How to Execute Distressed M&A

24:40What are the key differences between going through the sale process versus a traditional M &A process? One of the big differences is the publicity of the process. The debtor is trying to achieve the highest and best offer. The bid procedures are public. Bankers will reach out to a number of people in the process. And then at the very end, once you actually have qualified bids, hopefully you have a couple of them, you'll bring them to a banker's offices or law firm offices, put them in different rooms, try to get them on a similar contract, and then say, all right, let's make this a true auction.

25:19So it's like a Sotheby's style auction of$100 million,$105 million,$110 million going around. And then you can find what is the actual top limit somebody is willing to pay. for the business. Wait, they actually do that? Yes, they actually do that. That's the most fun part of a 363 sale is you've got people in rooms and then you'll bring them together and they'll actually say, this is my next bid. You see this other be like - Not the paddles. You have people, you go down the line and you say, okay, you can skip once, but otherwise you have to put in a bid or you're out. And then you might actually go down the line and say, all right, this person's bid this amount, this person's bid this amount.

25:56And then somebody will come back and bid higher. Yeah. Yeah. So as a buyer, you better come prepared with your checkbook. Yeah. I was hoping to learn how I could get a good deal in the auction. I don't know. This is the exact situation I'm trying to avoid, maybe. But if you're a debtor, you're trying to maximize value and that truly maximizes value. I'm a buyer. I'm on the buy side and not helping me out here. I thought I was going to learn how to find great deals and bankruptcy actions. Okay. We'll get to that part. We'll get to that part. Wow. So they really, you'll find bids and you'll get to the point where you'll create like a real auction environment.

26:29That's the goal. It doesn't always work out that way. Maybe the market is softer. Maybe you just can't get bidders there. Or maybe your bids are just so different that it's hard to compare them. But the goal of running this auction is to try to get everybody to like a very similar bid so that you can run that sort of auction. Because it tends to be a place where people start bidding up and giving you value. I would love to stream this, actually. If I could get an opportunity just to stream this happening, it would be... Different jurisdictions do it differently, but I think Delaware requires most auctions to be streamed.

27:04Or if you're a creditor of a bankrupt business, you're allowed in the room. So you could just be sitting there watching. Great to know. Yeah. That would be my new hobby to start live streaming on YouTube. And then is there anything recourse if they put a high bid in and don't execute on it? So deal certainty is something that you're going to put a high premium on when you do these sorts of deals. But it's going to really be on the financial advisor and the lawyers to craft as exit-proof a deal as possible. So think of almost like a public M &A deal where you want as few outs as possible. You're going to want even more of those in bankruptcy.

27:40The real out is if you get a topping bid, the debtor is going to want out of the contract, and they're going to have a fiduciary duty to get out of the contract. But otherwise, typically, as advisors, you would advise the board to take a deal that is much more certain. What's the aftermath in terms of leftover liabilities and things like that? I can imagine this list of creditors and how do you determine who's got priority, seniority, and what do you do with leftovers? So in the 363 sale, you're taking the assets. The buyer is buying the assets free and clear of liens, claims, encumbrances, and other interests.

28:17and all of those then attach in the same priority to the proceeds of the sale. So imagine all of the assets and the employees and the operating business go away. You're left with a pool of cash. And then the creditors would be fighting over that pool of cash in the same way they would otherwise be fighting over it. So if you're a secured creditor, you're going to have a better claim than certain unsecured creditors. All of that will still actually just be preserved. the structure, the credit structure will be preserved and they'll just attach to the pool of proceeds instead. Unsecured creditors ever get anything?

28:54Yeah, they sometimes get things back. In FTX, they're actually getting, they're supposed to be getting their entire proceeds back. Oh, very good. Okay. So they've planned this ahead of time. Who's getting what? Is it like a percentage or is it? There's a waterfall again, just based on the actual priority of claims. So there'll be some things that are mandated by the statute that'll be super priority claims or administrative claims, often claims that are amounts that are paid post-petition to maintain the business or for advisors, those get priority. And then you've got your usual secured claims.

