United States: Distressed M&A And Portfolio Acquisitions

 The distressed M&A market has continued to grow and evolve over the last five years. Following the financial crisis, the UK and Europe witnessed a significant growth in investors looking to acquire distressed debt, companies and assets, using various investment strategies, including:

• "Control" transactions, whereby an investor ultimately seeks to take control of a company in a distressed situation.
• The acquisition of large portfolios of debt, equity and/or hedging assets.

The growing presence of competing private equity, credit, and special situation funds has increased the sophistication of both the players and the types of deals commonly seen in the distressed M&A and portfolio acquisition market. This article focuses on the elements of these deals which are common within the UK and European market.

ACQUIRING CONTROL OF A TARGET GROUP IN A DISTRESSED SITUATION

There are three fundamental issues to consider in respect of the acquisition of a target group through a distressed strategy:

• Identifying and acquiring the right debt at the right price.
• Selecting and controlling the "loan-to-own" process.
• Commercial agreement with the stakeholders in the process and governance following the loan-to-own transaction.

These issues apply whichever European jurisdiction is relevant to the transaction. While each European jurisdiction has its own insolvency laws, EU-wide insolvency laws, in particular Regulation (EC) 1346/2000 on insolvency proceedings (Insolvency Regulation), also apply .The Insolvency Regulation provides that the jurisdiction applicable to insolvency proceedings should be that where the target company has its centre of main interest (COMI). A company's COMI is where the company conducts the administration of its interest on a regular basis and there is a rebuttable presumption that this will be the location of its registered office. However, importantly for distressed M&A strategies, the COMI can change over time and in many cases has been moved to the UK in order to benefit from English insolvency laws and English company law processes.

Identifying and acquiring the right debt

The key to acquiring control of a target company through a loan-to-own process is to identify the "fulcrum" debt. This is the debt which is most likely to convert to equity in a reorganisation, and by acquiring a controlling position in this debt the financial sponsor should be able to have the lead role in the loan-to-own process.

A key dynamic in a loan-to-own transaction is the degree to which the holders of the fulcrum debt have the ability to cram down "out-of-the-money" creditors (that is, those with no economic interest in the company) and equity holders. In the UK, there are several process factors to consider in identifying the right debt to acquire:

• Debt-for-equity swaps can be structured with a bidco (controlled by one or more lenders) credit bidding in an

• enforcement sale for the shares in a holding company of the target group. In a UK pre-pack administration (see below), the administrator will need to be convinced that such a bid is the best value recoverable for all the creditors of the target.
• Similarly, where a security agent takes steps to enforce security, it will need to consider its common law duty to achieve the best price reasonably obtainable in the applicable circumstances. There may also be additional criteria expressly set out in a relevant inter-creditor agreement for the security agent to take into account.
• In a UK scheme of arrangement, a valuation of the target group is key, due to the fact a scheme can be implemented without the participation of creditors/shareholders that are out-of-the-money.

Selecting and controlling the loan-to-own process

The aim of an investor seeking to acquire the target company should be to acquire at least a simple majority stake in the fulcrum debt. Often, a senior lender with a majority position has the power to accelerate and instruct a security agent to enforce the security once a relevant trigger under the loan documentation is passed. However, various blocking stakes may exist restricting the ability of the majority senior lender to fully control the loan-to-own process, depending on:

• The exact capital structure.
• Inter-creditor arrangements.
• The applicable governing laws and jurisdiction for the loan-to-own process.
• The exact form of loan-to-own process being used.

For example:

• Holders of more than one-third of the senior debt can frequently block an acceleration or enforcement in English law senior debt agreements.
• Holders of more than 25% by value or a simple majority in number (irrespective of value) of a relevant class of creditor can block a UK scheme of arrangement.
• Holders of a stake less than 25% may represent unwanted cash leakage in an enforcement sale structured with a credit bid and cash payment, the result of which could be to delay the loan-to-own process until a settlement can be reached.

