FORUM: Outlook for distressed M&A and investing in 2013
March 2013 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
FW moderates a discussion about distressed M&A and investing in 2013 between Jay J. Rittberg at AIG, Partha Kar at Kirkland & Ellis International LLP, and Daniel F. Fiorillo at Otterbourg, Steindler, Houston & Rosen.
FW: How would you describe the climate for distressed M&A activity as 2013 unfolds?
Rittberg: We expect growth in distressed M&A transactions in 2013. In 2012 we saw more requests for insurance from buyers acquiring businesses that were having difficulty meeting financial obligations, in foreclosure, or in bankruptcy. Insurance can be used by buyers purchasing a company from sellers that have foreclosed on a business and know little about its day to day operations. Sellers in these situations may be unwilling to provide an indemnity to the buyer since they have difficulty making representations about a business that they were not running. Even in cases where sellers are willing to provide significant indemnification and make broad representations about the target business, a buyer may be concerned about the creditworthiness of a distressed seller and may use insurance to sit along side a seller’s indemnity to provide credit support in the event the buyer is unable to collect against the seller.
Kar: I think it’s fair to describe the European climate for distressed M&A at the moment as one of cautious optimism, although some may say that optimism is misplaced. There seems to be a mismatch between valuations on the buy side and the sell side which means that material activity seems unlikely, at least for the early part of 2013 – and we will see how things shake out in the latter half of the year.
Fiorillo: While a modest increase of distressed M&A activity has been observed in the US, in the fourth quarter 2012 and heading into 2013, distressed M&A activity on the whole is not expected to be particularly robust in 2013. M&A activity has been down in the industrial sector, real estate, telecommunications, pharmaceuticals and biotech – and these trends show no signs of improving other than on an isolated basis. Billions of dollars are, however, sitting on the sidelines looking for a place to go. Rather than M&A as a vehicle for new investment, the trend is toward bringing new investors in to help shoulder the risks of existing deals. In contrast, distressed debt has been reported to be among the best hedge fund strategies. The result is that fewer and fewer companies have debt that trades below 100 cents on the dollar.
FW: In which sectors are the most attractive opportunities for distressed M&A surfacing? What factors are leading to distressed deals in these industries?
Kar: It seems opportunities are in a broad range of sectors and geographies but sectors commonly mentioned are energy – particularly alternative energy – shipping, food, construction and real estate, TMT, packaging and paper, and retail.
Fiorillo: We are still finding a large percentage of distressed M&A deals occurring among companies where the particular company’s assets have high intellectual property value – and in the retail space. For example, Kodak, a pioneer in film and cameras, filed for Chapter 11 in 2012. In part, Kodak was able to obtain debtor-in-possession financing because of the strength of its intellectual property rights, however, it was required to sell its digital patent portfolio as part of the financing. It expected to receive billions for the intellectual property sale, but instead it sold for a disappointing $525m. The ultimate outcome of the Kodak bankruptcy remains to be seen. In general, large retail operations with recognised brands have consistently experienced significant M&A activity. Going back to 2006, the Albertsons retail chain and operations were acquired by multiple investors including Cerberus, CVS and Supervalu. Its name and presence made it a viable candidate. Still, acquisitions can sometimes create larger distressed M&A and investment opportunities. In 2012, Supervalu announced that it was conducting a review of its own operations, which resulted in yet another opportunity for distressed investing for some of these same players.
Rittberg: Many of the distressed deals we evaluate for insurance are in the automotive sector, tech sector, or energy services. The automotive space is particularly competitive and cyclical, and even well run companies can become distressed because margins are so small. The tech sector also has its share of distressed businesses with many firms borrowing money to develop products in the hope that they will create sustainable revenue streams. The energy sector also sees distressed opportunities as rapid growth in the past few years has created many new entrants – including oil and gas services businesses – with positive revenue streams but that have grown too quickly and become over leveraged.
