November 01, 2007
Simeon Gold and Daniel Holzman
The end of the credit bubble may be the first shoe to drop towards a new spike in default rates and corporate debt restructurings over the next couple of years. However, the dynamics of these restructurings may be different from the last time default rates spiked and may provide opportunities for private equity sponsors. Some of the principal reasons for this are that good companies may be more likely to find themselves in financial distress and changes in the bankruptcy law and recent trends in the financing markets may make it more likely that companies will be sold rather than reorganize. Private equity sponsors may be able to buy good companies at attractive prices in this new environment, particularly compared to the still heady valuations attached to most companies in the non-distressed market. However, buying distressed companies inside or outside of bankruptcy court poses certain pitfalls and procedural and substantive challenges that don’t exist when buying a solvent company.
The New Environment
Historically, many private equity sponsors in the US have shied away from buying distressed companies. This was partly based on the concern that they didn’t have the expertise for operational turnarounds and partly based on the perception that buying financially distressed companies was a long complicated process best left to specialist distressed or special situation funds. There was also a concern that they would be potentially competing for the company against a management-sponsored plan of reorganization and that they wouldn’t necessarily get the management buy-in to the buyout that they needed to get comfortable with the transaction.
Some new factors that may be present in the next wave of debt restructurings may alter this dynamic and make acquisitions of distressed companies a more viable proposition for many private equity sponsors. These factors include the following:
- Good well-managed companies may be more likely to find themselves in financial distress due to excessive leverage and inability to refinance their debt. Prior to the end of the credit bubble, many of those companies had little difficulty refinancing their debt. However, as that debt matures, even profitable companies may find it difficult to refinance their debt and may have few alternatives to restructuring that debt. This may level the playing field for private equity sponsors that do not specialize in distress situations and feel more comfortable with a company that needs a balance sheet makeover than an operational turnaround.
- Changes in the law may promote more and quicker sales of distressed companies. The Bankruptcy and Consumer Protection Act of 2005 has limited the amount of time debtors have exclusivity to propose and get approved a reorganization plan. This may increase the likelihood that the debtor will be forced to consider other alternatives to a plan of reorganization, including a sale of the business.
- Changes in recent financing trends may promote more and quicker sales of distressed companies. Many companies were financed with “covenant-light” loans in the last few years which did not have many of the typical maintenance covenants that provided early warning signals to their creditors and required the companies to face the day of reckoning sooner rather than later. As a result, many companies may arrive in bankruptcy in a more critical cash position than in years past. Similarly, those companies may have few unpledged assets that can be used to secure debtor-in-possession financing. This may again increase the likelihood that the debtor will be forced to consider other alternatives to a plan of reorganization, including a sale of the business.
Based on these factors, private equity sponsors who do not specialize in distressed situations may be better placed than before to buy good companies with formerly bad balance sheets at attractive prices inside or outside of bankruptcy court. Prior to committing significant resources to an acquisition of a distressed company, however, sponsors should be aware of certain pitfalls and procedural and substantive challenges that need to be addressed in both out-of-court acquisitions as well as acquisitions of companies in chapter 11.
An acquisition from a financially troubled company in an out-of-court transaction poses several issues for the private equity sponsor to consider. One issue is whether a court would determine that a transaction with a distressed company is a “fraudulent transfer.” A fraudulent transfer occurs when both:
- the seller is insolvent at the time of, or is rendered insolvent by, a transfer of property; and
- the consideration paid for the property is less than its fair market value.
This issue typically arises when the seller is in the “vicinity of insolvency” (a term that has not been defined by the courts, but connotes a time period prior to the actual advent of insolvency). If the seller subsequently files for chapter 11, the bankruptcy court will look at the acquisition with 20-20 hindsight, and if the court finds that such transaction is a fraudulent transfer, then the transaction could be unwound, even years after the acquired business has already been integrated into the purchaser’s business. In that situation, the buyer would lose the benefit of its bargain and be left with a general unsecured claim against the bankrupt seller (often worth only cents on the dollar). While the use of fairness and solvency opinions can reduce the fraudulent transfer risk in a distressed acquisition, it cannot eliminate it.
Corporate law which requires stockholder approval of a sale of all or substantially all of a company’s assets typically presents another significant hurdle. In a distressed situation, it is unlikely that stockholders would approve an acquisition providing little or no value to the stockholders. In addition, difficulties often arise in dealing with the board of directors of a distressed company. The board of directors is often instructed to take into account the interests of creditors when a seller is in the vicinity of insolvency. The board, however, may be in denial of the extent of the seller’s financial difficulties and fail to adequately consider a sale strategy that enhances value for the creditors of the seller. Due to the fraudulent transfer risk and the obstacles that the stockholders and the board may present, the safest and possibly the only practical way to purchase a distressed company’s assets may be under chapter 11 of the Bankruptcy Code.
