Buying distressed assets
Growing Business looks at the potential offered by distressed assets, and what purchasers should consider before committing their cash
More than 250 UK companies went into administration in September, and each one could represent an untapped opportunity for the right buyer. Growing Business looks at the potential offered by distressed assets, and what purchasers should consider before committing their cash.
The banks may not be lending very readily in the downturn, but they are not missing a trick when it comes to absorbing assets that will pay back handsomely when it's over. “Bob Diamond's takeover of the bust Lehman's on behalf of Barclays Capital only reflects what is happening at a more micro-level all around the market,” says Julie Meyer, who has just launched the Ariadne Capital Entrepreneurs Fund to invest in early-stage companies. “Those who have the money are making transformational and asymmetrical moves to completely change the landscape on the other side of the recovery.”
She adds that the current economic climate favours the bold. “If timing is everything in life,” she says, “then add ‘buy low, sell high', and you have a double whammy maxim to lead you to business happiness. “That's as good a model of the business edifice as any you are likely to see, and the key words are ‘those who have the money'. It may be hard to borrow from the banks, but entrepreneurs prudent enough to have built cash reserves are getting ready to pick up basically sound businesses that have run into the financial buffers.
It's a time for self-sufficiency. If now is the right moment for you to expand, you can bolt on a distressed business that has assets you need, whether its people, premises, market share, capital equipment or a combination of these. Luke Johnson's Risk Capital Partners (RCP) has signed three bolt-on acquisitions this year. The latest includes 11 sites from the administrators of Tootsies Restaurants to expand the Giraffe group that RCP backs, along with 3i. “Current economic uncertainties mean now is a great time to do deals,” he says.
Test your motivation
There are plenty of good reasons for wanting to acquire a business, but the fact that it's a bargain isn't one of them. You need to bear in mind that you may be about to swallow something that disagrees with you.
“Buying a company is like shopping in a sale. If you buy something just because it's cheap, it doesn't mean you'll wear it,” says Simon Cope-Thompson, a partner at boutique corporate finance firm Livingstone Partners. Livingstone has not seen an avalanche of distressed companies up for sale, and Cope-Thompson suggests that more companies go bust just after a downturn, meaning the distressed assets market could peak as the recovery begins.
“In the next 12 months, more companies will be facing a liquidity crisis than in the last 12,” he says. If he's right, this is just the right moment to get your head around the pitfalls that await the over-enthusiastic.
Essentially, an acquisition from an administrator or liquidator is the same process as a normal acquisition. However, there are two significant differences: speed of transaction and the total lack of warranties, according to Teri Hunter, a corporate lawyer at Moorcrofts LLP. “Normally, when we are purchasing a business, we would expect to take three months from start to finish,” she explains. “When purchasing from a liquidator, the time available tends to be a week or two. There will not be much scope or time for negotiation in respect of the contract, and the liquidator or administrator will want to impose the terms, avoid any liability and give no warranties.”
Marc Boyan, founder of media bartering firm Miroma, confirms the need for an extraordinary degree of alacrity in the current climate. He is definitely on the acquisition trail, with plans to snap up a collection of bars, restaurants and clubs for his new leisure division. He has recently completed the purchase of two West End clubs: Bar Rumba and Maya. But he points out that these were not so much distressed as underperforming. “Right now, many clubs and leisure businesses are suffering due to the recession, poor management and high costs, but they are situated in prime locations, and offer punters a great experience,” says Boyan. “We're buying in at just the right time to reap the rewards when the economy improves.”
When Coffee Republic went into administration, he was one of the first in the race to acquire the café chain. It was a typical scramble, with upwards of 20 serious bidders involved in July. “We had to be ready to move in a matter of days, with a due diligence team and professional advisers,” Boyan explains. “The downturn offers great opportunities if you've got the capital and experienced teams in place to run the business.”
In the event, he lost Coffee Republic to Arab Investments, so it's wise not to pin all your hopes on one acquisition. “There will be a lot of opportunities out there,” says Boyan, “and the first deal that comes along is not always the best.”
The reality check
Even three months is not long to complete an acquisition, and it will probably mean you have to write off all that time to pull it off. So consider the buzz you'll get from wrapping it all up in a week. “The buyer must be prepared to move quickly and take advantage of the accelerated M&A processes around distress,” says Cope-Thompson. In a ‘pre-pack' situation the insolvency practitioner, the directors and the bank will have obtained valuations, agreed a sales price and drafted contracts to enable the business to be sold immediately after appointment.
“Buying an insolvent company is often a run to the wire with no warranties. Pre-pack is a cleaner process. You can pick the assets and leave the liabilities so there's less risk,” says Cope-Thompson.
Reduced liabilities made the difference for the consortium led by turnaround specialists Privet Capital and Paradigm, which bought the smart furniture retailer Lombok out of a pre-pack around the same time as Boyan was bidding for Coffee Republic. It was able to move quickly, pick the cream of Lombok's 19 stores, keep on most of the employees and secure existing orders.
The structure of insolvency is designed to get distressed assets sold on as fast as possible. This means that the words “buyer beware” should be stuck on your bathroom mirror. To get an accountant to look at the books properly within 48 hours will mean paying them a premium. The same applies to your lawyers. And don't be tempted to instruct the firm of accountants that has looked after you for years. This is a different ball game, and you'll need someone who plays it for a living.