FW: Is the ‘extend and pretend’ phenomenon set to continue? What impact will this have on distressed activity?
Fiorillo: Banks and other commercial financing institutions do not appear eager to change what have become the operative rules of the game. Banks will likely continue playing ‘kick the can’. At least for the near future, loan extensions will remain the norm, as opposed to declaration defaults and forcing bankruptcies or liquidations. That said, many corporate borrowers have already taken advantage of this opportunity and, consequently, the number of existing borrowers extending or refinancing in 2013 will likely be down significantly.
Kar: ‘Extend and pretend’ or ‘amend and extend’ is set to continue through 2013, although hopefully we will see less of it in Europe than in previous years – particularly given that there have already been, and are likely to be, a number of round two restructurings this year. The impact of this phenomenon will be continued dampened distressed activity as it will, in some cases, lead to reduced selling or over-valuation of debt by current owners.
FW: In general, how do you expect pricing trends for distressed assets and companies to shape up over the coming year? What overarching issues will influence pricing and investment decisions?
Kar: I am not sure that pricing trends for distressed assets will be much different to 2012 although, as we expect more round two restructurings to take place this year, there may a few more realistic valuations and expectations which will hopefully lead to more sustainable capital structures going forward, as well as shareholders who are better placed to act as owners of businesses and drive growth. Pricing and investment decisions will still, in part, be influenced by the ability of sellers to take write-downs or acknowledge devaluations, but also the possibility that buyers may be willing to overpay to maintain deal flow. Uncertainty as to the future prospects of the economy can make pricing challenging for a buyer.
Fiorillo: The financial markets are seemingly ‘awash’ with capital. Therefore, with capital in abundance and there being fewer and fewer distressed M&A opportunities in the marketplace, we would anticipate both a compression in pricing – if that is possible to believe – and more of this capital that would traditionally have been invested in the purchase of distressed assets going instead to the equity side of the ledger.
FW: How are investors funding their deals? To what extent are financing markets supporting distressed M&A transactions, and do you expect this to continue?
Rittberg: While most distressed deals we review are heavily equity financed, we do see deals where lenders support a buyer despite concerns about risk to their collateral base. In some of those cases, lenders may require buyers to purchase representation and warranty insurance so that the collateral base for the loan may be protected in the event that the distressed seller makes inaccurate statements about the business that causes the buyer to lose money. We expect that with the maturity of the representations and warranties insurance market, more lenders will utilise the insurance to allow financing of distressed deals and this will allow some deals that would not otherwise happen, to occur.
Kar: Funding appears to be available for the right kind of distressed deal at all levels of the capital structure. Non-traditional sources of lending have become quite active and are filling a gap left by the more traditional sources of funding. Our expectation is that this will continue at least through 2013.
Fiorillo: If the transactions that closed in 2012 provide any indication, distressed M&A funding requires an appetite for risk that money-centre banks are not showing these days, and given the lower returns resulting from competition in all segments of the marketplace, this reluctance is understandable. Still, the financing of distressed M&A does take place, but the sources tend to be non-traditional lenders. This means that the lender will likely want favourable loan covenants, sufficient collateral and, where possible, guarantees and additional protection. Obviously, actual and projected revenue streams still matter to the lender. In the absence of a favourable revenue stream, a would-be lender will likely balk at funding the acquisition of a distressed company.
FW: What strategies and techniques are distressed investors employing to get deals done? Is there any evidence to suggest that more sophisticated innovations may gain popularity in 2013?
Rittberg: The strategy that we most often see for distressed deals is for buyers and sellers to shift risk of loss from unexpected events to the insurance markets. Whether it is the risk that liabilities that buyer and seller expect to stay with the seller will make their way through to the buyer in an Article 9 foreclosure sale or bankruptcy related proceeding, or that an undisclosed violation of law unexpectedly surfaces, these risks may be passed on to the insurance markets to allow deals to close. We insured more than 70 percent more deals in the US and Canada in 2012 than in 2011 and expect the popularity of these policies to further grow in 2013.
