As the economic shock caused by COVID-19 begins to take its full effect on UK businesses, many of whom were already stressed and highly leveraged, it is inevitable that there will be an increase in restructurings and distressed M&A opportunities.
The Cause of Distress
All businesses require working capital.
Revenues are drastically reducing while fixed costs continue to accrue.
Government schemes will provide some relief by subsidising wage bills and allowing business rates and tax holidays.
For some businesses, however, sources of working capital will diminish to the point that it will not be possible to pay debts falling due.
This gives rise to both risk for those responsible for managing the business, and opportunity for those interested in investing in or acquiring all or part of it.
The Drivers of Outcome
Management: Those responsible are potentially vulnerable to personal liability. To mitigate the risk, they must cause the company to act in the interests of its creditors and must do all they can to minimise losses.
While there may be nothing that can be done to minimise losses, that will fall to be determined with the benefit of hindsight.
A new investor seeking control may be well received.
Financial stakeholders: Senior secured creditors may no longer be adequately secure. Junior creditors at risk cannot obtain priority for new money without the consent of current senior secured creditors.
Financial creditors may be ready to compromise.
Commercial stakeholders: there may be key suppliers or customers who rely on the business for their own success who stand to suffer losses if there is no rescue.
Commercial stakeholders may be willing to accept compromises.
Critical information will be: (1) what is the cash need and (2) what would be the estimated return for creditors from an insolvency process?
Typically a licenced insolvency practitioner will be engaged to ascertain or verify answers.
There are the following options to achieve a controlling interest in the business:
1. A consensual deal
Involving agreements with (i) current shareholders (ii) current lenders (to acquire, reduce or reschedule the debt or share the equity) and (iii) commercial stakeholders with overly burdensome contractual terms.
Difficult where there are many parties and time is short.
2. A Scheme of Arrangement
A new capital structure is proposed by the company. Those affected by it are divided into classes. Minorities in each class are “crammed down” by 75% in value and a numerical majority voting in favour.
Useful where many shareholders and financial creditors are to be impaired. Requires two Court hearings.
3. A Company Voluntary Arrangement (CVA)
A new capital structure is proposed with secured creditors consent. All shareholders are crammed down by a majority, and all unsecured creditors are crammed down by 75% (and 50% of non-connected creditors) in value.
Useful where there are many operational stakeholders to be impaired.
4. Acquisition of the business and assets
The company will appoint an administrator who, with the consent of secured creditors, will sell the assets necessary to operate the business. With the exception of employees, all liabilities and contractual relationships are left behind.
Fast and (relatively) cheap. However, no warranties at all will be provided, and focussed due diligence is therefore important.
Coronavirus may not be the only reason the business is distressed, and an acquisition will provide an opportunity for a deeper restructuring. Attention to the following is recommended:
Does the business depend on the continuation of all group companies?
Are there cross-guarantees given by an otherwise solvent company or group tax responsibilities?
Is the participation of management or an owner of shares critical to the viability of the business?
Are there critical contractual counterparties with a right to terminate in the event of a change of control?
Are there creditors whose continued relationships are critical who may adopt a “ransom” position?
Does the business operate over jurisdictional borders, and what steps are needed to preserve value?
Are there critical regulatory permissions which could be revoked?
The holder of a controlling stake in the secured debt enjoys considerable influence over the outcome.
Accordingly, buying secured debt is a frequently deployed strategy for an acquisition of a business, via a CVA or a business and asset purchase (often described as “loan-to-own”).
Conversely, a stakeholder who has a “blocking” position in the debt or equity, may be able to thwart a proposed restructuring and thereby exercise leverage.
Time is inevitably short. With increasing personal risk for management and losses accumulating, value is liable to be destroyed to a point beyond which the business is not worth having.
A seller will be reluctant to engage with a buyer who does not appreciate the nuances of transactions of this kind; if a deal craters, there may be no second chance to preserve value.
Parties with a track record of honouring non-disclosure agreements and acting discreetly with integrity may be notified of opportunities, to the exclusion of others.
Where there are several lenders, to whom information is to be provided, it is common for it to be a condition that they agree not to sell their interests within a specified period.
If it is the intention to retain all or some of the existing management team, there is no reason why incentive arrangements should not be discussed
To be taken seriously, a party interested in acquiring control should engage a credible professional team conversant with the distressed environment.
This briefing is produced by KWM in conjunction with Jeremy Goldring of gunnercooke llp.