1. Igor Zax, CFA, Sloan Fellow (LBS) Managing Director- Tenzor Ltd
Special Situations and Distress-driven M&A: What Does it Take to Conduct a Successful Accelerated M&A Process
Igor Zax, CFA, Sloan Fellow (LBS)
Managing Director- Tenzor Ltd
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2. Who and Why Do Distressed M&A?
Buyers: specialised distress PE, hedge fund/PE distressed debt investors, corporate buyers, private investors
Sellers: PE, banks?, corporates
Principal approaches: “pure” debt restructuring, liquidation play, operational turnaround, integration
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3. Strategic Value Drivers
Buying “Cheap”
Typically driven by distressed seller
Timing is critical
Limited due diligence
Navigating Insolvency process
Loan to earn
Pre-Packs
Winning capital structure battles
Heavy reliance on legal process
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4. Strategic Value Drivers
Efficient Liquidation
Sum of parts is more than the whole
Individual assets are valuable but buyers are not interested in the whole
“Bodies in the cupboard”
Operational Improvements
Management Change
Integration/Synergy
Specialist Turnaround Strategies
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5. Principal Deal Structures
Purchase of assets
Purchase of equity
Purchase of senior debt
Purchase of subordinated debt
Purchase of participating interest
Joint Venture
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Why Turnaround?
Insolvency may be an efficient solution if there are substantial assets in the business (based on actual liquidation value) and they can be easily secured.
Otherwise, one needs to keep the company as going concern as the best way to recover- and this is not only lender’s decision.
To do so, one needs to answer why the company exists and how is it linked to its environment.
Bank lender makes a one-off decision to lend-supply chain partners making their decisions (including granting credit) every time
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Five “C” of Turnaround
Control
Creditors seek to control assets and decision making
Capability
The team (existent, new or interim) need to be capable for the task
Credibility
Turnaround plan and the team need to have credibility with all stakeholders
Clarity
What is the company’s core business, how it fits with the industry structure and does the business model match it
Co-operation
Lending group are not the only stakeholders. Ongoing support from suppliers, customers, distributors and others are vital for survival
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8. Operational Due Diligence-key part of M&A deal
Just one side?
ODD-Multi Dimensional Picture
Legal
Accounting
Target
We need not only answer “what” but “why” and “what does this mean?”
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9. Operational Due Diligence-core questions to answer
Re-construct the link between the numbers and physical process
Get the access outside of “professional seller”!
Do not limit your conversation to finance people- they talk about numbers, not the business
Speak to sales, procurement, manufacturing- and reconcile what you hear to what you see in the numbers
Understand external environment- suppliers, customers, distributors- they may tell you a lot of things you would not hear from the company
Visit the warehouse and manufacturing and ask few simple questions
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10. Practical Example- What Can you find in a warehouse
PCBA
PCB
What Do you see in Warehouse?
Two similar boards (one of which is PCB and one is assembled) are on the warehouse shelf
What do you see in Accounts?
Working Capital problems
What do you see in Manufacturing:
Delays, quality issues
What do you see in Customer Service
Quality Issues
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11. Question to ask – Why? And Is there a link?
The company is buying printed circuit board from a small supplier with advance payment
They have no way to properly do QC before assembly
They send the board for assembly to another far away provider
When they finally got the board back, they find not all of them pass testing. Complex process to find out whose fault (from the two suppliers) it is.
What we discovered – WRONG SUPPLY CHAIN causing the problem
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12. Industry structure and Supply Chain
Global industry structures changed massively
Platform companies "Produces nowhere but sells everywhere... know where the clients are and what they want and where the producers are. Platform companies then simply organise the ordering by the clients and the delivery by the producers (and the placing of their logo on the product just before delivery).“- GaveKal
Integrated and collaborative supply chains.
Contract manufacturing, outsourcing, muli-tier distribution
Changed structures are often ignored by analysts
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13. Supply Chain- Distribution of Risk and Reward
Customers!
Component Manufacturers
Component Distributors
Contract Manufacturers
OEM
Distributors
VARs
Understanding the supply chain is core to determining the future of the company.
How is wealth and risk distributed?
What is outsourced to whom? Who does financing- is the company a bank? Should it be?
Is the issue overall health of the chain, distribution of rewards and risks at particular layer or just company specific issues?
Who can “shortcut” the chain and what would be consequences?
Who is going to loose the most if company disappear and what can they contribute to rescue?
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14. Working Capital- Good Starting Point for ODD
Most of the problems of companies manifest themselves in working capital (A/R, Inventories, A/P)
Aged debtor list and its analyses vs. sales
Are receivables real?