Fiorillo: In the face of strong competition for deals, distressed investors have become more flexible in their approach toward getting deals done. Traditionally, Section 363 of the Bankruptcy Code has offered the preferred path for distressed companies to consummate a distressed M&A transaction. Companies that possess sufficient resources, or where the distressed deal requires greater certainty in terms of eliminating future unknown obligations, are ideal candidates for this route. The Chrysler and General Motors bankruptcies and the use of Section 363 have demonstrated that, under the right circumstances, Section 363 is the best vehicle for salvaging a distressed company. Within this construct, however, we are seeing more of a ‘marketplace’ mentality among 363 bidders who are no longer rushing to be the ‘stalking horse’ bidder, but are rather more interested in waiting to see the marketplace for the distressed assets at the time of the sale. An alternative route gaining popularity over the last few years is the out-of-court route. Bankruptcy is an expensive process that can make a distressed acquisition unaffordable, except in the case of larger companies. Consequently, many distressed companies look to work with potential sources of capital outside of a Chapter 11. Of course, the out of court route, while potentially less expensive, has its own risks, such as a higher risk of successor liability for the buyer and less certainty with the process.
Kar: The strategies and techniques that distressed investors are looking at have not changed for 2013. Typically, they will do their best to understand a company if they are not already involved in it and may look to gain an advantage by either buying a material part of the fulcrum debt, making super senior funding available or showing synergies with existing business they own that may allow them to realise greater value for an asset than other buyers and thus make them a more attractive bidder. We have also seen the lack of liquidity in the market meaning that distressed investors may team up with other investors, who would ordinarily be seen to be their competitors, in order to get a deal done. Finally, we are also seeing, in some cases, distressed investors rejecting the traditional organisation of a syndicate through the appointment of a committee, and so on, and proceeding on their own to negotiate a deal.
FW: Could you provide an insight into some of the major legal issues that frequently arise when acquiring distressed assets? Do you expect any new legal or regulatory developments to affect the process this year?
Kar: Typical issues we see in relation to the acquisition of distressed assets relate to the lack of accurate current and historical information as well as difficulty modelling future outcomes and so determining a bid price. The diligence required is really a product of the time available and the quality of information provided and this varies in each case. Other issues that we commonly deal with are how a deal can be implemented if it means disenfranchising an existing stakeholder – say a shareholder or junior creditors – or how to effect a transaction when, on the face of it, 100 percent consents are required of stakeholders. We have also seen buyers concerned that they are unable to effectively conduct operational restructurings without a potentially value destructive local insolvency process which makes it more challenging to rescue the viable parts of a business. In relation to developments, we have seen many European jurisdictions introduce new restructuring, rather than insolvency, legislation over the last few years and this has been somewhat successful, although it is still untested in many jurisdictions – certainly, government and regulators are heading in the right direction.
Fiorillo: In acquiring distressed assets, both the prospective seller and buyer confront the initial issue of whether to acquire the company or its assets inside or outside the Chapter 11 process. Bankruptcy presents advantages such as the protection of Section 363 and disadvantages, particularly that of up-front costs and the potential need for DIP financing. Regardless of the selected path, a buyer faces the issues of successor liability. Here, bankruptcy may offer additional protection by substantially eliminating successor liability or paving the way for a release of the debtor’s liability. Nevertheless, recent case law suggests that courts will permit certain successor liability claims to survive a Section 363 bankruptcy sale, including claims stemming from product liability that arises from an injury caused by pre-sale merchandise after the sale has been consummated.
