Dealing With Distressed M&A│Luxembourg

The geopolitical uncertainties initiated by Russia’s invasion of Ukraine in February 2022, compounded by the recent conflict in the Middle East, the increase in inflation leading to central banks raising interest rates, a volatile consumer market and post-pandemic uncertainties in the labour market have created an explosive combination for companies, particularly those heavily reliant on financial leverage.

Having become accustomed to an abundance of low-cost debt for more than a decade, companies are now confronted with a new reality as interest rates rise. This new reality puts enormous strain on companies’ ability to:

Default rates are on the rise and such a situation opens distressed investment opportunities to those willing to assume risk and use leverage to renegotiate debt.

The acquisition of assets, shares or a business from a seller experiencing financial difficulties is generically referred to as “distressed M&A”. The term can also apply to a situation in which it is the company or business being acquired or sold that is itself in a distressed position. Distressed M&A differs from traditional M&A and has its own risks and peculiarities.

A company facing the prospect of a potential default in a matter of months will likely start negotiations with its creditors to prevent its foreseeable bankruptcy (and/or avoid an enforcement of collateral with the consequence that the assets of the company are taken from the company). In this context, the company and creditors may seek to identify M&A opportunities to realise assets of the company and deliver value to the creditor group.

One of the particularities of the Grand Duchy of Luxembourg originating from its small size in comparison with other jurisdictions is linked to the composition of its economic market, which is mainly constituted of holding companies with limited operative activities. Hence, distressed M&A transactions involving Luxembourg companies will likely be structured as share sales of solvent subsidiaries, with the parent entity as seller and negotiating terms with its remaining creditors itself.

A certain number of considerations must be weighed while dealing with distressed M&A outside insolvency proceedings.

In distressed M&A, time is of the essence. The seller or the target company may be facing a rapidly declining financial situation necessitating an urgent need for funds. This urgency results in a compressed timetable of the sale process.

Owing to the time constraints, the buyer will generally have a limited amount of time in which to conduct an extensive due diligence as per a typical M&A transaction. Furthermore, the buyer may suffer from a limited access to the documentation or have inaccurate or incomplete information. Hence, more than ever, the buyer will need to focus on the key areas that may be the value drivers of the business in the future.

In contrast to non-distressed M&A, which usually only involves a buyer and a seller, distressed M&A is a complex transaction that involves several parties such as the existing lenders to the seller and/or group, the other creditors, customers, and other company stakeholders. The different interests of all the parties create additional challenges to navigate.

The interest of the lenders deserves particular attention. Indeed, the envisaged purchase price may not be sufficient to repay the lenders and any and all existing security granted over group assets will need to be released. Obtaining an agreement with the lenders should be a prerequisite to ensure the assets are transferred unencumbered and that the seller remains solvent as a consequence of the transaction.

The difficulty of assessing the value of the target company is increased in a distressed context. During the appraisal process, the buyer will need to consider the feasibility of turning the business around and will have to contend with the unpredictability of the future cash flow that the business may generate.

In the event where the seller filed for bankruptcy, the buyer may be at risk of a claw-back if it occurred within the suspect period or if the bankruptcy receiver can otherwise establish fraud. The suspect period normally stretches six months prior to the date that bankruptcy proceedings were opened by court order.

In a nutshell, a transaction could be declared null and void if:

To protect itself, the buyer should request that the share purchase agreement contains specific representations and warranties related to such risk of claw-back ‒ for example, a representation that the transaction is made at fair value and does not lead to the bankruptcy of the company and that the company is, as of the date of closing, foreseeably solvent for at least the duration of the suspect period. Such representations and warranties may have little value, however, if the sole recourse of the buyer for a breach of such statements is against the (distressed) seller. Hence, the buyer may instead want to obtain reassurance as to the manner in which the seller will apply the sale proceeds to pay or restructure its debt (and thus mitigate the risk that the seller will go into bankruptcy after the closing of the transaction).

Contingent value rights (CVRs) in the pricing mechanics may be a useful tool in bridging the valuation gap and preventing the risk of a transaction being considered “at undervalue”. CVRs may also be a useful means of allowing the stakeholders of the transferor company to share in the potential future value of the transferred assets.