Historically, when it came to mergers and acquisitions (M&A), the art of the deal was painted with a positive brush. Growth, through the effective identification of opportunity, was always the focus. However, in today’s world, beset by economic crises as a result of COVID-19, the true art of the business deal has shifted to focusing less on growth and more on survival. Notwithstanding this shift, the ability to timeously identify and effectively capitalize on novel opportunities, which are presenting themselves as a result of an ever-changing market, has become more important than ever before. Dealmakers armed with this ability are primed to, almost paradoxically, still achieve unprecedented levels of growth (even during unprecedented levels of adversity).
The business rescue and restructuring landscape has provided a fertile playground for dealmakers that are looking to create growth in an economy seeking to survive. It has resulted in the creation of numerous opportunities to acquire good value assets at significantly discounted prices. So, while many investors have focused on companies that proved COVID-resilient by remaining profitable since the advent of the pandemic, others are increasingly starting to take the path less travelled by opting to invest in companies which have gone into distress. These investors are managing to achieve the creation of value in a declining economy by taking advantage of the benefits provided by our business rescue process in the M&A space.
Considering the rarity of opportunities for business growth in the current economic climate, we are unsurprisingly starting to observe a steady increase in M&A activity in what has come to be known as the distressed asset-based market. In light of these developments, we thought it would be prudent to consider some of the frequently asked questions arising in relation to distressed investment opportunities.
How does business rescue create a beneficial environment for M&A?
In order to understand how business rescue has resulted in the growth of M&A transactions dealing with a new distressed asset class, it is important to first have a brief understanding of what the business rescue process entails.
Business rescue is a legal mechanism which is available to a company which is financially distressed. Where there is a reasonable prospect of rescuing the distressed company, meaning that there is either a reasonable prospect of returning the company to a solvent enterprise or placing it under business rescue would result in its creditors receiving more than they otherwise would have, had the company been immediately liquidated, then it can be placed under business rescue either by the resolution of its board of directors or by court order.
Once under business rescue, the responsibility for the governance of the company is essentially handed over to a business rescue practitioner (BRP). The BRP is responsible for drafting, proposing and implementing the distressed company’s business rescue plan (the plan), in terms of which the company’s affairs is to be restructured in order to achieve its rescue. The plan will likely provide for, amongst other things:
- the restructuring of the company’s debt, as its creditors are generally asked to compromise the value of their claims;
- the provision of post-commencement funding (PCF), which is funding provided after the company has been placed under rescue for the purpose of paying its ongoing expenses during the rescue process; and
- the sale of certain of the company’s assets and/or debt.
- Essentially, the plan is then adopted and becomes binding when it has been approved by the majority of the distressed company’s creditors.
- A few additional legal consequences to business rescue, which assist in facilitating deal flows, are that:
- a moratorium on the continuation or instituting of any legal proceedings, including enforcement action, against the distressed company is established;
- unencumbered assets owned by the company can be used as security to obtain refinancing; and
- contracts of the company may be cancelled, or the company’s obligations may in certain circumstances be entirely, partially or conditionally suspended by the BRP.
These consequences provide a glimpse into how the business rescue legal framework creates a supportive environment in which a purchaser can obtain a good value asset on favourable terms. For example, the purchaser is given the space to negotiate the terms of the proposed transaction without having to concern itself with pending or potential litigation and onerous contracts may be cancelled or renegotiated.
Having broadly covered what business rescue process and distressed asset-based M&A entails, we now turn to discussing some of the specific factors and benefits to be considered in order to perfect the “art of the deal” when it comes to distressed asset-based M&A.
What is the importance of PCF in distressed asset-based M&A?
The provision of PCF comes with various legislated benefits which create commercial opportunities for investors looking at distressed assets. Accordingly, in order to be able to effectively identify and capitalize on distressed investment opportunities, it is important to properly understand how this mechanism works in the business rescue process.
As mentioned, PCF is funding provided to a distressed company by a third party subsequent to the commencement of the business rescue process, and serves the purpose of keeping the distressed company afloat for the duration of its business rescue by enabling it to meet its ongoing expenses.
The provision of PCF is often essential for the distressed company to be successfully rescued. In the absence of PCF, a distressed company would almost certainly be fated for liquidation as it would otherwise not have a reasonable prospect of being rescued. In other words, it will not be possible to justify placing the distressed company under business rescue on the basis that there is a reasonable prospect of rescuing it, because it would not even be able to meet its minimum costs during the life of its business rescue.
PCF accordingly provides a purchaser seeking to acquire a distressed asset on favorable terms with a metaphorical foot in the door, as it enables both the purchaser and the company under rescue with the opportunity to capitalize on the commercial opportunities presented by the benefits of consummating a deal during business rescue. This is because the PCF enables the distressed company to go into business rescue by satisfying the legal requirement that there be a reasonable prospect of its rescue, which then consequently enables the purchaser to later emerge from the rescue as the owner of the distressed asset.
