Opportunities and Risks of Distressed M&A Deals
Distressed M&A transactions are currently en vogue – especially in Germany. Permanent changes in the energy sector lead to insolvencies, both in the solar industry and in energy intensive businesses. Insolvency situations often are seen as opportunities for investors, traditionally mostly for financial, but more recently also for strategic buyers.
Sometimes, despite insolvency, there is a healthy and stable core business. Also, some financial obligations (e.g. pension obligations, a partially redundant workforce or unfavorable supply contracts) may be left with the administrator due to the common asset deal structure in insolvencies. In addition, for the first three months of insolvency, wages are paid by the state. Also, substantial discounts are granted due to the insolvency situation. In turn, investors have to be prepared to act quickly, usually without meaningful due diligence and accepting only basic representations and warranties.
New Legal Framework for Distressed M&A in Germany
On March 1, 2012, the ESUG, a new change to the Insolvency code, was enacted. It is aimed at promoting the restructuring of insolvent companies by, inter alia, enhancing creditors’ influence on insolvency proceedings. The core provisions of the new German Insolvency Law are as follows:
- Creditors may themselves select the insolvency administrator by unanimous resolution of the preliminary creditors’ committee (prior to ESUG, the decision was at the sole discretion of the court);
- Introduction of debtor-in-possession proceedings (i.e., management remains responsible and represents the company while in insolvency);
- Introduction of the possibility of debt-to-equity-Swaps in insolvency plan proceedings;
- Introduction of pre-insolvency restructuring proceedings (combination of debtor-in-possession and insolvency plan proceedings)
These new instruments under German Insolvency Law also allow for new options in the structuring of distressed M&A transactions, in particular as creditor's rights in selecting insolvency administrators have been strengthened. On the other hand, by initiating debtor-in-possession proceedings, the target's management now has the possibility to play a much more active role in potential restructurings out of insolvency.
Successful Restructuring Requires Planning
The selection of the insolvency administrator is of significant importance for the process. In the past, some creditors and potential investors often have been reluctant to invest in German distressed situations, as the selection of the administrator was exclusively left to the discretion of the competent court. Now, a mandatory preliminary creditors’ committee has to be established during the preliminary insolvency proceedings (i.e., the period between filing and the formal opening), subject to meeting certain thresholds: balance sheet total of at least EUR 4,84 Mio., annual revenues of at least EUR 9,68 Mio. and more than 50 full time employees. Now, the insolvency court has to follow suggestions for a particular administrator, if they are made by unanimous resolution of the preliminary creditors’ committee.
As important creditors (e.g. banks or customers or suppliers who have granted loans) are also elected to the creditors' committee, they have a key position, regarding investments. Beyond influencing the selection of the administrator, all relevant information is provided at committee level, and may be discussed quickly with major creditors and the insolvency administrator. As a sale of relevant assets always requires the approval of the creditors and the administrator, the membership in the preliminary creditors’ committee provides the opportunity to present the investment rationale first hand to the decision makers. In order to avoid conflicts of interest, it might be advisable to abstain from voting (particularly if there is competition regarding certain assets). Obviously, a conflict is less likely if other creditors and the administrator support the concept.
Usually, however, potential investors are not also necessarily key creditors. For third party investors, early access to management and key creditors may also be crucial in order to facilitate a restructuring concept being approved. Aligning the major creditors will be helpful in order to select the administrator. In addition, management may file for the opening of insolvency proceedings and simultaneously present a restructuring concept, an investor and a candidate as insolvency administrator to the court. With support from the creditors, chances are that a court will approve such candidacy.
Distressed M&A in Debtor-in-Possession Proceedings
Debtor-in-possession proceedings are quite common in some countries (such as the US), but have only been very rarely used in Germany in the past. The ESUG now provides for easier access to such procedures, in which the management of the insolvent company continues to run the business – despite having filed for insolvency. Management is supervised by a custodian – again appointed by the court. The day-to-day operations are conducted by management. A restructuring concept, as described above, may now also be combined with an application for debtor-in-possession proceedings by management (provided that the management is backed by the creditors). Furthermore, in an instance where the investor provides financing within debtor-in-possession proceedings, the insolvency court may order that any claims for repayment of granted loans are preferred claims. As a consequence, such claims would be satisfied in full.
It is, however, uncertain whether some of the usual procedures commonly used under the old legislation will also work under the new debtor-in-possession regime. Therefore, some questions have been raised regarding potential liability of management and, even more importantly, of the custodian. This uncertainty sometimes even leads management and custodian to switch from debtor-in-possession to regular insolvency proceedings – simply to avoid the risks of personal liability.
We have recently advised a large industrial client in the acquisition of a business unit out of insolvency. As we were involved early in the process, we helped ensure that our client's proposal regarding the administrator was accepted, in turn maximizing chances of a positive outcome in the acquisition.