Distressed Businesses Selling: Consider the Opportunities and Risks

While the United States has experienced a strong economy for most of the past decade, companies and investors who have purchased businesses have been focused on improving already successful businesses. As the economy slows and businesses suffer from persistent inflation, higher interest rates, supply chain issues, labor shortages and the end of pandemic-related aid (among other factors), many companies facing difficulties, will look for buyers or new investors. Private equity firms and businesses with access to capital can purchase distressed businesses at a discount with the ability to restructure their targets into successful businesses such as a new platform or enhance their current operations (such as an add-on, bold or insertion acquisition). But these situations also pose unique challenges that must be considered.

With a good understanding of how to approach due diligence, the right deal strategies and tactics, and experienced advisors engaged throughout the process, buying a distressed business can be a very successful endeavor.

The Due Diligence Challenge

There are reasons why a target company is in trouble, and some of them present challenges in conducting due diligence. One cause—or symptom—of the disaster is the victim’s poor financial, business and legal records. Many distressed buyers get frustrated and decide not to bid when they can’t verify every number or contract as they would in a traditional, comprehensive verification process. To avoid this problem, potential investors (whether private equity firms or others) should seek to leverage their extensive network by engaging industry experts, financial advisors, and legal counsel who know the market and can assist in the assessment of the financial and legal risks associated with the purchase of the distressed business. Successful buyers of distressed assets focus on identifying the risks, pricing the identified risks, and working with specialists to reimagine the business after removing liabilities and other obstacles preventing the business from being successful.

Assessing the situation and executing with the right strategies and tactics

In addition to being comfortable with his understanding of the business, the potential buyer focuses on making sure his new investment is not burdened with the liabilities of the struggling business and other issues. There are a number of different formal and informal processes that a buyer can use to deal with this. Troubled assets can be purchased without a formal process, or they can be purchased through an Article 9 foreclosure process, receivership, assignment in favor of creditors or other state law process, or a federal bankruptcy process. Think of them as tools for making the purchase of a distressed business, each with their own advantages and disadvantages. The right tool for the job depends on the situation. After analyzing the situation and working with advisors to review the various legal processes available, the investor can determine which one is best for acquiring the business at the best price. With proper planning, a distressed business can be acquired free of liens, claims and other encumbrances on the assets of most creditors.

There are operational and other business risks to consider before buying a distressed business. Distressed companies may have poor relationships with suppliers as a result of late payments or other problems. Likewise, customer relationships can suffer if a struggling business fails to deliver on promises. In addition, management and employees are likely to experience stress of their own as a result of having to work for an employer in financial or operational difficulties. It is important that potential buyers and investors are sensitive to these concerns. At the same time, there are opportunities to develop an operational plan and communication strategy that proactively addresses these issues and positions the buyer or investor as a savior.

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