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Distressed Due Diligences: Seizing opportunities

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last updated on 19 October 2021 | reading time approx. 4 minutes
 
In a due diligence review performed in connection with the acquisition of a (share in a) company in crisis, certain special aspects should be taken into account. It is important to include the company’s growth opportunities in the valuation.
 
In principle, the focus of a ”due diligence” review or a risk assessment performed with due care is on identifying risks involved in the potential target company. The facts and risks identified as part of the due diligence are then often used on the buy-side as arguments for a purchase price adjustment or security agreements in negotiations with the sell-side. By contrast, in the case of target companies in crisis, opportunities should also be taken into account accordingly so that the transaction is not written off from the outset as unlucrative based on calculation of the mere figures. Knowledge of the target's success potential also increases the competitive chances of the potential acquirer against other bidders.
 

Current developments and market situation

Due to the still middling situation on the M&A market, distressed M&A transactions continue to garner focus. The potential target companies offer lucrative opportunities for specialised investors who have sufficient experience in dealing with distressed companies and liquidity. In addition to financing the purchase price, it is often necessary to finance the operating business and restructuring measures in the medium term. Specialised investors include, in particular, private equity funds and non-capital market-oriented companies with a high level of knowledge of the respective market. Due to reporting obligations, capital market-oriented companies are under a lot of pressure as regards the turnaround they are expected to achieve and may make rather short-term oriented decisions. These are not necessarily consistent with restructuring measures that are necessary in the long term.
 

Timely involvement of all relevant stakeholders

An important aspect of distressed due diligence is the buy-side communication with all relevant stakeholders of the potential transaction. A confidence-based relationship must be established with the company's management, but also necessarily with the advisory boards, shareholders and the main financing entities (banks and suppliers) as well as, if applicable, the customers or a (future) insolvency administrator. This requires the strictest degree of confidentiality. Since the transaction usually involves financial losses and loss of control by the previous owners, their consent to the transaction and the confidence that the new investor can succeed in achieving the turnaround are indispensable.
 

Options for distressed transactions

Different models can be used for venturing into a distressed company. They should necessarily be included in the considerations early on, as they involve different steps to be taken in preparation for the transaction depending on the choice of the transaction model. The following models are possible:
  • Share deal, also in the case of restructuring involving the payment of an exit fee by the seller;
  • Capital increase financed from the participation of the new investor;
  • Debt-to-equity/mezzanine swap, also by acquiring liabilities in advance;
  • Asset deal before insolvency;
  • Restructuring by transfer during insolvency (by means of a transfer company);
  • Insolvency plan procedure, including share transfer and/or debt-to-equity swap, if applicable.

 

Focus of distressed due diligence

In addition to the analysis of past business development, the focus of due diligence should be on the following factors:

  • Identification of opportunities and risks of the business model;
  • Understanding what factors led to the crisis;
  • Key parameters of the business model at hand;
  • Liquidity development on a sub-monthly basis to determine the maximum financing needs for investments and working capital in addition to the acquisition financing needs;
  • Determination of the quality of corporate management and controlling instruments, including the comparison of direct and indirect financial planning to detect possible control weaknesses;
  • Analysis of the liquidity situation, in particular cash burn rate, supplier and customer relationships and delivery conditions (working capital management), covenants in loan agreements and issues that jeopardize the company’s ability to operate as a going concern;
  • Development of a new business plan that makes it possible to identify further inefficiencies and restructuring costs, but also to show areas of potential and synergies;
  • If necessary, identification of financing potential, e.g. through the sale of non-essential business assets or not strategically essential parts of the company/group, simulation for the restructuring of liabilities;
  • Based on the above findings, presentation of options for the correct transaction structure;
  • Support in negotiations with the financing banks and other stakeholders (e.g. also trade credit insurers).

 

In order to achieve the best possible result for the potential investor and to cover the need for urgent action in crisis situations, the transaction team should include both transaction and restructuring specialists. Also the potential buyer should have a sufficient level of restructuring know-how or have it covered by engaging external consultants. Distressed companies often involve diverse internal weaknesses, such as reporting and management systems not adjusted to the size of the company and missing internal controls. This means that in addition to a new strategic orientation and adjustment of the product portfolio, often there also arises the need to adjust internal processes and structures. If the pitfalls are overcome, the distressed company may become a genuine asset.

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Isabelle Pernegger

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