is less than the secured debt, the prospective buyer will have significant leverage negotiating an applicable discount to par value.
Unsecured creditors claims are often impaired and the Unsecured Committee can hold a sales process hostage if their constituency has not been managed during the process. For this class, while a sale is generally not as advantageous in comparison to a reorganization, as long as the sale price improves the unsecured parties recoveries in relation to a liquidation, the process will generally succeed. Furthermore, if the “assets” involved in the transaction are to remain in a productive capacity, there is the opportunity for the unsecured parties to still have a customer post transaction.
Whether the potential suitor is a financial buyer or an opportunistic strategic buyer, significant due diligence and post-acquisition planning is imperative in a distressed situation. Furthermore, in today’s uncertain economic environment, the investing concept of “a rising tide lifts all boats” is no longer applicable. Regardless of whether or not the target company is utilizing an investment bank in the marketing/sale process, with limited representations and even fewer remedies, a prospective buyer should undertake a rigorous review process when assessing the target company. If the business is going to operate on a stand-alone basis, the buyer must maintain a level of object skepticism when evaluating the management team and business plan. If the assets are going to be merged into existing operations, an exhaustive integration plan must be developed to assure compatibility and success. Even a “fire-sale” price can be expensive in light of continued poor performance or unforeseen integration obstacles.
Buyers should consider utilizing a restructuring advisor when considering distressed opportunities. Such professionals can provide unique insight to the due diligence review process, developing negotiating tactics, assessing and/or developing further turnaround and improvement strategies, evaluating the management team, and assisting in post-acquisition integration efforts. In such situations it is critical to determine the long term damage that has occurred both internally and externally to the organization from operating in a crisis environment for an extended period. Often it the most valuable employees and customers that leave first as they generally have the most alternatives. It is crucial to understand how much additional capital beyond the purchase price will be required to revitalize the operational assets, normalize working capital levels, upgrade services and equipment, and restore faith with the customers and suppliers. Underestimating the funding requirements of a distressed acquisition can quickly imperil the parent company’s liquidity.
The opportunity associated with the successful acquisition of a distressed property/business is too great to be dismissed simply because of risk or lack of experience with the process. By having realistic expectations, utilizing methodical planning and diligence, and tapping the knowledge of crisis management experts, the value proposition can be maximized and potential pitfalls mitigated.