29:28And then after that, you've got your unsecureds. So it's the same waterfall that you would statutorily have. If we have the sale process happen, high spitter wins, proceeds are already laid out of the creditors are going to pay off, And then they get their money at close, basically. And then it's done. Everything's like over with. They get their money as part of the plan of reorganization. But yes, that gets to be negotiated afterwards. And sometimes it could take months and months for them to negotiate how much of a haircut each group of creditors is willing to take or how exactly that pot of proceeds will be divvied up.

30:06But yeah, it's done. And for the employees in the actual operating business, it's done well ahead of that argument. It's a pretty good deal for them. So if I get a customer that goes bankrupt and I get all these bankruptcy notices from the attorney, what should I be doing? You should call your own lawyers to figure out what you can do. So one of the other powerful tools that a company has, a debtor has in bankruptcy, is the ability to assume or reject contracts. So they can look at their contracts and they can say, these contracts, I want to keep performing and are valuable to me. I'm going to assume them.

30:45And then they have to cure all of the pre-petition debt. So they have to bring it basically up to current. But then they can also take a look at contracts and say, this lease is huge. I don't want it. I want a way to basically resolve it. And they can reject the contract. It's almost like a way of liquidating the damages if you had breached the contract. So you get out of the contract, the expectation damages under the contract are now unsecured claims that are against the estate, and you can leave that behind. So you can right-size the company that way. If you're a vendor, you have to be cognizant that is a possibility.

31:23You might have your lawyers reach out and figure out what's happening with the contracts, but the debtor has a lot of control there. And the buyer has a lot of control there because the buyer can say, I want these contracts. I don't want these contracts. I no longer need this shopping center. I no longer need this vendor contract. I'm going to adjust X, Y, and Z, and they can have a much better business going forward. Interesting. Do you have a case study or example you could share of how this pans out in the real world? Earlier this year, I worked on the sale of Kedif Fenwall. So Kedif Fenwall is a subsidiary of a company called Carrier, and it had significant PFAS liabilities, which are forever chemicals.

32:05They had significant lawsuits from a number of states because of forever chemicals that were used in the business over a decade ago. But of course, those last in the environment and we're seeing a lot of lawsuits there. And bankruptcy was one way to potentially deal with the liabilities while preserving two ongoing businesses. So Carrier sold the assets of Kitifenwal out of bankruptcy. And it was a fairly protracted process. Sale process was launched about a year and a half ago. It might have been September or October of last year. After there was a basic agreement about how to treat the proceeds, which is the proceeds would go towards covering these environmental liabilities.

32:51Engaged bankers did an entire sale process, ended up selling to a company called Pacific Capital, which is a private equity company. The business is ongoing and they're managing it separately. And then the amounts that was left is part of a pool in addition to amounts that carrier is going to contribute as part of a broader settlement for this huge litigation. So it allowed Carrier to extricate itself both from the business and it allowed the Kitta Fenwall business to extricate itself from this environmental liability under new management. That's pretty well played there. Yeah. But the settlement took six, eight months longer than the sale process did.

33:32So it was great that the sale happened early because it allowed the company to continue to operate without this overhang. Right. We didn't talk about that. like lawsuits could be a reason to trigger bankruptcy. Yeah. Large litigations. Exactly. Yeah. What was the one, the one in the news? Oh, Alex Jones. Yeah. Info Wars. Info Wars. What? Info Wars would be an example of. Yeah. Shedding lawsuits. It was partly, I can't remember if it's a personal bankruptcy, but certainly Info Wars went through bankruptcy as well. And it was a libel suit. So they were trying to get away from, right? And then the victims won, I guess.