Rittberg: The legal issue we frequently observe with distressed assets are around structuring a deal to avoid successor liability and fraudulent conveyance claims. Buyers are concerned that courts will not respect deal parties’ attempts to transfer the business free and clear of certain liabilities. Buyers expect the process under Article 9 or bankruptcy to wipe away certain creditor claims. Insurance may be used to insure that the process implemented in the sale satisfied legal requirements, thereby properly limiting claims as expected and reducing challenges that the seller fraudulently transferred the business to the seller. We also expect insurance to be used more in 2013 to protect against claims that a buyer is a legal successor to a seller, and the underwriting of this type of insurance requires a review of the relevant state and federal laws related to successor liability.
FW: The time constraints surrounding distressed transactions can make due diligence problematic. What is your advice to investors on overcoming this issue and adequately managing risk and potential liabilities?
Fiorillo: When confronted with a compressed due diligence schedule that usually accompanies a distressed transaction, parties should avail themselves of electronic databases, internal corporate records and interviews with key personnel of the intended target. Additionally, the distressed company’s existing creditors stand to be a valuable information source. The question is: How cooperative will this particular community be? Within a Chapter 11, due diligence may be aided by a first-day order that enumerates deadlines and provides an opportunity for diligence and inspection. Again, and not surprisingly, a court supervised process tends to provide for greater transparency, and when time is of the essence easier access to needed information is highly valuable. Whether you are inside or outside of a bankruptcy proceeding, however, it is always beneficial to have the full cooperation and support of existing management. As the current keepers of the keys to all relevant company information, existing management can have all the material due diligence identified and analysed in real time. However, in a competitive sale transaction, typically only the lead or stalking horse bidder will have the lion’s share of management’s undivided attention.
Rittberg: Diligence can be challenging in distressed situations in which deal timelines are compressed. While transactional insurance is not a substitute for a traditional due diligence process, it can be a valuable supplement in distressed situations because it is designed to protect buyers against liabilities that arise after closing that were not discovered through the diligence process. The transactional M&A insurance market has matured over the past 15 years and now a policy can typically be implemented in a matter of days to satisfy the demanding diligence timeline for distressed transactions, allowing buyers to protect against gaps in diligence without slowing down a deal.
Kar: Every investor has a different risk appetite and so approaches its due diligence in a very different way. Where time is constrained it is important to understand the key or most valuable parts of the business as best you can, but also try to get a grip on what potential big ticket liabilities or downside risks there may be in an enterprise. Distressed transactions usually do not involve any material representations or warranties of value, so investors will need to price in any risk they are taking – all investors can really do is as much work as possible given the time and resources they have.
Jay J. Rittberg specialises in mergers and acquisitions, transactional liability, representations and warranties insurance, tax insurance, and contingent liability insurance. He is a former corporate attorney with a background in mergers and acquisitions and finance, and is currently vice president of Mergers and Acquisitions Insurance at AIG, based in New York. He is responsible for underwriting, marketing and developing transactional insurance products for AIG in North America.
Partha Kar has a wide range of cross-border restructuring and insolvency experience. He has acted for financial creditors, turnaround advisers, companies and insolvency practitioners and appointees in multi-jurisdictional restructurings and insolvency proceedings; directors, shareholders and creditors of companies that are financially impaired or subject to solvent reorganisation; and for vendors and purchasers of distressed debt or equity. Mr Kar has worked on all stages of this work including contingency planning and strategy, negotiations, documentation, post-restructuring/appointment and exit.
Daniel F. Fiorillo specialises in the representation of foreign and domestic banks, commercial finance and factoring companies, hedge funds in the structuring and restructuring of financing transactions, including revolving credit facilities, term loans, forbearance and workout arrangements, acquisition financing, and Chapter 11 debtor-in-possession and exit financing facilities. He also represents private equity groups and companies in connection with various financing and capital market transactions, as well as the acquisition and sale of the assets or businesses of financially distressed companies.
© Financier Worldwide
Jay J. Rittberg
Kirkland & Ellis International LLP
Daniel F. Fiorillo
Otterbourg, Steindler, Houston & Rosen