Acquiring a distressed business may be a bargain but beware pitfalls

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31 January 2011 | Category: Corporate finance

The past two years of economic turmoil have resulted in a deluge of distressed companies available at bargain deals. But buying a distressed business can be risky as buyers overlook important objectives in favour of the attractive low price of the target company, the risk of someone else doing the deal, or the fear of missing out on a valuable opportunity.

“Buying a distressed business provides a huge opportunity to generate value, but the offer comes with a lot of risks,” warns Jeanette Hern, Partner and Head of Corporate Finance at Grant Thornton. “Retaining knowledgeable advisors is highly recommended – by preparing upfront and retaining proper counsel, the acquirer positions themselves for the greatest chance at success.”

In addition to financial due diligence, which is as important in a distressed transaction as it is in a healthy deal, the following areas require particular focus.

Suppliers
Unlike typical merger and acquisition transactions, in which normal working capital liabilities are assumed by the buyer and paid in the normal course of business, many types of distressed transactions permit the buyer to leave those amounts with the old entity and start afresh.

For a valuation perspective this is important because it theoretically means that the company can generate profit from its inventory on hand while simultaneously buying new material on credit for a few months.

However, relationships with suppliers need to be addressed upfront well before the transaction closes as any disruption can raise costs exorbitantly,” states Hern.

Customer relations
In any business, customers are the most important asset. In the case of a distressed transaction, evaluating customer relationships is critical but not easy.

“In distressed situations, customer relationships can be strained as a result of supply disruptions or negative public perception,” says Hern. “The buyer needs to understand the reasons behind the strained relationship and take prompt action to amend customer concerns.”

In some cases the relationship can be recovered simply by providing assurance that the business will be properly capitalised and capable of meeting supply requirements going forward.

However, particularly when the business is retail in nature, the negative publicity surrounding financial distress may require a more concerted effort to repair the company’s image and regain customers’ loyalty.

Management/Ownership
In many mid-sized companies, the shareholders also manage the business and they are therefore critical to the day-to-day operations of the business. In a typical deal, the buyer structures the purchase to retain necessary management, including the selling shareholder, for a period of time. Doing so ensures continuity of management and minimises disruption to the business.

However, retaining senior management in a distressed transaction is often not a viable option — whether out of concern for past performance or because of the nature of the transaction itself.

“It is therefore very important to identify either an external management team that is very familiar with that type of business or junior managers that are capable of taking over operational control,” says Hern. “In either case, there is an added dimension of risk.”

Employees
Finally, but certainly of great importance, employees form the backbone of any successful business.

“Often, employee morale is low once a business is in distress resulting from forgone pay raises, or caused by work load stress due to hiring freezes and loss of confidence in senior leadership,” says Hern.

A buyer must be aware of the employee situation at the target company as there might be a need to budget for immediate steps to address shortcomings such as pay and headcount increases. These costs need to be considered as part of the evaluation process. Furthermore, a buyer needs to expect some attrition and plan accordingly.

“Losing sight of your objectives and goals when buying a distressed business can be a huge mistake,” advises Hern. “If a target company does not meet specific acquisition objectives, chances are it will underperform expectations and potentially steal management attention from the core business. Such a deal can even destroy value in the acquiring company.”

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