Commercial issues and post loan-to-own priorities

A successful loan-to-own transaction also depends on the controlling sponsor reaching commercial agreement with the other stakeholders in the post loan-to-own group, in particular those investors who will inject new money and/or participate in the loan-to-own transaction alongside the controlling acquirer.

The controlling sponsor will seek to identify a structure that works from a governance, control and tax perspective, and that has the potential to deliver high returns. Key issues to consider include:

• Form of instruments for governance and new money. Irrespective of the exact holding structure used for the target group following the loan-to-own acquisition, the controlling sponsor should ensure they hold at least a majority of the ordinary equity in the relevant holding company or general partner (where a limited partnership is used) in order to have a base level of control of the target group.

Thought should be given to the form of instrument through which any new money is injected into the target group and any additional instruments that may be offered alongside the new money instrument to ensure a priority of return and upside recovery by the new money investors. Depending on what new third party/bank debt might be obtained for the target group, this could take the form of some or all of senior debt, junior/mezzanine debt, payment-in-kind debt, preferred equity certificates, preference shares or warrants.

• Control of the post loan-to-own group. The priorities of a controlling sponsor will be similar to those for a straight private equity deal that results in control of a portfolio company, namely:
  • the ability to control the strategy of the target group through a majority of board nominees;
  • the selection and incentivisation of executive management;
  • the setting of a new business plan and business priorities; and
  • maximum flexibility to determine the nature and timing of future strategic transactions, refinancings, and an exit.
• In a typical non-distressed private equity acquisition, the private equity fund may need to consider certain reserved matter rights and minority protections for a minority co-investor (such as a relevant industry player that brings advice on day-to-day management) alongside the rights of management investors. In a loan-to-own transaction, the governance picture is often far more complicated due to the potential for significantly larger number of and more diverse holders of ordinary equity. These other holders of ordinary equity often fall into two camps:
  • other sophisticated private equity/special situation funds that have built up a minority position in the fulcrum debt and who then act alongside the controlling fund and often have shared interests, but in return expect significant reserved matter rights and minority exit rights to ensure liquidity after a certain period (in a similar fashion to the governance and shareholder arrangements seen in the larger private equity "club" deals before the financial crisis); and
  • much smaller shareholders who could be high net-worth individuals or more passive institutions, which is particularly the case if the fulcrum debt for the loan-to-own had in the past been listed or traded on an exchange.
• Such shareholders will likely hold very small stakes individually but their existence will:
  • potentially increase the administrative burden in relation to the target company (for example when following a mechanic under the shareholders' agreement relating to the target company such as a pre-emptive offering); and
  • be particularly relevant to the directors of the target company when considering their fiduciary and other duties in the context of strategic matters relating to the target group, such as a capital raise or exit transaction.

Accordingly, the controlling fund will need to ensure the shareholders' agreement and related equity documents provide clear and flexible steps for all processes that may involve large numbers of shareholders.

• Anti-trust. Where one or more private equity/special situation funds will be sharing in the governance with the controlling sponsor following the loan-to-own, consideration will need to be given as to whether joint control will be shared between one or more of the funds. If it is determined there is joint control and the funds have levels of turnover in relevant jurisdictions that exceed applicable thresholds, then an anti-trust filing and clearance may be required before the joint control arises. Even without joint control, a filing or clearance may be required as a result of the change of control if the target group and controlling sponsor both meet applicable turnover thresholds, see Practice Note, Transactions and practices: EU Mergers & acquisitions.
• Change of control. The controlling sponsor will need to consider the impact of the change of control on the target group. These concerns will be the same as change of control issues in a typical private M&A transaction, with a key difference being that the controlling sponsor will likely not have been able to carry out due diligence on the target group as thoroughly as is the case in a non-distressed acquisition. Accordingly, the controlling sponsor should carry out a diligence process as soon as possible in order to understand the possible change of control issues. These issues will likely fall into two main areas:
  • regulatory issues including anti-trust and industry specific regulations, both of which should be able to be considered and analysed before the change of control; and
  • commercial issues arising from change of control clauses in contracts which may not be discovered until after the acquisition. These can typically include changes to shareholder governance rights, employment or management rights, termination provisions within commercial contracts, and covenants within financing documents.