Put up or back out
Let's say an opportunity has dropped into your lap – it's unlikely you'll have time to pitch it to financial backers. This is a moment to put up or back out. James Caan built his portfolio by doing just that. “At Hamilton Bradshaw we invest our own money, so we can make some very independent decisions,” he says. “And yes, the downturn is a time of opportunity. In fact, 2009 will be our record year.”
Caan made his name partly by asking the right questions and listening carefully to the answers. Perhaps that is a viable definition of due diligence. “Ask around,” he says. “If it's cheap, find out why. Is there a flaw in the business model?” According to Caan, too many companies have been founded on a model that only works in a strong market.
The dragon has recently moved into the health sector by picking up some marginal assets from LA fitness as the core for a new gym brand called Nuyuu. Going to the gym is probably something people are cutting back on just now, but he is planning to invest to expand the new brand under the management of former LA fitness national sales manager Ben Silcox. And all the existing staff have been offered the opportunity to transfer to the new company under Transfer of Undertakings (Protection of Employment) or TUPE regulations.
Pot of gold or can of worms?
Teri Hunter points out that TUPE regulations are something you will have to check with your lawyer. You may only be interested in the sales contracts of your target, but there will be employment ones, too, and you need to know if these are being transferred. “In some circumstances, when you are buying a distressed business, some of these TUPE regulations can be relaxed and you can pay reduced redundancy packages,” she says, but only if redundancy is on the agenda.
It is possible to get obsessed with the product, warns Caan. “People are always the key, so when acquiring a business, always focus on the experience, talents and execution capabilities of the management,” he says.
Then there's the question of premises. If your target is a manufacturing business that requires leased factory or office space, what is the situation with its landlord? Usually, the liquidator or the administrator would want to disclaim the lease, which means you don't have to take it on. That may be a good thing, but you could then find yourself without the premises you need to continue running this business. Although the landlord may be happy to negotiate a new lease, if they are owed back rent, they'll want you to pay it before doing so. You'll need to know if you will be liable for this ‘ransom payment'.
The supply chain is a sensitive beast, too. “The liquidator may not know whether there are likely to be retention of title clauses in the supply contracts,” says Hunter. “If there are, and the supplier hasn't been paid, they can reclaim their goods.” Without key suppliers, there might not be a business, so you need to know they will be happy to go on trading with you. If they are owed money, they could use your need for them as leverage to get you to pay it, even if you have no legal obligation to do so. For a manufacturing firm, stock, moulds or tooling may be outsourced or stored off the main site, so you ought to know who controls them.
Even the name of the business is an issue. If it has gone into administration, its name may have a negative impact on your own sound business. Will your reputation be tainted by the association? Nuyuu launched with a new brand identity, whereas with Giraffe's takeover, the assets will continue to trade as Tootsies until they can be converted and integrated.
You have to be prepared to compress all of this work into a fraction of the time due diligence normally takes. “You may not get all of the information, but it's better to have some than none at all,” says Hunter.
Every M&A specialist we spoke to agreed that buying distressed businesses is a high risk process. But risk is what entrepreneurs are about. As Marc Boyan point out, when you have done everything in your power to minimise the risk, there is always a leap in the dark to be taken – so use whatever time, resources and good advice you can muster, and, ultimately, trust your instinct.
How to purchase from a liquidator or administrator
A one-week legal checklist
Employment issues – Factor in the Transfer of Undertakings (Protection of Employment) Regulations (TUPE)
Insurance – Check employer liability insurance. Was it kept up to date? Does it need to be continued to get run-off cover?
Lease/Licence – Do you need the premises? If so, can the liquidator grant a licence for a short period? Contact the landlord
Assets included in the sale – If possible, make your own inventory. If you're buying a manufacturer, for example, check for stock, moulds and tooling held off site. You don't want to have to pay a ransom to get the tools released
Are any crucial assets on HP? – Will you be able to negotiate with HP companies?
Are there unpaid suppliers? – Can you deal with them? Has the cost of cutting a deal been factored into the price?
Retention of title – Have you factored in the likely cost of retention of title? If such clauses are in place, the supplier can reclaim stock if they haven't been paid
Data Protection Act – Does the business require registration? Does the registration allow transfer to successor businesses?
Disgruntled suppliers – Some may not want to deal with you going forward. Talk to suppliers in advance to avoid ransom payments
Reputation – If damaged, how will this affect your business?
Disgruntled customers – Will you need to offer discounts to get them back on board?
Work in progress – Will you have to finish jobs at a discount to retain customers?
VAT registration – Do not take over existing VAT liabilities when filling in the form
Source: Teri Hunter, Moorcrofts LLP
A Busted flush?
James Caan's hints for buying distressed assets
Processes and procedures for the two firms must be similar. It can be quite time-consuming and costly to change one or both companies' modus operandi
Approaching the deal
Wait until the target is in dire need of a cash injection – that's when it will be most flexible about its valuation
Paying the price
Market timing is critical, because earnings multiples tend to decline in a downturn. Watch out for ‘extraordinary items', such as sales that are isolated events, but are projected as recurring, or expenses that are actually recurring, but are projected as isolated events. These can change valuations drastically
The focus on culture and employee relationships should begin pre-integration. Many deals go sour simply because of conflicting personalities and a cultural mismatch
The turnaround phase
Research shows that M&A transactions sometimes don't create value because forecast ‘synergies' don't materialise. In my opinion, more analysis should be done on the financial impact of merging, offsetting increases and decreases. Moreover, creating and executing an effective 90-day plan is critical to fast-tracking change at the target company, and adjusting the pace and efficiency at which it operates