By Joseph J. Radecki, Senior Member, Restructuring and Special Situations Group, Lincoln International LLC and Jason Solganick, Senior Member, Restructuring and Special Situations Group, Lincoln International LLC
With valuation multiples high and financing generally available, the M&A market for middle-market companies and assets, including distressed assets, has been relatively active lately. Notwithstanding the current markets, though, the sale of the assets of a financially distressed company is always fraught with difficult issues. What if the sale proceeds are insufficient to cover the funded debt? How do you handle obligations to lessors — particularly on unprofitable locations? What about litigation or environmental claims? Luckily, albeit expensively, the market has developed a tried and true method to deal with the issues inherent in the sale of financially distressed assets: bankruptcy.
Bankruptcy is a fantastic tool to organize, negotiate and generally deal with known and unknown liabilities in a well-worn track. Lenders can provide capital through DIP loans at minimal risk to keep the company alive. Claims can be adjudicated, discounted and even crammed down and forced into a certain recovery, most times at a discount. Sales of assets or businesses can be consummated even over the objections of shareholders and junior creditors.
Bankruptcy itself, however, comes with a significant cost. First, there’s the obvious need to pay what has become increasingly large amounts to the debtor’s attorneys and advisors handling the case. Add in the fees of bankers to sell the assets, claims handling firms, attorneys and advisors for various stakeholders paid out of the estate, fees to the U.S. Trustee and the administrative costs are daunting. Even worse can be the detrimental business effects in lost sales to nervous customers, vendor or supply issues and the opportunity costs of distracted management teams dealing with the court process.
A bankruptcy proceeding also implies a significant loss of control over the sales process itself as the judges, creditors and other parties in interest exert leverage over the proceedings. Finally, although bankruptcy sales attempt to extract the highest price, the practical reality is bankruptcy naturally narrows the potential field of buyers, the timing over which the sale process ensues and generally forecloses deal complexity, all of which has the net effect of lower sale prices.
So, is there a choice? Do you have to file bankruptcy to sell assets if the expected sale value is less than the debt outstanding? Increasingly, companies, lenders and other creditors are answering, “No.”
What factors determine whether a distressed asset or business is headed toward bankruptcy or not? The answer is complex and driven, to a large degree, by creditors’ and buyers’ consent to play along.
First, a seller of distressed assets attempting to stay out of Chapter 11 must examine the size and complexity of its existing capital structure. Sales outside of bankruptcy require the consent of the parties whose contractual rights are being altered. The more creditors a debtor has, whether dispersed inside the same, or even worse, separate tranches of debt, the less likely the possibility of a sale occurring outside of Chapter 11. In the middle market, however, where funded debt can often be comprised of just a few lenders, deals can be done outside Chapter 11.
The second consent usually required is that of the buyers of the assets. Many buyers want a court’s “good housekeeping seal of approval” or final order on a purchase to ensure the assets are being gained free and clear of all encumbrances other than those the buyer has specifically assumed. While not without effort, outside bankruptcy, this necessity can usually be handled with releases for known players and good disclosure by the seller and due diligence by the buyer to eliminate unknowns.
Equally important to the analysis of the layers of debt and absolute number of debt holders is their type. Certain distressed companies have encountered trouble over the last few years getting out-of-court deals completed when their debt has been held by structured institutional lenders such as CLOs or CBOs. Depending on the structured vehicle’s overall financial health and charter, such entities may not be able to make an economic decision on a voluntary offer and may need to have their obligation’s claim adjudicated.
The complexity of completing a sale outside of bankruptcy can also be impacted by the liquidity of the debt. Debt that is frequently traded is very hard to pin down to a deal and subject to significant “hold up value” — the ability to stop the out-of-court restructuring or sale with demands different than other similarly situated creditors. While, again, more difficult, “lock up” agreements, where creditors or lenders agree to either not trade their debt, or alternatively, only trade their debt to parties willing to comply with the terms of the agreed upon deal, is a potential solution.
To properly sell distressed assets outside of bankruptcy, other claims — such as litigation, environmental claims, and leases or lease rejection claims — must be assumed, settled or accommodated. All these claims can be difficult to handle if the dollar amounts are large or the claims numerous, as very few buyers are prepared to assume unknown levels of risk and very few secured lenders are willing to settle significant amounts of unsecured claims to avoid Chapter 11.
