Guest comment by Paul Humphreys, Scott Talmadge and Andrew Goodman of Freshfields

Following the global implementation of stay-at-home orders in response to covid-19, businesses suffered unprecedented declines in demand. As the US struggles to rein in the contagion, a number of household names – from Chuck E Cheese to JCPenney – have filed for bankruptcy. Logically, distressed M&A transactions should rise as corporations struggle under historic levels of debt. But who is poised to take advantage of a boom in distressed M&A, what are the new realities of these deals and how will these transactions proceed?

M&A since the pandemic began

Global M&A activity has declined precipitously with deal volumes falling by 32 percent for H1 2020 over H1 2019 and deal values declining by nearly 53 percent for the same period. Although deal activity may continue to lag until there is better visibility on when, and how, the world returns to normal, M&A transactions will continue.

The Harvard Business Review recently surveyed C-suite executives and business development professionals across a range of industries. Some 23 percent of respondents reported that they expect their own dealflow to remain on track, or even to accelerate, during the balance of 2020 due to an increase in opportunistic targets or more attractive valuations brought on by the pandemic.

Many in this optimistic group cite the possibility of delivering on digital transformation strategies as a key growth opportunity, spurred by the pandemic-driven move to virtual business models.

Of those who will continue to pursue opportunistic transactions, 49 percent expect to look at distressed companies, even though, as one respondent indicated “it’s been over 10 years since we even thought about doing a distressed deal, and I’m not sure we ever had a playbook for that”.

In addition to strategic M&A, the realities of the covid-19 market will necessitate ‘financial’ distressed M&A transactions, whether as a result of opportunistic financial players or as a result of existing debtholders taking control of a distressed company or forcing a sale.

The covid-19 cliff

Corporate debt now totals almost $10 trillion. Some bankruptcy experts have described a “covid-19 cliff” coming where Paycheck Protection Programme funds have dried up, demand is non-existent and liquidity remains tight. Some predict over 60 bankruptcies with more than $1 billion in debt in the US alone. Notably, there were only 49 of these mega-bankruptcies in 2009 in the fallout from the great recession.

This says nothing of the small and medium-sized companies that will seek bankruptcy protection in the coming months.

Preference for an M&A solution

Many, if not the vast majority, of distressed M&A transactions in the US will occur through a Chapter 11 bankruptcy process, either through a section 363 sale or a plan of reorganisation. Given the uncertainty surrounding valuation, in particular for targets in sectors hit hardest by the pandemic, buyers of distressed assets outside the Chapter 11 process should be wary of the ‘clawback’ risk that could follow a post-acquisition bankruptcy of the seller.

Creditors of distressed companies may actually prefer to either force a sale through a bankruptcy in order to protect their interests or to acquire the seller through their own secured debt claims if a ‘market-check’ via a Chapter 11 proceeding does not yield sufficient liquid value.

Unique challenges

Distressed M&A in normal times is hard work, and covid-19 has only made these transactions more challenging. First, speed matters in distressed M&A processes, so due diligence must be completed in a compressed timeframe. Covid-19 makes due diligence more difficult where parties may not meet face-to-face and sensitive data must be shared with individuals working from home, potentially on unsecure networks.

Second, valuations remain challenging and traditional tools to bridge value gaps, like earn-outs or some form of equity consideration, may be non-starters for a company’s creditors that expect to be satisfied on closing of the acquisition.

Finally, closing certainty is of paramount importance in distressed M&A. Corporate buyers with significant market overlaps and non-US players pursuing assets perceived to implicate national security may be at significant disadvantage in distressed M&A processes.

Here again, customary risk allocation technology such as break fees and divestiture commitments may be non-starters for a distressed seller whose creditors refuse to wait for regulators to perform in-depth reviews or for acquirers to implement required regulatory remedies.

Acquirer’s approach

Developing a distressed M&A playbook with the corporate development team is critical ahead of any potential acquisition. Having a clear strategy for due diligence on an expedited basis, assessing and incentivising management, valuing distressed assets and planning for integration, among others, will ensure corporate development teams can pounce on opportunities as they arise and adhere to the strict auction timelines.

In addition to acting quickly, being the ‘stalking horse bidder’ is often key to winning the auction. The statistics support this: in bankruptcy sales, the stalking horse bidder is successful nearly 70 percent of the time.

In addition, creativity will help acquirers to reap the benefits of distressed opportunities.

Shopping mall owners Simon Properties and Brookfield Properties have partnered with branding/licensing company Authentic Brands Group to rescue iconic brands such as Brooks Brothers, Forever 21 and Lucky Brands out of bankruptcy. These retail brands also happen to be major tenants throughout Simon’s and Brookfield’s shopping malls.

Private equity’s role

Private equity is sitting on more than $1 trillion that remains undeployed. Undoubtedly, some of that dry powder will be used to acquire debt of distressed companies as part of a ‘loan-to-own’ strategy for the near term and with an eye towards a future exit when the target has been de-levered or market conditions have improved.

For acquisitions of distressed assets in bankruptcy sale processes, buyer financing outs are a likely non-starter and a reverse termination fee for financing failure is equally untenable to creditors. We have, however, recently seen more private equity funds willing to equity finance the entire purchase price, with the expectation to refinance when markets improve.

Rise of protectionism

Pre-covid-19 changes in regulations significantly expanded the jurisdiction of the Committee on Foreign Investment in the United States to review transactions involving the acquisition of control – and in some cases, even a minority stake – in critical technology, critical infrastructure and sensitive personal data.

As the pandemic is further politicised, foreign control over medical equipment, pharmaceutical products, personal protective equipment and food, among other key goods, will be increasingly framed in national security terms. Non-US buyers may therefore be disadvantaged if distressed opportunities fall within the purview of CFIUS.

As noted above, speed to execution and certainty of closing are paramount in a distressed process. The CFIUS review timeline has lengthened, meaning a distressed acquisition requiring CFIUS approval could take several months to clear.

Notably, there is not yet a CFIUS analogue to the expedited review under US antitrust law for section 363 sales. Non-US acquirers pursuing US distressed assets will need to engage with CFIUS counsel early to understand the risk profile and will need to demonstrate to a distressed seller a clear path to timely clearance as a first priority.