The rapid rise in interest rates over the past year has essentially put much of merger and acquisition activity in cold storage — except for distressed assets.
Many startup companies, almost all of which rely on leveraging their business to open lines of credit to pay operating costs (such as employee salaries) for years before turning a profit, are now in trouble, making them attractive acquisition targets.
For this reason, there has been a significant uptick in distressed asset deals in the U.S. and globally.
Who’s buying distressed assets?
Given the current credit market, it may seem odd that any asset, distressed or otherwise, is an acquisition target right now.
However, there are mature companies with liquidity either from operating cash flows or research and development budgets actively seeking strategic acquisitions of distressed assets.
Many of these companies are specifically looking for distressed startups at risk of defaulting on their loans with valuable intellectual property to sell.
Those buyers have done the math, and, in this climate, it could be cheaper to acquire the IP they need rather than finance their own R&D.
Consider, for example, a large company that has set aside $40 million from revenue to develop a software solution in-house. Meanwhile, a startup has developed that software but is deep in debt. That IP may typically be worth $30 million-$35 million, but a startup may accept as little as $15 million under current conditions to avoid defaulting on its loans and missing payroll. It makes more sense in this situation for the larger company to acquire the IP.
Caution is required when structuring distressed asset transactions
The previous situation would certainly be tempting. A potential savings of $20 million coupled with a dramatically shortened implementation period could propel the potential buyer’s business forward. However, distressed asset deals often have tight timelines because the target frequently has urgent loan repayment and payroll deadlines.
It might seem like there is no time to do the usual due diligence that parties in more traditional M&A deals take as a given. That would be a mistake, however.
A buyer should still conduct as extensive a due diligence process as possible when acquiring distressed assets, even in a time crunch. Buyers must take extreme care not to assume liabilities not disclosed by the target.
A distressed asset is, by definition, a troubled company, and a buyer will not want to be saddled with disproportionately challenging problems just to acquire specific assets it could acquire elsewhere with less attendant risk.
If thorough vetting is not possible, buyers should consider using specific language for representations and warranties in the transaction agreement.
Essentially, this should convey that the buyer is only purchasing the particular asset (or group of assets), not anything else, because there has not been time to do adequate due diligence. This also means the buyer should be clear about the exact assets it is acquiring. Limiting the contract language this way will help ensure a buyer does not unwittingly take on liabilities along with the assets it wants to acquire.
Bargains may be worth the risk if pursued properly
During the current period of rising interest rates and a tighter credit market, companies that do have cash set aside can take advantage of the many bargains out there right now for distressed assets.
While it might seem like an awkward undertaking for the buyer, distressed asset deals are often a net benefit to all stakeholders involved: the target company avoids default and bankruptcy; the employees of the distressed target receive greater job security and myriad other benefits that come along with employment at a more mature company; and, last but not least, the buyer saves significant costs not only in the purchase price but also through the near-instantaneous build-out of a new division or product line with an experienced team that already knows how to operate it.
The most important thing for buyers contemplating acquiring distressed assets is to avoid getting so caught up in the idea of a bargain that they neglect to conduct as much due diligence as possible and strategically structure transaction agreements to mitigate risk.
Ultimately, a “good deal” that brings unanticipated liability will not be worth it in the end.
Stephen Moore Jr. is a partner and chair of the M&A practice group at Smith Hulsey & Busey. Justin Robinson is an associate with the firm.
NOTE: This column initially appeared in the Jacksonville Daily Record‘s September Bar Bulletin section.
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