Although m&a activity has suffered a sharp slowdown in H1 2020 across markets, the general expectation is that there will be a wave of distressed transactions led by sponsor activity, since private equity firms raised record funds before the pandemic and are now sitting on huge amounts of dry powder with pressure from their limited partners to invest. Distressed companies can be attractive targets for acquisitions or investments (debt or equity), since investors that can decipher the complexities around such companies can unlock value to boost returns. The current distressed environment is therefore ripe for the picking for tactical opportunists or sophisticated alternative investment managers who can identify value dislocation in companies and markets.
To prepare for the expected wave of distressed transactions, dealmakers can turn to the playbook written in the years after the last global financial crisis in 2008. Several methods of acquisition were used then: (i) acquisition coupled with refinancing or debt restructuring; (ii) asset disposals and carve out transactions, where a company disposes its target assets or a subsidiary to generate much needed cash; (iii) acquisitions through prepacked reorganisation plans; and (iv) hostile acquisitions through workout sale of assets. Let's take a closer look at each of these and at what to expect in the current environment.
When this article was written, a five-month long moratorium on the repayment of bank loans was about to end in Serbia. Many banks have already agreed to restructure their facilities, in some cases such that annuities due in the current and next year are paid as a balloon at the end of the repayment period, hoping that borrowers and economies will recover by then. However, some of these lenders would be willing to take a haircut on their loans if repaid immediately and this is where opportunity lies for private equity funds looking for equity or debt investments. Sponsor-backed acquisition, where the target's existing debt is refinanced by banks and sometimes also by funds providing debt (often at high yield), can be a win-win scenario for everyone in distressed situations – for the target, repaid lenders, new lenders and, of course, the sponsors.
In the pandemic, cash position on the balance sheet has become more relevant than ever. Many regional groups of companies present in Serbia and neighbouring countries are cash deprived and struggling to service their debt. A possible solution is to dispose of their assets to deleverage. The types of assets offered for divestment range from stakes in subsidiaries to real estate. If the seller is severely distressed, a major risk associated with such transactions is clawback, both in imminent insolvency of the seller or by creditors outside insolvency. Investors should take every precaution to avoid their investments being second guessed by local courts if they have been made at fair market terms and if they may have damaged other creditors. The key test applied by courts is to determine if the buyer knew or must have known that the transaction is damaging other creditors by preventing them from settling their claims. In addition to fairness opinions, buyers may also want to commission an independent solvency opinion stating if the company will have sufficient liquidity post-transaction to settle their debts.
Prepacked reorganisations have been a popular tool for distressed companies in Serbia facing looming debt. Often a sponsor would buy into specific debt classes (typically at a discount on face value) to ensure the voting majority required to adopt a prepacked reorganisation plan, prepared together with the debtor. The debtor would then submit the plan to the court, enjoying an automatic stay on all claims in preliminary insolvency proceedings until the plan is adopted. The voting classes in the prepacked reorganisation plan are set to ensure that the investor has a majority, either standalone or with other supporting creditors. The plan provides that claims of certain classes are discounted (sometimes drastically) and repayment obligations are deferred with very low interest. The plan sometimes provides for an equity investment of a sponsor that acquired distressed claims at the outset or a share deal is agreed with the owner of the business outside the plan. In any case, prepacked reorganisation plans have been widely criticised as too debtor-friendly, leading to extremely flexible debt restructuring possibilities and making it an attractive tool for many investors, both strategic and financial.
When there is no deal with the owner or other creditors/stakeholders, acquiring an asset through workout is always an option. Pledges are enforce- able instruments in Serbia, meaning creditors that hold pledges over shares or other assets may directly commence enforcement without needing to obtain a court judgment first. Depending on the security , creditors may commence enforcement in or out of court to sell the asset or acquire it themselves by participating in an auction, where they can set off the price against their claim. When the face value of the claim exceeds the fair value of the asset, this gives the creditor lots of room to increase their bid and acquire the target asset. In addition to participating as bidders in the auction sale in enforcement proceedings, investors sometimes acquire a secured claim at a discount and then commence enforcement themselves. Enforcement proceedings can be highly efficient in Serbia, assuming underlying debt documentation and security is well prepared.
Having all these tested tools to acquire distressed assets should facilitate deal-making, since the playbook is already there and merely needs to be applied correctly to specific situations and perhaps tweaked in certain cases to today's environment.