Is ageing real ?
Why payments are late – disputes vs. credit?
Are sales real?
What happened prior to sale?
Sale is converting inventory to A/R showing a profit. Did it
Push the problem next level?
Chanel overstocking?
Produce uncollectable A/R
Is there actual end user demand?
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15. Working Capital Analyses –cont.
Analysing late payments allows to uncover issues with quality, logistics, systems, etc. –credit management is the best source of information about the company issues
A/P
Short terms – why terms are not offered?
May be wrong supplier, no insurance cover, bad history?
Long terms –are these sustainable?
Overdues- would these be tolerated?
Key question – are suppliers still supplying or they already or about to stop?
May be significant cash outflow post acquisition.
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16. Working Capital Analyses- cont
Inventory
Clear distinction between finished goods, components and work in progress
Obsolescence
Components for wrong models? They may be perfectly good but perfectly useless
Is there a process for managing inventories?
Overreliance on ratios- these are just averages
“Good” DSO may be a mixture of prepayments and massive overdue
“Good” DIO may be a large pile of useless stuff and a massive shortage of needed inventories
“Good” DPO may be a mixture of pre-paid suppliers and the ones who already stop supply and looking for legal action
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17. CAPEX/ Development Costs
EBITDA focus creates a strong incentive to under invest
Company can run on close to zero CAPEX and even maintenance for a while – but this would mean massive cost in the future
Cutting R&D improves short term profitability but negatively affects future cash flows.
Cutting people improves profitability but in many business this is the main asset.
Particularly relevant for industry buyers- often overestimating own ability to develop/support
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Processes
Assets are not enough –there should be a process for business to run
If one thinks of outsourcing (either manufacturing or service) one needs to have a n efficient process in the first place
Efficient and well documented process can be “portable”- i.e. Moved to different location etc. If the “process” is based on a “fire fighting” skills it is not only inefficient, but not “portable”
One needs to understand what they are buying – “whole business” or its part (for example sales team or R&D capability)
If part of the business is not needed, what would it cost to liquidate and would this adversely affect the “desired” part.
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19. Value is in the eyes of the beholder
Type of due diligence would depend on type of the buyer
Financial investor needs to look if the business is going to perform in its current form- this becomes focus of the due diligence
Strategic (industrial) investor looks if the business would fit/add value to it – this changing the operational due diligence process
And type of the seller
Understanding seller motivation and way of operating
Spin offs- are these truly autonomous? And how they can fit? What do their numbers reflect in reality?
PE –the buyer is dealing with professional seller
Emerging markets – can company operate being managed by investor that have to comply with Bribery Act (UK), FCPA (US) or other regulatory or ethical requirements?
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Rise of ABL
Cash flow lending was the main trend in the past. Today, EBITDA is much more volatile- not only reducing multiples, but also making cash flow lending unavailable in many areas.
Lending against assets becoming more used, especially where the value can be clearly determined.
Illiquid and long term assets are difficult to lend against-shorter term is easier.
“New Financial Engineering”- how to reduce the risk in transactions
Still, constrains on supply of ABL credit.
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21. Credit Insurance and Receivables Financing
Trade Receivables
% Insured
% Financed
Europe 35 5 UK 30 6 US 4
In Europe, credit insurance is extremely important (domestic and export)
The supplier may not be the one making decisions
If cover is withdrawn, company can try to negotiate with insurer (to restore cover) and/or supplier (to continue sell uninsured) IF debt is current
If the payments are overdue, supplier may not supply or risk the claim not being paid...
Receivable financing is underutilised by suppliers-they paid for taking off the risk but did not use the financing available!
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22. Working Capital Management
Loosing supplier credit is the major risk-do not provoke by late payment (but try to negotiate longer terms) and keep good communication. No supplier’s support-no deal.
Receivables are major asset- they need to be managed properly and financed were appropriate. Both quality and financibility of receivable book may be key in pre-deal due-diligence.
Manage inventories-but understand that many optimisation models assume risk free counterparties.
Analyse the product mix not only from profitability standpoint, but also working capital effect –and go out of products you can not afford
If the company is not right place for financing and risk, find one in the supply chain who can take it
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23. Redesigning the Model -Distribution example
Credit Insurance?
Factoring?
Securitisation?
What credit limit?
Sell
purchase
Distributor
Supplier
Payment
Risks:
Distributor credit risk
This risk may be highly concentrated
Customer credit risk (if distributor has little capital)
Product liability (any case)
Provides:
Marketing/Sales
Logistics
Service
Working Capital Finance?
