Investing in distressed assets can be a highly profitable modus operandi. However, whether distressed investors realize value can be predicated on a variety of factors, including transaction price, assessment of operations and achievability of the business plan, management execution, capital markets, and exit opportunities. Additionally, strategic buyers or existing platform companies must also take into consideration challenges that include achievability of synergies and growth expectations, cultural implications, and integration execution.
Distressed companies represent complex acquisition targets that have suffered any number of damaging events in their recent (or not so recent) history, whether financial, operational, or managerial in nature. Beyond the obvious external signs of distress that a target may present, the true extent of its challenges may not always be fully visible or quantifiable. Equally, additional value may lie beneath a distressed target’s clearly damaged exterior, awaiting realization by smart distressed investors.
As such, a very particular skill set and experience is required to assess distressed companies and to best position a buyer to unlock value. Restructuring advisors who are intimately familiar with troubled situations can bring perspective and diligence assistance versus more traditional diligence efforts for nondistressed targets.
This article focuses on critical operational issues that must be contemplated by an acquirer as it conducts diligence on a distressed target and operational issues that must be addressed by an acquirer once it takes possession of a distressed asset.
Distressed investors are highly sophisticated investors. They have the ability to consider a diverse range of investment opportunities and conduct top-down financial analyses of potential targets, often evaluating various deals simultaneously. Their well-rehearsed and refined analysis of potential distressed targets allows them to quickly evaluate opportunities and determine if the target meets their investment criteria. When this initial analysis yields a green light decision to commit further time and resources to the potential transaction, distressed investors can benefit significantly from engaging restructuring advisors to conduct a thorough, bottom-up diligence of the distressed target.
In the distressed acquisition context, a restructuring advisor’s mandate typically involves conducting:
Fulsome and effective diligence in the context of a distressed target is intensive in nature and requires advisors to conduct a number of in-person, on-site meetings with the target’s management team. Simultaneously, advisors should provide frequent updates as they conduct their diligence so that the buyer maintains a fluid opinion as to whether the acquisition remains an attractive prospect.
Additionally, when identifying potential cost savings and synergies in the context of a strategic acquirer, an advisor must avoid certain dangerous but common pitfalls. Distressed buyers may tend to latch onto “the numbers,” which may result in irrational headcount reductions. But by doing so, they run the risk of severing key personnel who have highly valuable institutional knowledge. Advisors shouldn’t ignore the “soft stuff.” When designing future state organizational structures, an advisor must be conscious of personality and cultural differences that may exist, as mismatches can have detrimental implications that will be felt over time. When possible, the diligence process should include in-person meetings and site visits to gain a full understanding of the people and the assets behind the numbers.
The end-goal of these efforts is to obtain a comprehensive understanding of the business and its financial outlook, including the potential cost savings and/or synergies achievable if the acquisition is successful. Each target and industry have certain unique characteristics, but some of the more common potential cost initiative opportunities include: headcount reductions, organizational redesign, reduced operational footprint, dispositions of certain noncore/unprofitable businesses or assets, and replacement of inefficient systems—information technology (IT), financial, and customer-facing—to name but a few.
By grouping potential cost savings into distinct buckets, the advisor can clearly define and articulate the opportunities identified to the buyer and any other key stakeholders in the process. Importantly, this information provides the buyer with the specific financial targets against which post-acquisition execution will be measured.
While conducting this type of deep-dive diligence and bottom-up analysis, advisors must navigate and overcome various issues that are characteristic of distressed targets. Examples include:
The ability of the acquirer and its advisors to recognize and delicately manage such challenging operational issues through the diligence process will determine their success in assessing the opportunity of the acquisition target.
Armed with this bottom-up analysis, a buyer will have a more complete understanding of the value proposition the distressed target presents. Moreover, this information will prove to be a critical tool for the buyer as it conducts its final scenario analyses and negotiates price.
If a buyer’s bid is successful, it must then develop strategic goals for those managing the integration of operations, followed by a detailed integration plan for the combined company. The integration planning phase is the road map the acquirer follows to capture synergies and cost savings, streamline processes, and achieve financial growth expectations identified during the diligence process. Before integration planning can commence, the company must design and communicate the ultimate future state company, post-integration.
Integration planning must set overall goals and objectives that are to be achieved and completed in advance of closing the transaction. The buyer’s ability to achieve these integration planning goals will impact the success of the early stages of the acquisition. Lack of controlled, well-organized project management, poor communications, and lack of accountability for results during the planning stage can significantly increase the risk of execution failure.
