By Kenneth A. Rosen, Esq.
There is great fear and uncertainty in the market. Retailers and restaurateurs have been reeling from the inability to serve customers. Curbside pickup and home delivery do not compensate. Oil and gas bankruptcies also are piling up. Other industries are experiencing reduction in sales as consumers spend less, and there is a “ripple” effect among suppliers to manufacturers. Lenders are anxious to exit industries that may suffer the most if mass pandemic closures return or remain in an extended recession. This fear and uncertainty creates unique opportunities for investors.
Consider the well-run company with a product that has not been superseded by new technology, but whose sales have suffered due to less consumer spending power or the pandemic. Perhaps it suffers from over-leverage from a prior acquisition or buyout. EBITDA is down and, consequently, valuation. Equity holders may be reluctant to double down due to uncertainty as to recovery time. The debtor’s lender called a default or is threatening to do so. A multi-year recovery plan is simply beyond the lender’s line of sight. So, the mandate is to explore “strategic options” – from refinancing to sale to new investors.
Of course, not all distressed situations justify salvation. Consider the retailer that failed to develop a robust e-commerce platform, over-expanded into too many “B” and “C” malls, lost sight of its customers and whose products have become “tired” as consumer tastes changed. In such situations, value may only be in a relatively small fraction of the debtor’s assets – such as intellectual property.
Distressed situations (and bankruptcy) present opportunities to acquire assets at bargain prices. Going-concern value typically yields to liquidation value as the point of embarkation in sale negotiations in which there is a recent track record of losses. Despite their assertions to the contrary, secured lenders – with much control – only care about a price realized in excess of its indebtedness. Rarely will they forbear or modify covenants for an extended period of recovery time – even with additional collateral.
Management’s projected EBITDA – typically premised on further lender concessions and/or forbearance and/or additional capital in order to withstand the current crisis – is interesting and may be insightful, but has relatively little impact on ultimate sale price. Purchasers begin with liquidation value rather than a multiple of (theoretical, but absent) EBITDA. The question is: What capacities do the assets have to regenerate EBITDA, in the buyer’s opinion? Bidding begins at or slightly above liquidation value. In an auction, bidders drop out as the spread between liquidation value and achievable going-concern value narrows.
Chapter 11 is supposed to serve as the reorganization chapter of the Bankruptcy Code. Instead, it has become the sale chapter as lenders became impatient with continued losses in chapter 11. A successful chapter 11 is predicated on a turnaround that may or may not materialize and is intolerant of the costs of bankruptcy. Consequently, a large percentage of 11s are simply used to accomplish an expedited bulk (“363”) sale.
Buyers accustomed to moving fast with due diligence (assessing relationships with vendors, customers and employees), promptly going to contract and with financing readily available, have a distinct advantage. Such buyers are the dream of lenders and of the debtor’s investment banker. Chapter 11 debtors rarely age well and everyone fears further devaluation.
Chapter 11 also has the magic of “free and clear of all liens, claims and encumbrances.” In other words, the buyer of assets can get a Federal Court order decreeing the assets to be “clean” prior to closing. For a seller with pending litigation against it or which seeks to sell certain of its assets without the buyer assuming all of the seller’s liabilities (leases for example), this is a huge benefit. For a buyer, it avoids future surprises (reduces risk) and facilitates a speedier sale process for the ready buyer.
Chapter 11 “363” sales can provide bargain opportunities for investors who have ready financing, are able to complete due diligence quickly, understand how risk can be minimized in a bankruptcy sale, and know the practical dynamics of price negotiations.
Kenneth Rosen is a partner at Lowenstein Sandler LLP and Chair of the firm’s Bankruptcy, Financial Reorganization & Creditors’ Rights practice group.
The views expressed herein are those of the author only and are not necessarily those of any other person at Lowenstein Sandler LLP. Each situation is unique. This article is not intended to provide legal counsel.