To address any qualms which may arise from the idea of providing money to an ostensibly failing company, investors should also note that there are certain protections afforded to them. Firstly, they can require that the PCF be secured by obtaining security over any of the distressed company’s unencumbered assets. Secondly, the Companies Act 71 of 2008 (Companies Act) also confers providers of PCF with a preference in the order of repayment of the company’s creditors. In other words, the Companies Act and the business rescue plan will essentially provide that PCF providers’ claims for repayment will be paid before that of unsecured pre-business rescue creditors.
In addition to meeting the company under rescue’s short- to medium-term funding requirements, PCF can also be cleverly used by an acquiror to achieve their own long-term goals. For example, we have seen that some private equity players have extended PCF as collateralised debt during the lifetime of a company’s rescue, which they then convert into equity once the company emerges from business rescue.
What are the other ways in which debt for equity transactions can be used for both the benefit of the company under distress and potential acquirors?
Recognising that the immediate liquidation of a distressed company could result in receiving a lower return than if the company were rescued, creditors have also opted to enter into debt for equity transactions. These transactions entail the distressed company’s creditors agreeing to convert their creditor claims against the distressed company (i.e. the debt owed to them) for equity in the distressed company.
By essentially causing a seismic shift in the balance of the distressed company’s accounting books, these conversions make it possible for both the distressed company to be rescued and for its creditors to receive a good value return in the long term.
These sorts of transactions are ideal where creditors identify that a distressed company holds real long-term value should it be returned to profitability, but all other efforts to rescue it are proving unsuccessful. For example, the BRP may be having difficulty in obtaining PCF or selling off some of the company’s non-core assets, making the likelihood of rescuing the company low. In such circumstances, the debt for equity conversion may just be that extra push which the distressed company needs in order to be successfully rescued. The debt for equity swap also creates the possibility of further improving the distressed company’s equity standing, as it will become more attractive to potential investors as a result of becoming a viable trading entity.
When implemented correctly, debt for equity conversions during business rescue can result in a win-win situation as the company is given the lifeline it needed in order to survive and return to profitability, and its erstwhile creditors (now shareholders) have generated greater value for themselves as the value of their equity stakes would be greater than the dividend which they would have received in a liquidation scenario.
Creditors of distressed companies should accordingly not be too quick to write these companies off, but should rather be alive to these options and maintain a keen eye for distressed investment opportunities. As the saying goes, “one man’s trash is another man’s treasure”.
Are there benefits to buying the business of a company under distress as a going concern during business rescue?
In addition to the legislated benefits to concluding a transaction during business rescue, there is one benefit pertaining to transactions where the company under distress disposes of its business as a going concern which requires mentioning.
Section 112 of the Companies Act provides that the shareholders of a company which is disposing of the whole or a greater part of its assets or undertaking must adopt a special resolution, and goes on to provide a list of onerous and somewhat ambiguous requirements to be met by the resolution in order for it to be valid. The resolution itself is also then required to authorise the specific transaction. However, there remains uncertainty as to what level of specificity is actually required in order for the resolution to stand, notwithstanding the fact that it may have been passed at a duly convened meeting.
Time and other practical constraints pose a risk of invalidating such resolution, with the result that the transaction may also become invalidated. However, section 112(1)(a) of the Companies Act exempts a company under business rescue from these requirements, and thereby stimulates a sale of assets for a company under rescue by providing greater ease for all.
The legislative provisions of Chapter 6 of the Companies Act have provided benefits to parties conducting M&A transactions with companies under business rescue. These benefits have further created a wealth of distressed investment opportunities, as the business rescue process has created an entirely new asset class for investors to pay attention to.
To successfully capitalize on these opportunities, at a minimum it is required that there be an early identification of a distressed asset, the ability to fund the acquisition, as well as an ability and inclination towards assisting the company through rescue by providing PCF. However, from what has been discussed in this article, it is clear that there are a variety of ways in which one can go about capitalizing on these distressed investment opportunities, as well as a variety of considerations, both legal and commercial, which have to be borne in mind when doing so.
Although exciting, investing in distressed assets does pose a level of risk which demands a specific skillset to successfully address. Having the right advisors, with the necessary experience, is vital to successfully identify and capitalize on distressed investment opportunities.
The CDH Business Rescue, Restructuring and Insolvency Sector looks forward to further engaging in this developing investor landscape, as well as to continuing to assist our clients in being at the forefront of successfully acting on the unique distressed investment opportunities which are starting to present themselves with more frequency.