As a result, it is often in the interest of the controlling sponsor to build up good relations with the current/previous private equity fund owning the target group (if applicable) in order that key information may be provided before the change of control.

• Management incentivisation. The controlling sponsor will likely install new senior executive management in the target group following the loan-to-own process, and will want to incentivise them and align their interests with those of the controlling sponsor in much the same way as in a standard private equity transaction. The capital structure in the holding companies of a post loan-to-own target group are often more complicated than following a standard private equity deal. Thought must be given throughout the putting together of that structure as to the form of incentivisation that will be awarded to management, in particular whether real or phantom instruments will be granted to management and where in the capital structure the rights under such instruments will sit.

DISTRESSED PORTFOLIO ACQUISITIONS

Opportunities to acquire distressed or non-performing portfolios of debt and equity were predicted soon after the financial crisis. It was expected that the major banks in the UK and Europe, under pressure from regulators to manage their balance sheets and to refocus on core businesses, would be selling vast quantities of distressed assets. The flood of assets did not materialise but there has been a relatively consistent market of distressed assets being sold off by banks in certain European jurisdictions over the last five years. While the number of assets being sold in some jurisdictions, such as the UK and Ireland, may be declining, new jurisdictions, especially in Central and Eastern Europe, are now seeing increased levels of activity which should mean a continuation of such deals for several years to come. In certain situations, "secondary" portfolio sales are also being seen, where sponsors have acquired portfolios over time and consolidated them into a single portfolio which is then sold in a secondary transaction to a new private equity/special situation fund.

The market for distressed portfolio acquisitions since the financial crisis has evolved in a way that there are now certain typical transaction processes and key issues that arise on most deals.

The auction process

The majority of distressed portfolios are sold through a competitive auction process, similar in style to those used in typical private M&A auction transactions.

The first stage of the auction sees the selling bank and/or its financial advisor approaching potential bidders, who are then provided with basic information on the portfolio. The bidders are invited to submit non-binding indicative bids based on the information disclosed to them at that stage.

The seller then progresses several of the bidders to a second round, where the bidders are provided with access to a virtual data room with more detailed information on the portfolio and the underlying assets, including:

• Relevant agreements.
• A form of sale-and-purchase agreement for the acquisition of the portfolio.
• A pricing template with certain inbuilt assumptions for use in calculating the second round bid.

The bidders carry out a detailed diligence process during this second phase and produce a mark-up of the sale-and-purchase agreement and possibly related transaction agreements (for a discussion of key terms in these agreements, see below, Acquisition agreements) to submit with their binding second round bid.

In assessing the second round bids, the seller takes into account a number of factors including:

• Deal certainty.
• Identity of the bidder(s) and their reputation and experience in acquiring and working out previous portfolios.
• The price bid.
• The proposed mark-up of the transaction documents.
• Source of financing/commitments in respect of the bid.
• The ability and/or willingness of the bidder(s) to:
  • become lenders of record under the terms of the loans included in the portfolio;
  • take on agency roles related to the loans in the portfolio;
  • acquire hedging transactions related to the loans in the portfolio.
• Any other assumptions on which the bid is based.

The third and final phase of the auction sees the seller seeking to negotiate and exchange contracts with a preferred bidder as quickly as possible, while keeping in touch with the other bidders in case a deal with the preferred bidder is not reached. In this phase the sale-and-purchase agreement, all related transaction agreements and detailed transfer procedures in respect of the loans, are all negotiated and agreed.