34:11Like literally. As they should. That's really interesting. I guess that's a whole other thing. It can take someone down with a bunch of lawsuits and push them into bankruptcy and then buy their business. When it comes to the different types of creditors, we talked about secured versus unsecured. Are there other factors that would determine how much influence creditors have during bankruptcy? see? So typically, and this is something that you find out very early in a case, there's something that we call a fulcrum creditor. So oftentimes, even the secured creditors, there's a waterfall of those secured creditors.

34:50So some of them are secured or oversecured. They know they're going to be paid in full. You don't really deal with them as much. There are sometimes with the unsecured, they'll have a committee that represents them and make sure that their interests are heard, but often they're pretty far underwater. And certainly any equity is well underwater. There tend to be what are called fulcrum creditors. And those are the ones that kind of swing things. So they're the ones that tend to drive the case because how much they're paid out really depends on how much value is able to be recovered by going down a sale process versus a reorganization process.

35:27The creditors have different ways to be heard, but it is often that fulcrum creditor group that really drives the case forward. Again, in connection with certain other groups that are formed or statutorily have to be formed, like the Unsecured Creditors Committee. There's a main group that sort of lobby together. There is a main group of creditors that lobby together and that tend to have significant influence on how the case unfolds. And then the unsecured creditors will have a committee that's formed by statute so that they can make sure that they have interests heard and different creditors get onto that committee.

36:03So it might be customers, different types of vendors, landlords, and they will also see everything in the case, be given copies of all of the notices and be able to help drive the case forward, even if their recoveries might be minimal. What's my best approach in negotiating with these creditors? Depends on the case. It's really hard to say. It really depends on the dynamics. And sometimes it just takes a long time to sort through how much value each of the groups is going to get. I guess it wouldn't be too hard to find who to talk to. Like they would pretty much be knocking on your door. Oh, yeah.

36:35Is there any approaches or just things that you've seen that might be best practices when dealing with creditors? I.e., like don't avoid them at all costs type of stuff. I don't think you're allowed to avoid them. You're in a court process. They can come knocking. Let's see how he's noticing. Don't hide from your creditors. They can always find you. They can throw you into bankruptcy as well. It's much more unusual in a big corporate context, but they have the ability to force an involuntary restructuring. You need a certain number of creditors to file, but then if they get that number to file, they can force you into bankruptcy.

37:13You really shouldn't just try to avoid that. It's interesting. It makes me want to be a creditor. Okay, don't avoid the creditors. Try to work with them. And then it really depends. Big variable on how much leverage they have over you and how important it is to overcome that. One of the things we didn't talk about, stocking horse bid, one of the cool, sexy M &A slang terms. Can you explain what that is? A stocking horse bidder in a Chapter 11 is actually like the court-ordained lower price for an M &A transaction. So if you go into a Chapter 11 case knowing that you're going to try to sell the company, you might actually try to line up your stocking horse bidder ahead of time.

37:54And basically, then the stocking horse bidder provides the floor price in an auction. And the contract that they've negotiated is going to be the base contract that all other bidders have to work off of. And in exchange for that, the stocking horse bidder gets bid protections. So nobody else in the deal is able to be awarded any break fees except for the stocking horse bidder who's approved by the court because they're performing this function of, again, setting the floor price. but they can get a break fee of 3 % of the value of the transaction plus expense reimbursement, which could be pretty significant if they're the ones that are doing the most of all of the diligence upfront.

38:35Wait, they get a break fee? That means... Yes. So they get a break fee because their bid is potentially being shopped to other people. They get a break fee that comes out of the proceeds of the topping bid. So if you have a stocking horse bid of a hundred million and there's a three million break fee, then the next best bidder has to come in at... I can't make a business just doing stocking horse bids. But you have to show, of course, that you're able to buy the business if nobody shows up. But it can still be a pretty value-based bid. And then if I get it for the price, it's a good deal. But if I get topped, I'll get paid on it.

