Buy-Side Middle Market Deals in the Distressed Economy
Corporate & Finance Alert
September 8, 2009
Despite the global economic conditions in 2009, if you look hard enough you will find that middle market companies have found a way to get deals done. Although activity is not what we were used to in early 2008 and prior, Gibbons Corporate Department, and in particular our Distressed Situations Group, have continued to close transactions throughout 2009. In many of these transactions, the target company was in a distressed situation. In this article, we feature three of our buy-side distressed situation M&A deals and highlight some of the key factors occurring in these transactions. At the end of this article we also highlight a few additional transactions we have closed this year.
In the first deal we represented a UK based buyer in a stock acquisition of a private company based in NJ, in the second deal we represented a NJ based buyer in a sale by a private equity owner of a portfolio company, and in the third deal, we represented a telecommunications provider in a loan to own transaction (a multi-step acquisition of a financially distressed business). In each deal, we can see the effects of the recession on the sellers and the ability of the buyers to potentially benefit from the current uncertain climate. We can also see illustrations of larger trends which are affecting the global M&A market. Now is the time that good deals can be made by buyers who show an understanding of the changing nature of the M&A market. Today’s market calls for flexibility and creativity by all parties involved, including the lenders, and blind adherence to historical M&A models is rapidly becoming a thing of the past.
Deal One – U.K. Buyer and NJ Sellers
Synopsis: Gibbons represented the U.K. buyer, a large private company. The target was a long-established family business based on the East Coast. The acquisition was strategic for the buyer to expand its European operations into the United States and Central America. The acquisition was for cash with no debt required.
- Uncertain Economic Outlook. The parties had been in discussions for more than a year regarding a potential deal and had a business relationship for many years prior to commencing discussions. The uncertain economic future convinced the sellers that now was a good opportunity to partner with a larger organization that had better diversity and better access to funding sources.
There is no question that the current climate means that sellers are generally more receptive to potential approaches than may have previously been the case. Many small and mid-sized businesses are very aware that to survive the continued downturn they might need to partner with a more sizable operation that is more able to withstand shrinking demand and tighter credit availability.
- Extensive Due Diligence. Although our client had intimate knowledge of the sellers’ business over many years they were insistent on continuing to carry out significant due diligence up to the last minute including a closing day site visit and review of the target’s financials up to the closing date.
We are finding that client’s are prepared to invest more time and money in carrying out extensive “hands on” due diligence rather than merely relying on hold-back escrows, closing balance sheet adjustments and indemnity protection.
- Retained Equity. Although our client was offered 100% of the business it choose to purchase 75% upfront and take an option over the remaining 25%. In addition, our client took an option over the sellers’ related business in another jurisdiction rather than acquire this at the outset.
In the current uncertain environment our clients are insisting that sellers be fully invested in the success of the transaction. Ensuring that the seller retains an equity stake is one way to achieve this. Another is to defer some of the purchase price. In this deal, in addition to the retained equity, a large chunk of the purchase price hinged on the target achieving certain before tax profits in 2009 and 2010.
Deal Two – NJ Buyer and Private Equity Seller
Synopsis: Gibbons represented a NJ based client in the acquisition of a financially distressed business which was in technical default under its secured revolving credit documents for failure to comply with various financial covenants. The majority owner of the target, a private equity fund in the process of liquidation, decided to write off its investment in lieu of continuing to own the target and funding its future operations.
- Creative Thinking and Problem Solving. Our client developed a new business plan for the target which included a new, profitable line of business to reverse the historic negative cash flow history of the target. It became apparent that this new source of cash flow, coupled with a minimum equity investment by the client and certain modifications to the target’s revolving loan facility, would cure the financial covenant defaults and provide a sufficient collateral base to fund the target’s future operations.
The current climate may be hampering sellers in ways that materially disadvantaging the target business. In this instance the business needed fresh ideas and new investment. The private equity seller was unable to provide the additional commitment. Our client was quick to recognize that the underlying business was worth financing going forward.
- Timing May Be Key. The private equity fund agreed to sell its majority ownership to the client for an amount equal to its out of pocket transaction costs. The client negotiated a modification to the target’s revolving loan facility which administratively was processed by the lender as an amendment to the facility rather than an application for a new credit.
Often sellers are more prepared to accept disappointing financial returns if the process can be handled simply and efficiently. Getting the target and its lenders on-board with the continuity of the business was critical to expeditiously obtain the lender’s approval within a mandated 30 day window to close the transaction and avoided the additional cost and expense of a new credit facility.
- Dealing with All Stakeholders. The transaction was structured as a reverse subsidiary merger which enabled the client to “cash out” the minority shareholder of the target for a nominal amount. The client also established a stay bonus plan and equity incentive plan for management. As mentioned above, the target’s lender structured the loan modification as an amendment to the existing facility rather than incurring the time and risk of returning to their credit committee. With all stakeholders on-board our client successfully closed the transaction within 30 days from the date of the letter of intent with the private equity fund.