In addition to a detailed integration plan, the buyer must develop both a Day 1 and a 100-day plan to guide all actions that must be taken immediately after closing. The senior and midlevel management teams at both the buyer and the target must be evaluated to determine whether each individual has the capability and skill set required to manage the post-acquisition operations. They must also ensure that during the integration planning and integration execution phases the core business of both companies is being properly managed.
Those managing the integration of operations should establish a project management office (PMO), determine who will sit on the cross-functional steering committee, and select the integration team that will communicate with functional teams within the target company. The PMO will oversee the integration and execution planning processes, as well as progress reporting.
The PMO should develop a plan with each functional area that identifies cross-dependencies, responsible individuals, timelines, and concise action items. Identification of cross-functional dependencies is necessary and must occur early in the process, as decisions made by these functions often impact everyday core operations.
In acquisitions requiring antitrust review and regulatory approval, a clean team may be established. This team is comprised of individuals operating under confidentiality agreements who can review competitive data that would otherwise be off limits to the acquirer’s employees. Some of these areas include sales, human resources, and IT. The clean team’s work helps maintain and possibly accelerate the integration timetable once the deal closes.
Depending on the dynamics of the deal and the access that the acquirer’s advisor team has to the target’s management team and finance department, a very useful tool through the distressed acquisition process is the 13-week cash flow forecast. Besides the obvious benefit of gaining clear visibility into the near-term cash position of the target, this tool can provide an additional barometer for near-term events, such as customer attrition and one-off payments.
The acquirer should establish a strong integration team for its billing/collections cycle processes. The integration team should ensure that the employees are fully trained, have full knowledge of the systems, and can properly handle the representation of the existing and new customer base. As this area of the business can have a significant impact on the company’s cash flow, it is highly recommended that an independent team be created to review all post-closing billing errors, determine the causes, and address the implementation of corrections required.
Communication is critical during all phases of an acquisition. Key communications include the customer base, vendors/suppliers, and employees of both the acquiring company and the target. Provided there are no regulatory constraints, the acquirer must communicate with the target’s customer base to provide assurances that the acquisition does not change the level of service(s) or quality of the product(s)/service(s) being provided. Key customers should be educated on the history of the acquiring company, any changes they should expect (if applicable), and new contact information. Key vendors/suppliers should be assured that existing payment terms will be honored until expiration or renegotiation of their respective existing contract(s).
Communications with employees of the buyer and the target requires a delicate balance. Employees will want to know how this acquisition affects their individual positions and their futures with the company. To retain historical knowledge, reduce the loss of high-performing employees, and minimize operational disruptions, it is best to communicate to employees who will be staying and negotiate retention bonuses for employees only required for the integration planning process. Employee buy-in and commitment is a key factor to successful integration.
The period immediately following the transaction close can be quite challenging for employees involved in the execution of the integration plan. This part of an acquisition requires the largest commitment of time and resources and poses the greatest risk. Poor execution can result in business interruption and the loss of customers to competitors, the loss of highly skilled employees, and the loss of projected savings/synergies. Tight controls are vital during this period to avoid business risks and capture identified cost saving opportunities without any business interruptions. The focus on Day 1 is the implementation of operating structures, systems, and controls.
A detailed Day 1 plan typically includes some of the following:
When the target is a carve-out or subsidiary of a larger organization, a transition services agreement (TSA) between the buyer and seller may be required. In the TSA, the seller agrees to provide the buyer with transitional support, such as accounting, human resources, and IT, for an agreed period after the transaction closes. The TSA should specify the length of time, pricing, service levels, and staffing. Normally put in place to cover a fixed period of time post-acquisition, TSAs also typically contain provisions for extending the agreement if necessary.
Upon the closing of the acquisition, the buyer’s focus should be on implementing a detailed 100-day plan that should be prepared during the integration planning phase. Closely monitoring progress is critical, and adapting and making changes to the plan will be keys to success. The future state executive management team should understand and support both the financial and nonfinancial integration objectives and possess a clear understanding of the targeted operating model. Simultaneously, management should review the alignment of its operating model across both legacy businesses to determine whether systems, processes, and key performance indicators are aligned and clear to all.
This is the time to fine-tune the new company’s bottom-up budgets, 13-week cash flow projections, long-term business plan, and financial and operational metrics/tools, and to incorporate processes and develop reporting. Upon completion of the integration, the executive team should make sure to establish financial discipline and accountability across the organization.
Further areas to assess and evaluate post-acquisition include:
While distressed acquisitions differ from one to another, certain themes that are common to transaction dynamics remain. In any distressed acquisition, investors can benefit significantly from the following: