UK: Zero To Hero - Achieving Value From Distressed M&A

Paul Elliot, Corporate Finance Partner at Baker Tilly Corporate Finance LLP, considers the issues involved in seeking to exit under-performing companies, and how to maximise value.

Introduction

Many groups and fund portfolios hold companies which are facing difficulties. With the deterioration in credit conditions – both short-term liquidity issues and longer-term rising finance cost trends – and a more challenging operating environment to come, the focus on stressed and distressed businesses will increase. Often, perhaps understandably, there is limited appetite to 'grasp the nettle', and these businesses can be left to deteriorate in the hope that performance will somehow improve. However, approached in the right way, exits can be undertaken to crystallise value, remove negative contributors to a group's earnings or fund's performance, and to free up executives to focus on more profitable activities.

Although these transactions are rarely easy, and often characterised by their complexity and the intensity of effort required, there are a number of areas which can enhance the value of troubled companies for exiting shareholders. Working along-side advisers who are experienced in turnaround based exits, who can lead processes and support already time-poor management teams, can bring considerable benefits.

The team at Baker Tilly Corporate Finance has a huge amount of experience advising on the sale of loss-making or otherwise troubled businesses. These include exiting subsidiaries of large listed groups, selling or breaking-up listed companies in distress, and disposing of companies in forced circumstances. The team has acted on deals in the UK, and across Europe, including Germany, the Netherlands, Spain and France, dealing with a range of turnaround scenarios and issues, and with numerous acquirer categories, including corporates, private equity funds, hedge funds, and specialist distressed investors, from around the world.

The Plan

A key part of the process to deliver value will revolve around the creation of a credible turnaround plan. This will need to address the key issues the business is facing, and map the bridge through to profitability. This will include the future revenues, costs and cash-flows of the business, with considerably greater value being attributed to restructuring and cost-cutting plans than blue sky sales projections.

A detailed plan with projections based on clear and supportable assumptions will be a corner-stone of a successful exit. A restructuring plan focussed on reducing the cost base is a more verifiable and tangible area for buyers to due diligence, and will usually be an important element of any turnaround story.

Each business will have different cost dynamics, however the typical areas which can be focussed on include:

• Employees: the creation of a plan to reduce the labour force can have a material impact on the financials. The costs and legal issues will need to be worked through, together with potential union and Works Council matters, depending on the jurisdiction. In addition, more efficient working patterns can be considered, for example to reduce overtime or the use of temporary staff.

  It may also be possible to agree salary sacrifice arrangements with employees or to amend other terms, for example overtime rates. In the context of an MBO, it is possible to trade-off ongoing employee terms with some form of equity interest in the business going forward. Although employees (or their representatives) may see the necessity to rebase remuneration packages, they may however attribute little value to this interest, particularly in a potentially failing business.

• Loss-making contracts: the ability to terminate or avoid renewing contracts with negative contribution may again materially change the future prospects of a company. The timing and operational impact of such contract exits, and the potential for early termination penalties or consequent redundancies, will need to be analysed and understood, but can have a significant impact on the profit bridge.
• Property: the property portfolio should be analysed to understand the potential for renegotiation of onerous lease liabilities. Reducing ongoing rentals and / or lease periods may be a material area of value creation.
• Synergies available only to certain buyers: these can include elimination of duplicate costs, arising for example from administrative personnel and overlapping property costs, and pricing synergies through increasing market share.
• Synergies available to all buyers: these can include non-executive director costs, listing and other regulatory costs; one-off costs such as settlement of litigation and management incentives.
• Tax losses: the value of tax losses and the ability to utilise them going forward can be a significant asset in a transaction. The appropriate structuring to realise this value is vital.

The issue of who implements the plan is one of timing and value. Vendors willing and able to execute the plan prior to exit will clearly benefit from the value created if successful. However the risk of failure, together with other time constraints often faced, typically result in vendors presenting the plan to acquirers as an opportunity. As the exit process develops, initial aspects of the restructuring plan may be implemented. It is key to the credibility of the overall plan that these are successful, hence it is sometimes appropriate not to attempt major restructuring elements at this stage. Equally, the need to improve a business' performance in any event may be a sufficient driver to pursue the plan aggressively and rapidly.

A controlled process with a clear negotiating strategy to achieve the above changes is important. There is a risk that third-parties will seek to gain a commercial advantage knowing that there is an imperative to change the situation. Employee representatives may seek to negotiate improved terms for their members; landlords may seek the buyout of outstanding lease terms; recipients of outstanding earnout obligations may seek to crystallise these advantageously - in the knowledge that they represent an important step on the path to a successful exit. The threat of insolvency may ease the negotiations.

Management

Management will be key to the development of a backable plan, and to demonstrating its deliverability. Key weaknesses in management teams need to be addressed early if possible. An unconvincing CEO or CFO with limited grasp of the detailed financials will damage value prospects.

