Distressed or insolvent M&A: navigating the pitfalls and opportunities

One of the surprising features of the pandemic, given the damage it has caused to businesses in many sectors, is how little M&A activity we have seen so far involving distressed or insolvent businesses.

The expectation at the outset of the crisis was that distressed M&A would almost immediately be a very busy area of the market.

With the exception of some high-profile retail deals and activity in the tourism, hospitality and automotive sectors, distressed activity to date has been relatively limited.

There are various contributing factors including:

• government employment and financial support schemes have allowed companies to put off what may still be the inevitable
• the temporary suspension in some jurisdictions, such as Germany, of insolvency filing obligations, has given troubled businesses time to breathe

As support schemes end and usual of insolvency rules are reapplied, we are likely to see a sharp uptick in deals targeting distressed or insolvent companies. Some market watchers expect to see a surge in such deals in the second half of 2021.

Buyers prepare

For buyers contemplating acquiring a distressed or insolvent business, there are many issues that distinguish such deals from normal M&A transactions.

For example:

• deals usually need to be executed at high speed
• opportunities to carry out deep due diligence may be curtailed
• normal contractual protections that buyers are used to, such as warranty cover, may be limited

Understanding the pitfalls and the opportunities, and being able to identify “red flag” issues from the outset, can often be the key to success.

Deal structuring

Where the target business is a “going  concern”, buyers also need to establish what kind of sale process is most appropriate and what conditions may attach.

For example, cherry-picking selected assets might be a better bet than acquiring the shares of the company (and inheriting all its liabilities).

Negotiation of the sale on an exclusive basis may be possible. Alternatively, there could be a race to complete the sale, with the seller talking to other prospective buyers.

Understanding risk is crucial. In particular, the buyer should consider whether there is any danger of the sale agreement being set aside (or an order made for the payment of additional consideration) as a result of the transaction avoidance provisions that can apply in an insolvency proceeding. These provisions are in relation to transactions entered into in the period immediately before the commencement of the insolvency proceedings.

Moreover, because information about the company may be restricted, limiting the ability of the purchaser to carry out full due diligence, the buyer must assess the likelihood of recovering any amounts in respect of breach of warranty and any other red flags raised in assessing the target.

Some of these issues will have a direct bearing on the terms of the deal.

Potential red flag issues

Certain assets will be treated very differently in an insolvent sale compared with a solvent transaction, raising a further range of potential concerns.

For instance, special issues may arise in a management-sponsored buyout. There could be constraints on continuing to use the company’s name and substantial property transaction considerations, while confidentiality issues may arise in respect of the seller and the management team.

Retaining all or part of the company’s workforce could also land the buyer with significant potential liabilities. Careful scrutiny of relevant employment laws is vital.

Relevant pensions regulators may have the power to intervene. If so, it may be worth seeking confirmation that the regulator does not intend to take action.

Where property assets are involved, the onus is on the buyer to carry out the best investigation possible in a limited timescale.

Other issues to look out for include:

• ensuring the release of security over shares and assets being acquired
• suppliers’ retention of title claims over stock
• book debts and ongoing access to books and records
• consents and approvals required in different jurisdictions
• continued performance of contracts and change of control provisions
• ownership of intellectual property