39:08Yeah. If you'll do that. Yeah. So a lot of people want to be the stocking horse bidder because you get those bid protections. But it's just another tool that the debtor has because not every auction has to have a stocking horse, right? If you think it's a valuable business and a lot of people are showing up, you might say it's not worth paying the bid protections because that precludes other bidders from coming in unless they pay the break fee. I'm just going to run a naked auction and let everybody go up. But if it's a business where you're trying to hold it together a little bit more or you think you need that floor price to really get people up in value, then it's a very powerful tool.

39:46That's fascinating. There are a lot of dynamics in how you can set the auction procedures. The stocking course has to be approved by the court because you're using estate proceeds. So they have to approve the fact that you're granting them potential bid protections. There's a lot of expenses that go into this because we're trying to protect the business so it can continue to operate. And there's obviously a bunch of OPEX that the company has to manage. Does the court manage all that stuff? They have to approve everything? How does that work? They have to approve everything that is outside the ordinary course, and they have to approve significant expenditures.

40:21So often one of the first things you do, either on the first or second day, is you go to the court and you say, I want to pay this amount in wages. I want to pay my usual vendors and payables. And the court basically blesses all of that. But the protection you get is you don't have to pay anything that happened pre-petition. So all of that is halted. If you owed a major vendor$100 million, but then post-petition, you're continuing to pay them in the ordinary course, that$100 million would be an unsecured claim. And you don't have to necessarily pay them at the outset of the case. Okay. So stuff that before you don't have to worry about affects you from that.

41:00But then if there's some specific big expense coming up, things out of the ordinary, you'd have to get that approved. Otherwise, you can still run your business. What if you're in a really bad shape where you're even going to do payroll and stuff like that? In that case, typically, it ends up in a liquidation. It moves pretty quick to liquidation. Yeah. If you're administratively insolvent and you can't pay your ordinary payroll and you can't pay your advisors, you're probably in a liquidation situation. A lot quicker in liquidation. What are some do's and don'ts we haven't covered? The key don't is don't panic.

41:35People think about bankruptcy as like this terrifying thing that departs so much from the usual ways of M &A. But it tends to be a very orderly process that has a lot of helpful tools. You have to get used to the court process. You have to get used to everything being done publicly and your creditors objecting. But you have a lot more time. And once you actually get into it, people can sort through things very well. And so don't panic if you're going into bankruptcy. Don't panic when you're in bankruptcy. Don't panic if the sales process isn't going well, because most of the time, your bankers and your lawyers can come up with something to help fix it.

42:13Stay calm. Stay calm. How about on the buy side? I always get excited when I hear about bankruptcy deals. I've worked on a handful that were more real estate oriented. And there were things that you end up buying like 50 cents on a dollar. Those are good ones for clients way back in the day. But as somebody that's interested in finding those opportunities, what's the best approach to do that? Because there's obviously bankers involved, but even attorneys directly who found helpful. And there's obviously public announcements too. There are a lot of ways to find out if a company is in distress or selling its assets.

42:47In bankruptcy, the company is much more likely to be listening to your inbounds. If you've got good bankers who can back channel and provide reasonable offers, you're much more likely to find a good audience for something like that. So networking with bankers? Networking with bankers, yeah. That's probably true of like most standard M &A to know your bankers. Know your bankers. Would it help to know the attorneys directly? The attorneys will be public, but they'll probably route things related to M &A through the bankers. Okay. Ultimately, but also know there's value to potentially being a stalking horse.

43:22So if you want to raise your hand and run for something like that, then you would be pushing for a break fee and to front run some of that process. Do they ever sell these businesses without a banker? It's unusual. Unusual. Okay. So usually there's a banker involved. Usually there's a banker. That's your best fit. Network the banker. What about following public listings? I know there's some companies that offer as a third party service. You could. I mean, I think it's mostly like debt hedge funds, distressed funds that follow things like that. If you're a strategic, I don't know if that's your best way in the market.