In addition, management may have a number of different objectives. They will have a duty to the shareholders, but may also, understandably, have loyalty towards colleagues and employees. The opportunity for management to be interested in the acquiring vehicle, by way of an MBO for example, or the possibility of losing their jobs as part of a deal, is also likely to influence behaviour.

Management teams may dampen the prospects of a business in order to improve the value at which they can acquire, or may delay the implementation of restructuring initiatives and / or exit processes in order to frustrate other bidders. They may also form alliances with employee representatives to seek to position themselves as the only solution for exit, with employees threatening action if the business is sold elsewhere.

The issues of management conflicts and incentives, and personal liability risks in the case of failing companies, are best addressed early.

Funders

The issue of which stake-holders are in practical control must be understood. Increasingly structured deals mean that control may lie away from the equity.

The sophistication of financial investors and willingness to seek work-out solutions is likely to provide companies with opportunities to renegotiate financial structures and pursue controlled exits. However, the widespread dispersion of interests in companies, through the syndication and on-sale of debt (packaged or otherwise), has led to an opaqueness of control in distressed situations. The impact of this will vary, however corralling a diverse investor base, with potentially diverging objectives, to agree a restructuring solution is inherently more complex.

Funders' goals and their negotiating leverage need to be factored into any exit decision. Where a lending syndicate or individual syndicate member can veto a transaction, the challenge of seeking some form of commitment, to mitigate potential acquirers' concerns of a deal being blocked, is key.

Equally, it is important for over-leveraged companies to act quickly. The constraints on developing the business - where surplus cash is required to pay down interest and capital rather than to invest; where management resource is diverted to endless negotiations with funders; where customers and staff are constantly aware of going concern issues – can result in a vicious circle of non-recovery.

Acquirers

Understanding the appropriate potential buyers for any business is obviously fundamental. Along with this is the need to understand what buyers are capable of and what they are looking for.

There is a spectrum of turnaround focussed financial investors, ranging from the more traditional private equity community to hedge funds to specialist distress funds. The speed at which these parties are prepared to act, the level of due diligence they require, and the inherent risk they are prepared to accept will vary.

There is often a trade-off of value against time. For vendors with a need – for example a listed company with announcement deadlines or a vendor with regulatory authority timetables to meet – it may be possible to transact very rapidly. The price for speed is however reflected in the value and terms at which such deals can be undertaken.

Equally, it should be recognised that, although strategic buyers may seemingly have the most compelling rationale for making an acquisition, trade buyers will often have more cumbersome internal (and potentially external) approval processes, will, if listed, be concerned as to the perception of an acquisition and its impact on short-term earnings, and will often have a more cautious approach to the risks involved in turnaround transactions.

Corporate buyers may also give rise to anti-trust issues. Although a competitor may be able to extract the most value from an acquisition, if the necessary delay to seek competition clearance results in customers and employees leaving the business, it may be impossible to close such a deal prior to the business formally or practically imploding. It may well be in the interests of other market participants to represent that an acquisition by a competitor would give rise to competition issues, with the objective of causing a deal to fail, preventing the acquirer from achieving greater market strength, and potentially forcing the target into insolvency and hence taking out capacity.

There may be opportunities to introduce 'alternative' investors into deals. For example, it may be possible to enhance deal value through the presale of IP to a customer, with a commercial interest in achieving security over the IP and seeing the business survive to provide continuing support. Alternatively, vendors may be in a position to retain surplus assets, for example freehold property, which may then be leased to the target, ideally on commercial terms, and sold on to specialist asset investors.

Deal Structuring

Cash on completion is good. Debt for equity swaps are typical. Other structures to be considered include:

• Deferred consideration dependent on, for example, retention of key personnel or customer contracts.
• Earnout based consideration based on the future performance of the target. These always need careful structuring and are open to manipulation. Contribution by the vendor to certain ongoing costs, with agreements to share any savings achieved by the buyer.
• Contribution by the vendor to certain one-off costs, for example redundancies and rebranding, again with benefit-sharing arrangements.
• Vendor loan notes, with or without interest and security, with repayment based on future cash-flows or triggers such as ultimate exit by the acquirer.
• Ongoing equity participation, direct or through convertible instruments. The use of ratchet mechanisms may also be introduced.
• Option or share / asset pledge arrangements to allow vendors to reclaim ownership in certain circumstances, for example the breach of undertakings by an acquirer.
• Anti-embarrassment and claw-back provisions to allow the vendor to benefit from any unexpected value (in terms of quantum or speed) achieved by the acquirer.

Whilst private equity funds will rarely give extensive representations or warranties, it is possible that corporates can also avoid giving such undertakings. This caveat emptor approach will typically have an impact on up-front value, however this may be limited in any event, and provides greater clarity of exit for the vendor. The clean break can be very valuable in its own right. The ability to avoid lengthy negotiations on detailed legal issues, as opposed to key commercial terms, also assists in timing.

In seeking to achieve some negotiating leverage, often with few cards in the hand, there are a number of potential pressure points. Obviously achieving competition in a process, and interesting a number of buyers in the opportunity, is important. In addition, using the threat of company failure may bring results. Although not without risk, the probable loss of goodwill, customers, employees and pipeline may assist in forcing buyers to deliver to preserve value.

