Distressed investing—Step 4: Structure the deal

Start with the big picture

Should you buy assets or restructure the company to acquire and control the existing equity?

An asset purchase can provide greater flexibility from a restructuring perspective and can eliminate the need for a plan of compromise or arrangement in a formal restructuring. In a court-driven restructuring process, buyers are often attracted by the ability to purchase assets free and clear by way of a vesting order. An acquisition of shares can preserve valuable tax attributes but adds the complexity of successfully completing a plan of compromise or arrangement. The correct path will depend on your risk tolerance and the specific circumstances of the opportunity.

Appeal to the stakeholders

Distressed M&A can be complex. Unlike a conventional transaction, where shareholders typically select the winning bidder, a distressed M&A process may have varying degrees of input from many different stakeholders, such as trade creditors, lenders, shareholders, pension committees and unions.

Understanding the motivations and objectives of each of the critical stakeholders can be a powerful tool in increasing the attractiveness of your bid.

• Are stakeholders interested in increasing their immediate cash recovery?
• Are they more interested in participating in the future results of the business to recoup losses?
• Can you provide options to make your offer more broadly appealing?

These are all important considerations in structuring your transaction and positioning your offer for success.

Differentiate yourself from competitors

Speed, certainty and simplicity in your proposed capital structure are often key to winning the deal. Distressed M&A transactions are completed on tight timelines, so a deal that’s ready to execute with little closing risk is often preferred to a deal that may offer a higher price but comes with conditions, such as a financing clause or diligence condition that increases the uncertainty associated with closing the deal.

Another way to get your offer to stand out is to provide additional liquidity and capital to the business to help calm nervous customers and creditors and put the company in the best position to affect a turnaround. New capital and liquidity can be a powerful competitive advantage in a distressed situation. Often, a company’s distress is caused by a liquidity crisis—whether it’s company specific or due to a macro event. And as the company’s liquidity options wane, new capital becomes more and more valuable. 

Be creative

Distressed M&A transactions and, in particular, transactions completed within formal restructuring proceedings provide opportunities to be much more creative in tailoring your capital structure to meet the needs of both the business and its stakeholders.

Common strategies in structuring distressed transactions include the following:

• Debt for equity swaps: Debt holders receive equity and the potential to participate in equity returns in exchange for reducing the financial leverage and debt service burden of the company.
  
• Risk-sharing mechanisms: The outlook for distressed companies can often be unclear. Risk-sharing mechanisms like contingent value rights, contingent seller notes and earn-outs can be helpful in bridging gaps between sellers and buyers when there are widely diverging expectations about the valuation and future performance of the business.
• Financial incentives for continued support: Lenders and creditors of a distressed business may be willing to support the buyer, particularly if they believe in the turnaround plan. Consider keeping existing creditors in your capital structure by offering concessions, such as equity participation in the form of warrants, to get support like loan extensions, relaxed covenants, principal repayment holidays or better terms.

Plan for contingencies

Since distressed M&A transactions involve uncertainty, it’s critical to plan for contingencies when you structure them. Make sure the amount and structure of your financing is consistent with the findings of your due diligence and your turnaround plan.

• Will you have enough liquidity to turn around operations?
  
• Do you have contingency liquidity for unforeseen events?
• Will your debt repayment obligations be manageable based on anticipated cash flows from operations?

Experienced distressed investors often start by using a flexible financing structure. This may be more expensive, but you can refinance it with a more permanent capital solution on better terms once you can show an effective turnaround to lenders.

While these are some of the common strategies that experienced distressed investors use in a transaction, there are more considerations:

• Understand all the issues: A detailed quality-earnings report and due diligence process will prepare you by informing you of the inherent risks and unseen value drivers in the business so you can structure the deal to your advantage.
  
• Know your competition’s next move: Gain insight into what the other players’ game plans might be, how they tend to look at things and what might drive their behaviour when trying to structure your deal. Connect with partners that have experience dealing with other debt holders—often based in different countries—to bring a greater market knowledge to the table.
• Manage cross-border concerns: Understanding your security rights and how foreign legal jurisdictions operate can be critical to structuring your deal appropriately. And in the case of a cross-border investment, it’s important to get a global perspective to help reduce the complexities from a tax and legal perspective.
• Reduce risk: Find the right path with a full understanding of risk. At the end of the day, a well-structured deal is going to lower your risk and increase your expected return, so give this step the necessary attention to build distinctive capabilities that will drive performance.

Once you’ve structured your deal, it’s time to close it with confidence, which we’ll cover in the next post.