Risk mitigation???
Diversified risk?
Low concentrations?
Single vs. multi tier?
How do you finance receivables in EM?
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Distribution example
Credit Insurance-easier to obtain?
Invoice discounting?
Factoring?
We are in Europe!
Sell
Supplier
Provides:
Marketing/Sales
Logistics
Service
Collections?
Performance risk mitigation?
Distributor-now agent?
Diversified risk?
Low concentrations?
Single vs. multi tier?
No need to finance in EM?
Low working capital needs!
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25. Why Do You Need Working Capital-Business Model?
Working Capital needs are related to structure, not necessarily value added
Supplier’s upmost concern now is risk
Learn the core lesson from banking crisis- the fact that you transferred risk on paper DOES NOT mean you transferred it if counterparty is or becomes week
Variety of legal structures to mitigate risk, while reduce working capital needs
Similar models can be applied to contract manufacturing, printing, material processing, etc.
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Example-Printing
Paper Supplier
Printer
Publisher
What business the printer is in?
What worries the Paper supplier?
What worries the Publisher?
What worries banks/factoring company/credit insurer?
Would acquisition resolve any of these?
Is there alternative model?
Whom do you need to speak about what?
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27. Supply Chain and Turnaround Financing
The supplier (even a highly distressed) is a lender, providing next step in the chain (distributor, manufacturer, end user etc.) with credit through payment terms (sometimes they are the only or main source of credit).
Buyer of the goods can effectively provide money to the seller through reduced payment terms without taking risk (providing supplier fulfilled the contract).
This may provide a workable alternative to DIP (Debtor in Possession) financing, allowing in some cases to provide funds to distressed company without being affected by possible bankruptcy procedures
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28. Practical Implications for Companies in Russia/CIS
Setting up oversees distribution entities is currently seen mainly from tax planning perspective
Setting an oversees distribution/operation entity (with transparent operations and reasonable capitalisation) may create significant financing opportunity as:
The company will have access to efficient receivable financing
The company will effectively lend to the Russian/CIS one through short payment terms without joining queue of creditors
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29. Examples of possible deal structures
Russian Company (high margin/low liquidity) buying a low margin/high volume distributor
Lower price-higher margin at distributor level
Distributor has access to WC finance-some times even for sales back to Russia/CIS
Short payment terms- resolving liquidity issue
Buying distressed Russian exporting Company
Very difficult to refinance locally
Invest at distributor level-refinance through payment terms
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30. Why Vertical Integration?
Recent years show a global trend to “platformisation”
This was driven by lower transaction costs, supply chain coordination and general low risk environment
This is changing now, as risk is again high on the agenda, and transaction costs are up
Deals start coming small and very large
Cost of acquiring supply chain partner may be lower than switching cost
Resolving of concentration problem- getting away from excessive dependencies.
A lot of supply chain optimisation techniques designed for a “risk free” world
In a risky world it is cheaper to have a solution within a firm- the very reason firms exist (Richard Coase, Nobel price in economics 1991)
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31. Supply Chain-its importance to creditors and turnaround investors
Company’s working capital needs depends from business model- and this can be changed (meaning less money needed to support the turnaround)
Instead of distressed financing of troubled company, one can often finance healthy one (such as its distributor) with the same net effect but different cost and risk
One needs to be aware of cross border differences- for example there are more solutions for financing sales to Emerging Markets from the West than for domestic financing within Emerging Markets.
Sick companies in healthy chains have much higher chances of survival than in sick chains.
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32. Vertical Integration- Working Capital Implications
Buying a week player up the chain- moving from concentrated non- financeable receivables book to diversified
Merged company can finance receivables- target on its own find it difficult because of operational risks.
Inventories – can be managed down on elimination of bullwhip effect and reduction of safety stock to cover supply risks
Payables. If target facing withdraw of lines from suppliers or credit insurance, restoring of these can provide immediate working capital boost.
Conclusion: Working Capital may change tremendously in a successful acquisition, providing cash boost instead to cash drain to acquirer
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Valuation Approaches
Discounting expected outcome by your target rate over expected horizon is the price you are willing to pay – you may get away with less.
Do not get into overconfidence trap.
Analyse seller’s motivation and competition
“Name me the price, I will name you the terms”
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Thank You and Good Luck!
Igor Zax, CFA, Sloan Fellow (London Business School)
Managing Director, Tenzor Ltd. (London)
Tel:
Web site:
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