43:51You're probably going to know your competitors are close to bankruptcy you're in a distressed situation and ready to swoop in. What about buying the debt and then being part of the fun? You could also do that. You could buy the debt. You could buy the secured debt potentially if it's trading on cents on the dollar. And then you could credit bid it or you could put yourself in the position of being that fulcrum creditor and they have to listen to you in the case. So that's a toehold into taking over a distressed company. Next podcast, how to buy debt. These are good approaches. And then any tips in terms of being involved in the auction process?

44:28That did not sound fun. I'm hoping to find these good deals where I'm thinking of a few companies I'm tracking now, actually, that may be getting in trouble. And I'd like to position ourselves as, hey, it's an alternative to winding the business down. That'd be more likely than bankruptcy. I'm just curious. Is there other tips on the buy side of how do you get ahead on these deals? On the buy side, it's always easier to get in before the bankruptcy filing because once the bankruptcy filing hits, it's public and you're dealing with all these other bottom feeders and everybody's trying to hold the business together.

45:01But if you can get in before the bankruptcy filing, either be the stalking horse or if it's not a company that would necessarily go into bankruptcy because bankruptcy is expensive, that's always helpful too. There's value in being the white knight in those sorts of situations. if you think that there's nobody else around. The White Knight. The White Knight, another great emanator. The White Knight is just, it is what it sounds like. It's the person that shows up to save the company. Yeah. You have the Black Knight, which is a hostile person that shows up to take over the company. And the White Knight is there to save the company.

45:36You're right, is if you get ahead of it or you know the company's in trouble before they file bankruptcy and see what you can work with the principals. Yeah. Maybe come in and try to put them in a better spot with your own terms. Get some equity at it. If you have financing, it's what the distress company needs the most, right? You've said bankruptcy is expensive. How do you budget for going bankrupt? So it's hard. It depends on the complexity of the bankruptcy. If you already have a deal going in with some of your creditors, it's going to be a couple of months. And then you'll have a much better sense of budget.

46:10And sometimes it's a freefall bankruptcy. that lasts much longer than you think it will. You are just burning expenses. In bankruptcy, the lawyers and the bankers, they're all, lawyers certainly are charging on an hourly basis. All of that is public too. So if the fees are outsized, sometimes we do get criticized from judges who are approving all of those fees. But the fees for your financial advisor and your structuring advisor and your lawyer, that all gets approved upfront as well. And the bankers, if they put a retainer in there, and success fees that all comes from this. Yeah. And it would come from the top.

46:47So most of those fees are treated as a priority claims. Wow. That is expensive. That's expensive. I think that's my moral of the story is try to avoid bankruptcy altogether and really do what you can with those options that we talked about. Negotiate with creditors, raise some additional capital. What's the craziest thing you've seen in M &A? In distressed M &A? Other than FTX, which is its own story. I had a bankruptcy deal where we were hoping to run an auction. We didn't quite manage. We had one buyer who was sitting there and the other buyer didn't show up. So we went to court to get that approved.

47:26And all of a sudden, somebody comes riding in with more money and finally financing commitments into the courtroom and said, I have a better offer. we had to adjourn the court proceeding. We were trying to approve a different deal and negotiate a better deal in the courtroom. That happens. It was like a super last minute. Yeah, all the way up until it's approved by the court. Somebody can come up with more money. Wow. It doesn't sound like there's a bunch of crazy deals that happen in auction. It sounds like it's really designed to get the most value of what's there. Yeah, it tries to funnel things into an orderly process, but the more you do bankruptcy, the more you realize it's not necessarily that easy.

48:10Unless it's super complicated and nobody wants to deal with it, I guess. Yeah, this was great. Amy, thanks so much for taking the time. You taught me a lot about bankruptcy today, helped me become a better M &A scientist. Thank you for inviting me. This was a great chat. Fellow M &A scientists, you made it this far. Thank you. I appreciate you listening. This was a podcast listener suggested topic, by the way. So feel free to reach out to me. I love getting different ideas on improving the podcast, as well as I take the criticism. I want to get good at this. Until next time, here's to the deal.

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