Investors may, for reasons outside of their control, find themselves with a financially distressed company in their portfolio and possibly in unfamiliar territory. Consequently, it is not just those investors who actively seek out opportunities within the distressed space who should be mindful of the implications of insolvency processes (most commonly administration which can often also be used as part of a wider restructuring).
Below are some areas which investors may want to bear in mind when considering approach/strategy to a portfolio company experiencing financial difficulties and throughout any portfolio company insolvency process.
When signs of financial distress first become apparent, parties are best advised to start the contingency planning process. This allows the business more time to plan for further investment, further financing, an accelerated M&A process, an insolvency process or a combination of these strategies. Insolvency practitioners can be instructed to conduct business reviews and assist with cash flow monitoring. Turnaround experts can introduce operational turnaround strategies or, at the very least, cost cutting strategies.
Involving IPs early is sometimes perceived as admitting defeat (given that they will often also be appointed as administrators, should that become necessary). However, that perception is not necessarily the reality and their involvement does not indicate the certain demise of the company. In any event, while a formal insolvency process may be a last resort, a well-planned and managed administration will render a far better return than a last minute frenzy.
The extent to which a private equity sponsor can control an insolvency process will depend largely on: (i) whether or not they hold secured debt; (ii) whether or not their security is second ranking (sitting behind, say, a bank or other financial institution); and/or (iii) their contractual relationship with the senior secured creditor.
The taking of secured loan notes, while, for various reasons, not universal, generally provides the “qualifying floating charge” which is necessary in order to exercise any control in an insolvency scenario.
Assuming the investor holds the only security granted by the company, then it can largely control the timing of appointment of administrators and the identity of those administrators. If the investor holds second ranking security then the circumstances in which enforcement action can be taken will depend on the terms of the agreement with the senior lender, varying from simply a “consultation” requirement to a situation where the investor can take no enforcement steps (including making a demand) until the senior lender has been repaid in full or has consented to such action.
The terms agreed between secured creditors will also be relevant to the question of who controls release of the security so that administrators can sell the business and assets. If there is a hostile secured creditor, a court application may be necessary to secure the appropriate releases.
Managing investor director conflicts
When a company is performing well, the interests of the company and of the investor are generally aligned. When things take a turn for the worse, however, interests can diverge. Nowhere is this more acutely felt than for the investor director who, in addition to being as exposed as all other directors to possible claims of misfeasance or wrongful trading, also has to balance duties to the investor as well as to the company. In an insolvency situation, a director’s duties shift from being owed to shareholders to the creditors which can also put an investor director in a difficult position.
There are some guidelines which can be followed to try and minimise potential challenge to the investor director’s conduct. A few examples include ensuring (where possible) that:
- a clear separation is maintained between shareholder/debtholder matters on one hand and board matters on the other, with the investor director remaining on the board side and (ideally) not being directly involved in decisions made by the investor in relation to the company;
- any decision made by the investor in relation to the company is relayed to the board at the same time or shortly after the investor director is made aware of the decision;
- the investor and the board (including the investor director) receive separate legal advice and instructions on behalf of the investor (and advice given to the investor) do not come to/from the investor director.
On any formal insolvency, shareholder returns will, in almost all cases, be zero. There may, however, be a distribution to unsecured creditors and, in relation to secured debt, a return is highly likely.
It is perhaps unsurprising that the administrators’ costs are deducted before any returns are paid to secured creditors. There are, however, a few other areas of leakage which can reduce returns to secured creditors. These include:
- amounts due to preferential creditors (primarily employees in respect of wages (up to £800 per employee), pension contributions and holiday); and
- a percentage of the net realisations up to £600k per company which is set aside for unsecured creditors (called the “prescribed part”).
The administrators will prepare an “estimated outcome statement” early in the process (once initial offers are received for the business) which indicates to secured creditors what their level of return is likely to be.
Negotiating a sale of a business out of administration (which could be through a “pre-pack” sale which occurs immediately following appointment of administrators), while generally quicker than standard M&A transactions, still takes time.
Administrators have a duty to creditors to achieve the best price reasonably obtainable for assets of the company and will require a robust marketing process. If one has not been recently undertaken on which they can rely, they will need time to do their own.
Buying from administrators
If you are considering acquiring the business out of administration, either through a credit bid (i.e. using a reduction of secured debt as part of the consideration) or a cash acquisition, it is worth remembering that administrators sell without any warranties or indemnities and on an “as is and where is” basis. This may not be too significant a concern given the involvement of the sponsor during the life of the company, however, if there are any particular areas of risk, consider seeking a retention mechanism which may be more palatable to the administrators.
For any distressed situation, being mindful of early warning signs and initiating contingency planning options sooner rather than later will assist in navigating what can sometimes seem like a minefield of issues which arise on an insolvency. Understanding from the outset a sponsor’s contractual and legislative rights will also assist in formulating an appropriate strategy.