COVID-19: How to approach impaired asset investments

Distressed asset opportunities

Acquisitions can present the following additional opportunities when compared to transactions in more normal macro times:

• Growing market share: by expanding geographic or product footprint and generating new revenue streams, as competitors urgently seek consolidation strategies.
• Liability management: via certain acquisition strategies that afford the ability to void loss-making contracts (possibly as a result of COVID-19) and counterparty inability to perform.
• Above-average returns: often achieved as sellers reduce price expectations on impaired assets and businesses, or are forced to sell due to capital constraints.
• Embedded leverage: Impaired or distressed assets often feature significant levels of embedded debt financing, which may remain through the transaction and be valuable to the buyer in a tight credit market.
• Defensive positioning: Impaired asset acquisitions can be a defensive measure, preventing customers, market share or proprietary technology and processes from falling into competitors’ hands.
• Productivity lift: Impaired assets often have an unmotivated workforce. New leadership and purpose can lead to an immediate productivity gain and performance improvement. 

Distressed asset challenges

Of course, by their very definition, distressed and impaired assets can also be risky investments. Key areas to assess before progressing are:

• Degree of familiarity: 
  Unfamiliarity with acquiring impaired assets and market outlook could cause the acquirer to overpay. Most target assets will be under-performing and will require a clear value recovery and integration strategy. To achieve this with speed and certainty requires strategic, operational and financial knowledge of the sector.
• The risk of potential hidden liabilities: 
  Inexperienced buyers, or those who are not able to perform adequate due diligence, can assume substantial liabilities from acquired assets, which are often transferred without warranties or indemnities. These may include:
  • Underfunded pension liabilities: Companies under duress may be less likely to have provided for future liabilities, so may have underfunded pensions. 
  • Extended Payables or avoided spend: In distressed situations, companies focus on conserving cash. Buyers should be aware of any deferred payments coming due or any planned and needed capital expenditures that have been avoided.
  • Employment contracts and termination agreements: Payments such as these may be triggered by acquisition.
  • Enforceable warranty risks: Companies under duress may have had issues with product or service quality, which may create the risk of customers claiming on warranties.
  • Product liability/regulatory issues: Facilities, supply chains, and products should be closely inspected, with particular attention paid to potential regulatory violations — in all relevant markets.
  • Breach of contract claims: Companies under duress may be on uncertain terms with suppliers and customers. Both contractual and ad hoc terms need to be carefully inspected during the diligence process.
  • Restart costs: If, for reasons related to COVID-19 or otherwise, operations have been shuttered, then restart costs also need to be factored in the valuation and working capital equation
• Potentially stressed supply chains:
  These must be considered and carefully evaluated. In the new normal arising from COVID-19, many may need significant investment and redesign.
• Valuation and due diligence processes: 
  These must be adjusted to reflect current market conditions. Operating in a COVID-19 and post-pandemic world is not business as usual, so due diligence cannot be confined just to backward-looking historical data. Rather, new sets of forward-looking valuation criteria, aligned with the buyer’s strategic goals and projects, should be considered.
• Slow moving decision-making processes:
  This can confer advantage to faster-moving competitor acquirers.
• Tax exposures: 
  Target acquisitions may also have their own inherent tax liabilities, and these — and their effect on the acquiring organization’s tax structure — should be another consideration during the valuation process.

Questions to ask to help decide whether to invest

Not all distressed assets are suitable for investment, and not all organizations are suitable investors. Any organization considering an investment will need to be able to answer the following questions:

• Is the price correct? 
  Just because an asset seems affordable does not mean it represents good value. 
• Can you handle this complexity?
  Acquiring a distressed or impaired asset is often more challenging than a regular acquisition. For example, a company may not be acquired outright but purchased through an insolvency process. This complexity can deter less experienced buyers and drive down the acquisition price, but acquirers must be confident in their ability to execute effectively and take advantage of this. 
• Are you working with imperfect information?
  Information quality and availability is often poorer for impaired assets and businesses. So knowing what information you need to make a decision, is critical — and identifying imperfections can even be an advantage, helping justify lower prices during acquisition negotiations. Being comfortable performing virtual due diligence may be important, especially if such steps become mandatory.
• Can you move fast enough?
  Not all acquirors can move at the same speed, and those who can move faster than others will have a critical advantage over slower moving competitors. You may therefore need to flex your decision-making governance structure to meet the timetable set by the vendor.
• Can you access embedded leverage?
  Using existing leverage may be important to the investment decision and risk–reward calculation. Addressing this early in the negotiations and gaining permission to open up a dialogue with existing debt capital providers can be helpful both in taking advantage of existing leverage and also securing the deal.
• Are you able to make necessary operational fixes?
  Commercial and operational due diligence carry elevated importance when evaluating businesses and assets, especially in today’s uncertain environment. At the heart of acquiring a distressed asset is the assumption that the acquirer can fix the acquisition and turn it into a productive, return-generating asset. Understanding whether or not this is feasible, and within what timeframe a repaired asset can be integrated into the acquirer’s operations, is key.
• Are you disqualified by other factors?
  The scale and scope of assistance provided by governments around the world in handling the economic fallout from COVID-19 has been unprecedented. But receiving support from governments may also put limits on what actions acquirers can take, and may affect what assets they can buy. Staying on top of these developments, on a week-by-week basis, is important.
• Do you have the right advisors?
  Having the right advisors can make all the difference when engaging in complex, risky deals. Selecting advisors with strategic, operational and turnaround or restructuring expertise is an important step to making sure that your strategy has been assessed and its execution optimized.
• Do you have an exit strategy?
  Acquirers must have clearly defined objectives and a value end-game before making the decision to invest. This may be particularly important in the post-COVID-19 environment, when traditional KPIs based on historical data may no longer apply.