Acquisition agreements

The primary agreement framing the acquisition of the portfolio is a sale-and-purchase agreement, together with some or all of the following agreements, depending on the nature of the portfolio and the assets contained in it, the time frame for the transaction and the parties involved:

• Funded participation agreements.
• Risk participation agreements.
• Pass-through swap confirmations.
• Local law transfer instruments.

The sale-and-purchase agreement is typically structured with the economic risk and reward transferring to the buyer on a pricing date in advance of signing and closing.

Key issues in the acquisition agreements include:

• Conditions. In particular, anti-trust conditions may be an issue where controlling equity positions are included in the portfolio or where the bidder entity is a formal joint venture between large funds.
• Interim covenants. These are particularly relevant where there are ongoing live restructurings or negotiations with a borrower while the relevant loan is being sold as part of the portfolio. The bidder will want as much influence as possible over that process, while the seller will want to maintain limits on the freedom of the bidder in such a scenario, often due to the selling bank's reputational concerns with its customer.
• Transfer procedures and participations. The seller and buyer will both need to consider the specific steps needed to transfer each debt, equity or hedge asset in the portfolio, and such steps and additional instruments are typically set out in a detailed transfer procedures memorandum. Where third party consents or notifications are required to allow the transfer of full legal title, participations are frequently used so as not to delay completion, with elevation to full legal title at a later date once the relevant consent or notice period has expired.
• Indemnities. It is typical for the seller to indemnify the buyer in respect of excluded liabilities, principally covering liabilities of the seller with respect to acts or omissions before the pricing date, and for the buyer to indemnify the seller in respect of the liabilities relating to the assets that it assumes under the sale-and-purchase agreement.
• Warranties and limitations on liabilities. Auction processes are typically very competitive and, due to the distressed nature of the portfolios and/or the status of the bank selling the portfolio, the warranties provided are often very limited in scope (frequently being pared back from the Loan Market Association distressed trade warranties) and are subject to private M&A style limitations of liability.
• Missing original documents. Very often, there are missing original documents that relate to assets in the portfolio and could cause issues enforcing security on the asset. In such circumstances, the bidder should seek undertakings from the seller to search for such documents and to assist the bidder in obtaining replacement originals and/or taking other steps to rectify any issues resulting from the missing documents to ensure the security is fully enforceable.

Joint bidders

For some of the larger portfolios, it is common to see private equity/special situation funds partnering for a particular bid, or partnering with special situation teams at some of the leading investment banks. This has obvious pricing and risk advantages, but can also be a practical and competitive advantage in a bid, by removing a potential competitor and, where the partner is a bank, by providing a regulated banking entity that should be able to overcome regulatory issues in certain jurisdictions, and can take on agent roles and hedging positions.

Although it does happen occasionally, especially where joint bidders are setting up a platform to manage the acquired assets, it is rare for a joint venture entity to be formed by the bidders to acquire portfolios. More often, relationship agreements are used between the bidders to allocate assets and purchase price liability, and, most importantly, to set out the mechanics by which the bidders can bring a claim in respect of an asset against the seller. In a back-to-back arrangement with two joint bidders, where only one bidder fronts the transaction, a key issue to resolve is how the other bidder has contractual recourse in the event that a claim for breach of warranty, undertaking, or indemnity, needs to be brought. Consideration will also have to be given as to how any seller liability cap is apportioned between claims by each bidder. The best solution for the "silent" bidder is to have direct recourse under the sale-and-purchase agreement as a named beneficiary of the seller warranties, indemnities, and undertakings in respect of the assets it will acquire. While this may not be possible where the silent bidder wishes to conceal its identity, it removes issues that can arise with back-to-back warranties or an assignment of rights to bring a claim. Where this is not possible, alternative options to protect the interests of the silent bidder are available and will be influenced by the jurisdiction of the bidders and the governing law of the sale-and-purchase agreement and relationship agreement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.