Acquisitions in Chapter 11
A purchase of the assets (including a subsidiary) of a chapter 11 debtor can be accomplished either as part of the consummation of a chapter 11 plan of reorganization or during the pendency of a chapter 11 case under Section 363 of the Bankruptcy Code. A Section 363 sale is often the preferred method because, among other things, it tends to be quicker while still offering the protections of the Bankruptcy Code. An asset purchase from a chapter 11 debtor, however, can be a complicated affair. Chapter 11 sales require the involvement throughout the M&A transaction of the bankruptcy court, as well as the need to deal with the seller’s various constituencies as part of the chapter 11 process. In order for a seller to conduct a sale under Section 363, the seller must demonstrate to the bankruptcy court a “good business reason” for the sale, which can often be evidenced by showing a diminution of the value of the distressed assets if a sale was delayed until the chapter 11 plan of reorganization is consummated.
A purchaser of distressed assets in chapter 11 must also be mindful of the seller’s creditors and other stakeholders. In addition to negotiating the transaction with the seller, the purchaser should seek to prevent the creditors from taking a “second bite at the apple” and renegotiating the deal that was already negotiated with the seller. Therefore, it is important that the purchaser make sure that the seller keeps its creditors informed and “on board” with the negotiations. Impaired creditors and even stockholders can potentially oppose the asset sale at the bankruptcy court approval hearing by arguing that only senior creditors would be made whole by the sale and that the sale diverts value to the purchaser that under a “stand-alone” plan of reorganization would benefit the seller’s other stakeholders.
Another key element of a Section 363 sale is the requirement that the sale be subject to “higher or better” offers in an auction process. This presents a risk that other bidders may make a topping offer at the last minute if the bankruptcy court has not yet approved the sale. The initial “stalking horse” purchaser, however, typically gets the benefit of certain protections. Because the sale is exposed to an auction and in light of the value the stalking horse creates in enhancing the ability of the seller to get the highest or best offer, it is customary for the stalking horse to receive a break-up fee or, at a minimum, some expense reimbursement in the event a different purchaser wins the auction. The bankruptcy court must approve the amount of the break-up fee and expense reimbursement, as well as the other auction bidding procedures. Once the bankruptcy court approves the bidding procedures, a full auction is normally conducted and “no-shop” restrictions generally are not permitted. In certain situations, the stalking horse may be able to negotiate the right to match the highest final offer at the auction, but a bankruptcy court may strike this matching right due to concerns that it will chill the bidding.
Typically, the seller’s representations and warranties in a Section 363 sale have a short post-closing survival period or no survival period and the amount of indemnification is often capped. Sellers argue that in order to satisfy their constituencies, they need a “net-net” deal with no potential to refund any portion of the purchase price to the purchaser. To the extent that the seller has post-closing indemnification obligations, purchasers usually negotiate to have a portion of the sale proceeds either placed into escrow or held back for a limited period of time to address concerns that the seller will not be around or have the wherewithal to pay its indemnification obligations that may arise.
Purchasing distressed assets in a Section 363 sale also provides benefits that are not available in acquisitions outside of chapter 11. The purchaser receives the assets sold pursuant to Section 363 free and clear of liens, claims and encumbrances. Upon completion of the sale, creditors of the seller cease to have a lien on the assets and instead have a lien on the sale proceeds and are not permitted to pursue the purchaser to satisfy any claims they have against the seller. Another advantage of a chapter 11 sale is that except for certain contracts, such as contracts pertaining to personal services and certain intellectual property licenses, the seller’s contracts are “cleansed” of non-assignability or change of control provisions. Subject to certain requirements (including the curing of certain defaults), this facilitates the assignment of contracts to the purchaser without the need for any consents of third parties which would otherwise be required in a sale outside of chapter 11. In addition, “successor” liability generally remains with the seller, except for certain product liability claims, environmental liability, tax liability and employment liability.
If a purchaser desires to strengthen its position in the acquisition of an entire company under a plan of reorganization, there are steps it can take. The purchaser can acquire a stake in the “fulcrum” securities of the bankrupt seller (i.e., those obligations of the seller that, based on the likely valuation of the seller’s business by the bankruptcy court, are likely to receive equity in the reorganized business). Acquisition of at least one-third of the fulcrum securities, subject to certain exceptions, may provide the buyer with a blocking position in the approval of a chapter 11 plan of reorganization. Even if less than one-third is acquired, this still gives the purchaser a seat at the table in the event that the transaction is contested.
The acquisition of the seller’s fulcrum or other securities is less effective in pursuing an asset purchase under Section 363, since there is no stakeholder vote on a Section 363 sale. However, the purchaser (even without owning securities of the seller) can still join forces or enlist the support of key creditors of the seller, such as bank lenders or other senior creditors (who will typically favor an asset sale in order to be repaid in full), to help push the sale to the purchaser. Ultimately, however, the bankruptcy court needs to find that the purchaser has presented the highest price or best offer in order for it to approve a Section 363 sale.
Historically, many private equity sponsors have shied away from buying distressed companies. Based upon changes in law and recent trends in the financing markets, the next wave of corporate debt restructurings may provide a more hospitable environment for private equity sponsors that don’t specialize in distressed situations to buy good companies at attractive prices. However, buying companies inside or outside of bankruptcy court poses certain issues that private equity sponsors need to be aware of before they commit significant resources to the transaction.