A distressed situation for one business owner could be an ideal opportunity for another. However, buying a distressed business doesn’t come without its risks.
In my time as an investment banker working on the buy-side and sell-side, I have seen successful and unsuccessful transactions involving distressed assets. In this article, I shall walk through one recent success story and provide a bit more context into why the buyers’ strategy worked — and what prospective buyers of distressed assets can take away from the story.
A Success Story
Hillel and Moshe Tropper, brothers, business partners, and serial entrepreneurs, knew what they wanted — a distressed company they could make more valuable by vertical integration and horizontal growth.
The brothers owned an entity, Cambridge Resources, which manufactured, imported, and distributed plumbing and HVAC supplies, mostly on the East Coast. When the Troppers heard through the grapevine that LDR Industries, a plumbing distributor, had filed a Chapter 11 bankruptcy case, they narrowed in on LDR as their target.
LDR’s bankruptcy was precipitated by a specific, identifiable crisis – goods held in Customs and a dispute over the proper fees payable to the Customs authority. The dispute held up a large quantity of incoming goods and endangered the company’s future viability. A Chapter 11 filing was necessitated by discord with the company’s lender, suppliers, and customers.
The Troppers retained me to advise in the process as well as Allen G. Kadish, a restructuring lawyer experienced in negotiation and moving a distress transaction through the court, and pursued a deliberate and thoughtful strategy. Their hope was to combine LDR with Cambridge Resources, thereby converting LDR into a manufacturer, expanding the customer base and product lines, and becoming more important to the customers.
After initial diligence, they made a bid in the court-approved process, contingent on the outcome of further diligence. An intense period of diligence and negotiation followed; we valued assets, evaluated key contracts for assumption or rejection, analyzed litigation, handicapped and isolated the Customs dispute, and addressed other lender/creditor issues. They quantified synergy and opportunity. In short order, a purchase agreement was executed, presented, and court approved; the brothers closed on the deal soon thereafter.
This transaction was a model in swift recognition and execution by a buyer of an opportunity. The Chapter 11 enabled the isolation and elimination of the Customs issue, thereby “cleansing” the target. This facilitated the addition of new product lines, expansion of the customer base (horizontal), and manufacturing capabilities (vertical), as well as the relocation to more economical facilities (bonus).
The Advantages and Dangers of Buying a Distressed Business
Can you too achieve this type of success by buying a distressed business?
The most obvious reason to buy a distressed business is the depressed price. As Hillel Tropper puts it, “A distressed company does not have its future mapped out so there is more opportunity.”
However, you should not lose sight of the risks. It may be difficult or impossible to turn around a failing business. As a purchaser, you may be exposed to successor liability or fraudulent conveyance claims.
So, what should you do? Once you’ve found your target, assess your ability to turn around the business or acquire profitable pieces of the company. Be realistic about risk and calculate how to limit your downside. Consider how you can run the business differently and what additional resources are at your disposal.
Buying a Distressed Business in Chapter 11 or “Out of Court”
The Troppers’ story is a classic Chapter 11 “section 363” asset purchase. Should you also consider buying a distressed business in an “out of court” process?
An “out of court” acquisition avoids the competitive bidding requirements of Chapter 11 that drive up purchase prices and the cost of outside advisors and lawyers. Also, with no court supervision, the buyer and seller can arrange their own timetable, conditions, and negotiating strategies. A sale may be completed quietly, without causing turmoil to customers, suppliers, and employees.
But if you buy the assets of a business through the court process, “the assets are cleansed by the Bankruptcy Code such that once sold there is generally minimal risk of successor liability, fraudulent conveyance or competition among creditors,” according to Allen G. Kadish, a New York restructuring attorney with Archer & Greiner, P.C, who represented the Troppers.“The Chapter 11 process is designed to make the risks fairly transparent,” he continues. “Out of court acquisitions of substantially all assets of a business in distress can leave a buyer, long after the closing, with hidden risks, liabilities and lawsuits.”
Therefore, I would advise: In considering an out of court purchase, analyze the facts carefully with your professionals and weigh the likelihood of a lower price and greater negotiating flexibility against the protections afforded by a Chapter 11 acquisition.
Finding a Distressed Business for Purchase
So, how do you find a distressed business to purchase? Here are a few suggestions. .
- Keep track of competitors and businesses that could provide vertical and horizontal opportunities.
- Follow industry trends. Higher transportation costs, changing legislation or licensing, tariffs, or swift-moving innovation might negatively affect your supplier, competitor, or venture partner more than you.
- Participate in industry events to keep abreast of industry trends. These events also uncover who is doing well and who is not.
- Get out. Talk with industry lenders, customers, associations and lobbying groups. Join a network like Axial.
- Communicate with suppliers, customers, and lenders. Things can go wrong in an instant and an opportunity can present itself in a flash. The more you know, the better you will be at addressing the risks.
- Know the competition. Who is ready to retire? Whose management succession plan just isn’t working? Who has taken on too much debt, an overwhelming new project, or keeps getting mired in litigation?
- Participate in buying, selling, and distress groups and events. A friend in the business is always an advantage.
- Find investment bankers, lawyers, and accountants who have their fingers on the pulse of the distressed world.
Design the Transaction
Once you have found a target for purchase, your approach must be tailored to the circumstances. Tactical expertise can be the difference between success and failure.
For a Chapter 11 purchase:
- Find a target that can be “cleansed” in Chapter 11.
- Develop a bidding strategy for auction. (I wrote more about this in “Memorable Lessons from Violin Memory and Other Auctions” (Law360, April 2017).)
- Consider a “stalking horse” position.
For an “out of court” purchase:
- Consider adopting a “vulture” strategy – an aggressive strategy taking advantage of the target’s weaknesses. For example, you can “loan to own” – an investment strategy to influence and ultimately control the target — but obtain legal advice to ensure that your actions are taken in good faith.
- Mitigate the danger of hidden liabilities by careful structuring, such as an asset (rather than a stock) sale, an escrow holdback, and an earn-out.
Tips that are applicable both to Chapter 11 and “out of court” purchases:
- Start negotiating early with the distressed company. Most are dysfunctional, so it is likely that the seller will become progressively weaker and you progressively stronger. If the company files Chapter 11, you will have a leg up on the competition.
- Explore under what terms the lender will allow the borrower to exit the facility.
- Management of a distressed business is often in denial so exert pressure. For example, you can send a formal written offer in order to trigger fiduciary obligations or (if your lawyer approves) you can approach the lenders.
- Consider purchasing only specific assets, such as a division, intellectual property or customer lists, rather than the entire business.
A distressed sale presents all participants – seller, buyer, management and employees, lenders, key suppliers, contract parties and customers – with the opportunity to exert leverage and gain some sort of advantage in the deal. In your acquisition of a troubled business, design a strategy at the outset that delivers the best value to you. Remember, a distressed company is an opportunity for you. It presents you with a depressed price and a chance to map a new future.