Another variable to consider is whether the secured lenders are “principled” or “economic.” Selling assets outside a Chapter 11 bankruptcy will inevitably involve secured lenders distributing a portion of their proceeds to pay unsecured creditors for settling their claims. Occasionally, a secured lender will make a principled stand on the issue: “They would get nothing in a bankruptcy proceeding, so they’ll get nothing from me outside bankruptcy.” While it can be debated whether that is actually what happens in Chapter 11 cases, thankfully, most secured lenders will normally take the economic route, calculating their share of the costs of a bankruptcy proceeding to the costs of settling out-of-the-money claims.
One sure factor to stop an out-of-court process dead in its tracks is the need for significant amounts of additional capital funding during the sales process. No lender or group of lenders want to take the risk that they’ll fund a sales process only to be held hostage by the other creditors and forced to deal with a bankruptcy anyway. Companies hoping to engineer their sales process to stay out of court need to find a way to maintain their businesses in a cash-flow neutral state.
So with these types of impediments, what can a company and its professionals do to alleviate them? First, as previously mentioned, is to make generous use of mutual releases. Buyers will demand them, generally from any party with a legitimate claim, and while there’s a cost involved, it’s often just assimilated into the negotiation of settling the unsecured claim. Another often used method promulgated by buyers is the use of escrows. While they put a target on cash available to handle claims, they can help shield buyers from assuming unknown or unliquidated liabilities.
Likewise, holdback accounts established between companies and secured lenders can be utilized to “close up shop,” allowing debtors to wind down their remaining operations, end their corporate existence and settle additional claims. Buyers have also become adept at working with their insurance brokers to identify legacy risks in distressed assets and insuring against unexpected future outcomes.
In addition to the cost of fees and expenses involved with a sale through bankruptcy, there are several other benefits to consummating a sale out of court. Often, an out-of-court sale process can be conducted quietly — meaning as opposed to a bankruptcy sale, there is no need for public notice of process/auction and negotiations can be done behind the scenes. This potentially minimizes unrest in the vendor and customer community that will result from the public airing of a company’s financial distress. Ideally, a quiet, out-of-court process will also help to insulate the company from predatory practices of competitors.
Another variable to consider is timing. Typically, if a company has had adequate time to prepare for bankruptcy and the auction process, an in-court sale can be consummated relatively quickly subject to the bankruptcy court’s approval and its calendar. However, a quicker sale is not always a better sale. Conducting the process out of court allows a company to conduct a longer and more thorough process. This additional time gives the company and its advisers more time to “tell the story,” and gives potential buyers more time to conduct due diligence on the business and industry (with which they may not be very familiar) and arrange financing for the purchase. Skillful investment bankers can use this additional time to both increase the universe of potential buyers and, ultimately, the number and value in bids received.
Another advantage is that an out-of-court process can keep unsecured creditors from having an outsized voice and role in the process. Inside of bankruptcy, unsecured creditors often are represented by an official committee appointed by the U.S. Trustee. The costs and expenses of this committee are borne by the company. Because of this, unsecured creditors in bankruptcy will often take a more aggressive posture in negotiations (potentially even threatening and pursuing litigation) because it isn’t “on their dime” and they do not have much to lose. It is also easier to divide and conquer the negotiations with these creditors, as they will not have safety in numbers and will not be sharing or privy to as much information as they would be in bankruptcy.
Finally, the bidding procedures of bankruptcy sales typically require the purchase price to be in cash and equivalents and discourage other forms of payment — seller notes, warrants, other debt instruments, etc. To the extent that these types of consideration would lead to a higher overall recovery, it can make bids that are not all cash more attractive to creditors.
Once it has been determined that a sale of a business is the preferred strategic alternative, the goal shared by a company and its creditors is to maximize the value received from a buyer. The major variable becomes the venue with the considerations boiling down to the simple question of how the sale can be effectuated with the least amount of cost and damage to the business. Distressed companies pursuing a sale will be better served by advisors that understand bankruptcy is not always the best venue and are experienced in consummating out-of-court sale transactions using the many tools available to achieve similar benefits to bankruptcy without the accompanying costs.
Joseph J. Radecki and Jason Solganick are senior members of the Restructuring and Special Situations Group of Lincoln International LLC. Together, they have over 40 years of experience providing advisory services to sponsors, shareholders, lenders, management teams, bondholders, creditors and court-appointed representatives of financially stressed and distressed companies. Transactions include out-of-court workouts, debt amendments and forbearances, exchange and tender offers, distressed M&A and Chapter 11 reorganizations. In addition to transaction execution, advisory assignments often include raising debt (including DIP and exit financing) and equity capital, valuing businesses and assets, and providing expert testimony in Chapter 11 bankruptcy situations.