How acquirers can ride the restructuring wave

Steve Zuckerman, director of the Special Situations Group at Farlie Turner & Co., writes exclusively for Corporate Dealmaker on how strategic buyers can muscle through tough economic conditions. The Corporate Dealmaker, February 12, 2008.

With less liquidity in the market and tighter credit standards now in place, it is likely that credit defaults will dramatically rise and companies will no longer be able to refinance themselves out of their financial challenges. This economic climate will create opportunities to acquire companies with overleveraged capital structures -- but sound business models -- for a significant discount.

The opportunities will develop in multiple sectors -- not just among real estate developers and mortgage lenders, but also in any industry tied to the housing market such as the myriad of building product and equipment rental companies. We also expect other industries to suffer considerable challenges, including retail, casual dining, manufacturers and distributors of durable goods. Within these industries, it is smaller and midsize companies that will feel the pressure first as they typically have fewer resources and are less likely to raise institutional capital.

Strategic buyers with strong balance sheets will benefit because they will be able to capture market share by acquiring undercapitalized competitors. Private equity firms, flush with capital, are also likely to find many favorably priced deals, although they will be unable to use as much debt to finance their purchases as in the past. Still, buyers will need to be vigilant, since different rules and strategies apply in distressed M&A.

When acquiring a company that is insolvent (generally defined as a company whose liabilities exceed its assets or one that is unable to pay its debts as they come due), one of the greatest risks is being sued for a fraudulent transfer. The term "fraudulent" is somewhat of a misnomer, since neither fraud nor misconduct needs to be proved. Instead, federal and state (constructive) fraudulent transfer law permits a transfer to be unwound if the transfer was not for fair consideration and the seller was not solvent at the time of transfer or become insolvent as a result of the transfer. A failed leveraged buyout, for example, is often attacked by creditors as a fraudulent transfer. As the buyer utilizes the target's assets to finance the transaction, the target arguably received less than "reasonably equivalent" value.

There are several ways for a buyer to limit its exposure to a fraudulent transfer claim, such as obtaining a fairness opinion, a solvency opinion or consummating the transaction in the context of a bankruptcy proceeding -- which is the most foolproof approach. Another interesting wrinkle in negotiating with a distressed company is that when the company enters into the "zone of insolvency," the fiduciary responsibility of directors and officers shifts from shareholders to creditors. Buyers can gain leverage by making this point painfully clear to directors and officers.

Whether the buyer is strategic or financially oriented, an important part of the acquisition strategy should be focused on whether the assets should be acquired in or outside of bankruptcy. Acquiring distressed companies and assets through a bankruptcy proceeding provides considerable benefits, such as cleansing the assets of liens, the ability to reject unfavorable contracts and the virtual elimination of various types of liabilities. However, these benefits must be weighed against the transparency of a bankruptcy proceeding, which is designed to fully vet an asset, foster competition and garner the highest and best price. Strategic buyers also need to consider the reputational impact of a bankruptcy and the effect it could have on trade vendors. If a company has critical and irreplaceable vendors, a buyer should consider contacting such vendors to determine whether they would discontinue doing business with the company if it files bankruptcy. In the end, each distressed situation presents unique facts and buyers should rely on experienced restructuring advisers to assist them in their quest to take advantage of the challenging times that lie ahead.

Steve Zuckerman. The author is director of the Special Situations Group at Farlie Turner & Co., a Fort Lauderdale, Fla.-based investment bank serving growth-oriented middle-market companies. Recently launched, the group provides investment banking, capital raising and financial advisory services to middle-market companies experiencing financial difficulties, ranging from underperforming to significantly distressed businesses.