This transaction illustrates how a company in distress with its lender and owner may be acquired with a minimum equity investment and a strategic approach with the lender to obtain necessary loan modifications and timely approval of the transaction. The ability to keep the existing credit facility in place, the merger structure to eliminate non-consenting minority shareholders and the support of management were all essential to meeting the 30 day closing time period imposed by the private equity fund seller as a condition to the transaction.
Deal Three – Strategic Buyer “Loans to Own”
Synopsis: Gibbons represented a client in a multi-step acquisition of a financially distressed business which, at the outset, could not be sold since the amount of its unsecured and secured debt substantially exceeded the fair market value of the business. As a result, our client entered into a subordinated secured loan and management agreement with the target which granted to the client a security interest against all of the target’s assets (junior only to the existing senior secured lender) and the exclusive right to manage the target’s business. The client was also granted an option to buy the target’s business (at fair market value), conditioned on discharging in full the senior debt.
- Timing Can Be Key. Within a year after the client made its loan to the target, the target defaulted on the loan and the payment of management fees to the client. At the time of the default, the target continued to have an amount of unsecured debt far in excess of the value of the business on a liquidation. The client declared the target in default under the junior secured credit facility and with the consent of the senior secured lender, the target initiated a UCC Article 9 secured party sale.
Since both the target and the client were regulated telecommunications carriers, the sale required Federal and various state regulatory approvals which were made a condition to the effective date of the secured party sale.
- Compromise in Negotiating. The client agreed to accept all of the target’s assets in complete discharge of the client’s loan and assumed the senior secured debt with modifications to various financial covenants and payment terms.
As a consequence, the client achieved its original business objective of acquiring the target, albeit in a series of steps originating with its loan to the target. The end result was a purchase by the client of the assets and business of the target, free and clear of liens other than the senior secured debt, at a price which reflected the actual fair market value of the assets sold to the client. The client intended to ultimately own the target at the time it made the original loan.
- Sale of Assets Free & Clear. The junior secured loan and management agreement structure was designed to enable the target to subsequently sell its assets and business free from claims by the target’s unsecured creditors.
The Article 9 secured party sale process avoided a costly and time consuming bankruptcy filing by the target and the irreparable damage it would have caused to its business. The entire sale process (including all regulatory approvals) was concluded in approximately 90 days from the date the client declared a default under its junior secured loan facility with the target.
Selected Additional Transactions
Following are several other select transactions closed by Gibbons’ Corporate Department and our Distressed Situations Group during 2009:
- Gibbons represented a NJ health care provider in its strategic acquisition of a smaller, distressed competitor. The transaction was structured as an asset purchase, and the final purchase price is to be determined by a variation of an earn-out, based on a multiple of revenues attributable to acquired customers for a specified time period subsequent to closing. Given the distressed situation of the seller, the transaction was closed on an expedited basis, with a limited initial payment due at closing and seller financing for the balance in the event institutional financing could not be obtained by a date certain.
- Gibbons represented the lead lender in connection with its syndicated financing of its borrower’s acquisition of a portfolio of defaulted mortgage loans. The acquisition was for cash, with confidential terms. The borrower intends to foreclose or take deeds-in-lieu for the properties collateralizing the mortgages, and will then rehabilitate, market and sell the properties. The lender will receive a mortgage on each property as title is transferred to the borrower, and will release its mortgage/lien on each property upon receipt of a pre-established release price.
- Gibbons represented a NJ non-profit health care provider in its strategic acquisition of the assets of another non-profit health care provider. Acquiring the assets of the target, together with the applicable health care license to operate in specific geographical areas, allowed our client to expand its geographic footprint in the State. Given the health-care regulatory scheme and the difficulties of expanding into new geographical markets in New Jersey without obtaining a license, the target company’s decision to sell created an opportunity for our client to not only expand its service area, but to work with another non-profit to provide residents of these communities with greater access to additional community resources and health care services.
Middle market M&A opportunities exist for buyers, who can achieve an outcome that may not have been possible in prior years. Today’s market is the “perfect storm” for well-financed buyers who are prepared to recognize that the difficulties facing sellers may not be reflective of the underlying business being targeted. Sellers understand that generally speaking historic “market” terms have shifted in favor of buyers. Buyers should be cognizant of this shift and assist somewhat reluctant sellers in being creative to harmonize buyer’s concerns and seller’s expectations during this credit crunch and the general economic slowdown. Lenders too can play an important role in facilitating a transaction, whether as a financing party or as a lender to a distressed company (in which case they may be able to accommodate a novel deal structure, like an Article 9 secured party sale, and enhance their ability to be repaid in full).
Both buyers and sellers alike recognize that today’s deals face increased hurdles imposed by lenders; or in lieu of bank financing, may require greater use of seller financing, earn-outs or post-closing price adjustments. Today’s buyers are rightly nervous about realizing their projected value from the deal. Accordingly, buyers are able to push harder on due diligence and should seek to negotiate increased “walk” rights in case they decide not to close the acquisition. However, as the deals profiled in this article illustrate, the success of any deal also requires creativity and the cooperation and ongoing assistance of the sellers. To ensure that buyers create a “win-win” atmosphere when they clearly hold most of the cards can be difficult but with some advance preparation, sound professional advice, patience and focus, everyone can come out feeling comfortable with their deal.