What Is Distressed M&A and How Does It Work?

Mergers and acquisitions (M&A) refer to the consolidation of companies or their major business assets. This can involve one company purchasing another, two entities combining, or the acquisition of significant assets. M&A activities are fundamental to corporate strategy, allowing businesses to grow or realign their market position.

This article focuses on a distinct subset of these transactions known as distressed M&A. Unlike conventional M&A, which often pursues growth or synergy, distressed M&A involves companies facing severe financial or operational challenges.

Defining Distressed M&A

Distressed mergers and acquisitions involve transactions where a target company experiences significant financial instability or operational distress. This means the company struggles to meet its financial obligations, such as paying bills or loan payments, and may be on the brink of insolvency or bankruptcy. The company’s financial condition leaves it struggling to pay its debts, which can ultimately lead to bankruptcy proceedings.

These transactions differ from traditional M&A, where companies are healthy and seeking strategic growth. In distressed M&A, the primary motivation is often to rescue the struggling business, restructure its finances, or facilitate an asset sale to satisfy creditors. The urgency stems from the need to preserve value for stakeholders before the company’s condition deteriorates further.

The seller in a distressed M&A scenario negotiates from a position of weakness, prioritizing liquidity and speed over maximizing the purchase price. The objective is frequently to obtain short-term liquidity to remain solvent or to facilitate an orderly wind-down of operations. This shifts the dynamics of the deal, making it a last opportunity to restructure or save a business before formal insolvency proceedings become unavoidable.

Buyers in distressed M&A often acquire assets at a discount, seeking opportunities to gain market share or technology. They focus on leaving behind the liabilities that caused the distress, often favoring asset sales over stock purchases. The distressed element introduces complexities related to risk, valuation, and the involvement of multiple stakeholders.

Common Causes of Corporate Distress

Corporate distress, which often necessitates distressed M&A, stems from internal and external factors that erode a company’s financial health. Internally, poor management decisions contribute to a company’s decline, including excessive debt accumulation, failed expansion strategies, or an inability to adapt to market changes. Operational inefficiencies, such as high fixed costs or inadequate working capital management, also lead to a company being unable to generate sufficient revenue to meet its financial obligations.

External factors can also impact a company’s stability. Adverse market shifts, such as an economic downturn, can reduce demand for products or services. Industry disruption from new technologies or changing consumer preferences can render a company’s business model obsolete. Regulatory changes or an increase in interest rates can also increase operational costs or debt repayment burdens, pushing a company into financial difficulty.

Key Characteristics of Distressed M&A Transactions

Distressed M&A transactions possess several unique attributes. One is the accelerated timeline and urgency. Unlike traditional deals that allow for extensive negotiation and thorough due diligence, distressed transactions often close within days or weeks due to the seller’s critical financial state. This compressed timeframe limits due diligence, increasing the buyer’s risk of uncovering unknown liabilities post-acquisition.

Another feature is the significant role of creditors, both secured and unsecured. In a distressed situation, creditors hold considerable power as they seek to maximize their recovery. Secured creditors, with claims backed by specific assets, often have a strong say in the sale process and may “credit bid” their debt to acquire assets.

Judicial oversight, particularly involvement of a bankruptcy court, is also common. Many distressed M&A transactions occur within Chapter 11 bankruptcy proceedings, such as through Section 363 sales. Court involvement provides a legal framework for selling assets “free and clear” of existing liens and claims, offering protection to buyers.

Distressed M&A transactions typically focus on asset sales rather than equity transfers. Buyers prefer to acquire only specific assets to avoid inheriting the full spectrum of liabilities. An asset sale allows the buyer to select what they acquire, leaving unassumed liabilities behind. This structure minimizes the buyer’s exposure to past financial issues and legal risks.

Different Types of Distressed M&A Transactions

Distressed M&A transactions can be structured through several distinct legal and operational pathways.

Section 363 Sale

One prevalent type is a Section 363 sale, which occurs within a Chapter 11 bankruptcy proceeding. Under Section 363 of the U.S. Bankruptcy Code, a debtor can sell its assets “free and clear” of liens, claims, and encumbrances, subject to bankruptcy court approval. This protects the buyer, as they acquire assets without the burden of the seller’s past liabilities.

Out-of-Court Restructurings

This approach involves the distressed company negotiating directly with its creditors and potential buyers outside of formal bankruptcy proceedings. This method offers more flexibility and privacy than a court-supervised process, potentially allowing the company to avoid the stigma and costs associated with bankruptcy. It requires the consent of creditors, which can be challenging to obtain if there are many disparate interests.

Assignments for the Benefit of Creditors (ABC)

ABC offers a state-law alternative to bankruptcy, often used for smaller, privately held companies. In an ABC, the distressed company transfers its assets to an independent third-party assignee, who then liquidates the assets and distributes the proceeds to creditors. This process is quicker and less expensive than a Chapter 11 bankruptcy, as it avoids federal court oversight. While the assignee has a fiduciary duty to maximize value for creditors, the “free and clear” sale protections are not as robust as those afforded by a Section 363 sale.

Receiverships

Typically initiated by a secured creditor or a government agency, receiverships involve a court appointing a receiver to take control of a company’s assets or operations. The receiver’s role is to preserve the value of the assets, manage the business, and sell assets to satisfy creditor claims. This process can be utilized when a company defaults on a loan agreement or when there are allegations of fraud or mismanagement.

Key Participants in Distressed M&A

Various parties play distinct roles in distressed M&A transactions.

Buyers

Several types of acquirers exist. Distressed asset investors specialize in purchasing troubled companies or assets at a discount, often with the intent of turning them around. Private equity funds frequently have dedicated distressed investment arms, seeking to acquire undervalued businesses and implement operational improvements. Strategic buyers, already operating in the same industry, may acquire distressed competitors or their assets to gain market share, technology, or intellectual property.

Sellers

The seller is typically the distressed company itself, represented by its management and board of directors. Their influence can diminish as the company’s financial situation worsens. In severe cases, an appointed trustee, receiver, or insolvency practitioner may control the selling process, particularly if the company is in bankruptcy. Their primary duty is to maximize recovery for creditors.

Key Stakeholders

Key stakeholders exert influence over the transaction’s terms and pace. Secured creditors, holding claims backed by collateral, often have the most leverage and can dictate sale conditions or credit bid their debt. Unsecured creditors, whose claims are not backed by specific assets, also have an interest in the outcome, though their recovery prospects are lower. Equity holders, the company’s owners, often face the highest risk of loss and may have limited say, especially if the company’s liabilities exceed its assets.

Advisors

Numerous advisors facilitate distressed M&A transactions. Investment bankers specialize in identifying potential buyers or sellers, structuring deals, and negotiating terms. Legal counsel is indispensable for all parties, advising on complex bankruptcy laws, corporate governance, and transaction documentation. Financial restructuring advisors provide expertise in assessing the distressed company’s financial health, developing turnaround plans, and negotiating with creditors.