Another issue to grapple with is whether to sell the corporate or the business and assets. A buyer may prefer the latter structure, in order to avoid taking on unknown liabilities, however the vendor may well take the opposite view. Key issues to consider with business and asset deals include: the need to novate contracts, and the price negotiating opportunity this may give customers; the requirement to follow TUPE, with appropriate arrangements as to who bears the cost of employees who will be made redundant and the risk of claims; and the issue of how to achieve value from trading losses within the company. The mechanics of routing cash back to a vendor must also be considered, with contingent liabilities in the vending vehicle potentially preventing a rapid return of any sale proceeds in an assets deal.

Process

An important contributor to value in exit processes is the simplification of the inherent complexities surrounding a troubled company. The objective is to present to buyers as clean and simple an acquisition / investment opportunity as possible.

Data control and availability are often poor in struggling companies. Understanding gaps in information, and how to address these as effectively as possible, are key to achieving an exit. Although time constraints may impact the lead in time, a preparation phase allowing for proper analysis, understanding and presentation of the key issues and potential solutions is always sensible.

Although it is important to maintain control over the process, it should also be recognised that exit processes for troubled companies are dynamic and events can change rapidly. Deteriorating trading conditions, flawed execution of restructuring plans, management resignations, employee actions, may at any stage intercede. In addition, buyers' own circumstances may change as a process develops. A willingness to maintain flexibility and a pragmatic, commercial approach is usually required. Whilst control is always an objective, the ability to react to changing circumstances is also important.

Separation

Groups selling subsidiaries need to consider a number of issues. There may be short-term operational issues relating to shared services. These may include the provision of accounting support - for example payroll, treasury, tax, - and shared office space. Allowing the acquirer a short period to absorb these functions and exit properties will be necessary. In addition, there may be longer-term financial impacts on the target. Separation from a larger group may cause a number of diseconomies, for example relating to insurance costs. The issue of funding changes in ongoing costs is one for negotiation, and will depend on how readily the buyer can replicate these functions or supplies.

The vendor must also ensure that any deal provides for the release of group support measures, typically parent company guarantees. A short, but pragmatic, period to undertake a rebranding exercise can also be agreed to protect the vendor's reputation going forward.

The commercial impact on the vending group of disentangling a subsidiary must also be considered. Where the target provides services to a group's broader customer base, the effect on multi-service contracts and ongoing price and supply discussions, may be material. Communications with customers must be well planned.

Equally, if the target still represents an important trading partner going forward, various continuing relationship arrangements may be agreed. These can range from 'best friend' agreements to hard contracts, and in any event are likely to improve the value of the business. Confidentiality and data protection issues will also need to be considered where employees of both vendor and target share premises or information going forward.

Other exit issues to deal with which impact on value, in common with most company sales, include: early redemption / prepayment fees arising from refinancing of a target's funding lines; change of control issues, for example customer contracts; the potential crystallisation of pension liabilities.

Listed Companies

UK listed companies face a number of specific issues driven largely by the regulatory environment they operate in. Continuing obligations to keep markets informed, whether in respect of unpublished price sensitive information, or by way of regular results announcements, may impact a listed company's ability to negotiate transactions out of the glare of public scrutiny. The objective of avoiding false markets and the consequent disclosure obligations may cause commercial issues.

Where, for example, listed companies have announced exit intentions in respect of an under-performing subsidiary, the need to achieve deadlines to meet market expectations, and to allow such businesses to be classified as discontinued, may give acquirers a commercial advantage. In addition, disclosure of difficulties may impact a company's share price, existing customer relationships, and new contract negotiations. Each of these may impair the exit value which can be achieved; in certain circumstances, the announcement of potential financial issues in the absence of a deal may be a self-fulfilling prophecy.

Where the listed company is itself the target, the City Code applies. This has a number of additional implications, including:

• Requirement to announce in certain circumstances: a company may need, due for example to rumour and speculation or an untoward movement in its share price, to announce it is in talks on a reactive rather than proactive basis.
• Offer timetable: the duration of the offer timetable may result in a company becoming insolvent prior to an offer going unconditional. In this event, it may be necessary for an offeror to inject emergency funding before it has gained control.
• Gathering acceptances: where an offer is of limited value to shareholders, but will ensure that the business remains a going concern, it may be difficult to persuade particularly non-institutional shareholders, potentially facing significant losses, to accept this offer. Additional circulars and telephone campaigns may be required. Taking control once the 50% acceptance level has been passed may also be necessary, as opposed to a more typical 90%.

Conclusion

Every deal is different but certain issues often reoccur when considering exiting under-performing companies. Experience of these situations - practical, tactical and emotional, - can greatly enhance the value achieved. The provision of an experienced, hands-on senior advisory team can also provide an objective view on often difficult decisions, and can allow management to focus on stabilising a business.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.