Schulte Roth & Zabel is pleased to present Distressed Investing M&A, published in association with mergermarket and Debtwire. Based on a series of interviews with investment bankers, private equity practitioners and hedge fund investors in the US, this report examines the market for distressed assets at home and abroad.
Economic uncertainty brought on by the looming US “fiscal cliff” have placed companies in difficult situations where many are forced to sell assets and restructure operations and debt in order to avoid a court mandated sale further down the line. The value gained and time saved by selling assets prior to in-court restructuring and liquidation is signaled by the respondents’ shift toward dealmaking early and out-of-court.
Outside of the US, the eurozone crisis and macroeconomic concerns in the emerging markets are having a similar effect. While some are waiting for a solution to the sovereign debt crisis, distressed investors are geared to take advantage of attractively-priced assets within the region. Hyperinflation remains a concern for the markets in Latin America and India, while economic growth has slowed in Brazil and China. Both are likely to create distressed opportunities over the next 12 months.
Respondents cite the energy sector as likely to be the most active for distressed M&A in the next year. Low natural gas prices in the US are hitting the bottom line and companies are feeling the strain. Additionally, inflation concerns in Asia may expose manufacturing companies, who respondents describe as “losing the battle” against prices.
In addition to the above findings, this report provides insight into pricing, litigation, club deals, and various other issues concerning the distressed M&A community. We hope you find this study informative and useful, and as always we welcome your feedback.
In the fourth quarter of 2012, Schulte Roth & Zabel commissioned mergermarket to interview investment bankers, private equity practitioners and hedge fund investors regarding their outlook for distressed M&A activity over the next year. All results are anonymous and presented in aggregate.
Respondents overwhelmingly use negative cash flow as their main indicator that a company or asset is distressed; 51% also use leverage signals. The two indicate a company is unable (or nearly unable) to make regular debt payments or refinance approaching maturities, which are highly likely to trigger distressed sales. This represents a change in opinion from the first edition of this report published in 2009 where leverage ratios were used more than cash flow.
There is a divide between respondents’ expectations for pricing of distressed assets and companies over the next 12 months. While 43% expect them to increase, 36% expect them to remain the same. The relatively split response is a far cry, however, from the pricing of 2008 through 2010 when distressed assets were selling at deeper discounts, and similar research showed as many as 90% predicting further decline. The markets and revenue have shown signs of stability and income-based asset valuations in the US appear to be improving, with increasing stability in the markets and in private sector revenues.
Availability of financing and the political climate will have the greatest influence on the valuations distressed companies receive, according to 40% of respondents. This year, distressed companies in the healthcare sector have seen stable valuations as the markets prepare for the enactment of the further stages of healthcare reform. With President Obama’s re-election, the strength of distressed healthcare M&A is likely to hold.
Monetary policy such as the Fed’s “quantitative easing” is not expected to impact the market for distressed M&A. Interest rates would potentially have the most influence, say over a quarter of respondents, while inflation and regulatory changes are not expected to play into pricing.
Overall pricing of distressed companies and assets are narrowly expected to decline throughout 2013, according to the 42% plurality of respondents. Corporate special situations-related investments are gaining momentum with alternative investment funds, but global investment banks are rapidly shying away as they lower the amount of risky investments in compliance with regulation.
While M&A professionals across the globe paid close attention to the presidential election, the political climate outside of the US has greater importance in relation to companies in distress, according to over half of respondents. As conflict in the Middle East continues, the effect is felt around the world, especially in the energy sector. Similarly, the impact of the eurozone crisis is felt in the consumer and manufacturing sectors around the world, especially in the US.
As one investment banker explains: “There is a great deal of change afoot in several key markets. One feels the eurozone is heading for a significant political shift in one or two member countries, which may well reap some great opportunity for sharp-eyed investors.”
Energy and industrials and chemicals are the top two sectors respondents identify as offering the best opportunities for distressed acquisitions both within and outside the US. The fall of natural gas prices has put strain on the American oil and gas sector providing prime opportunities for larger strategic and financial buyers who can bear the brunt of what is most likely a transitory weak revenue stream.
Since the height of the US economic downturn, the real estate sector comes in as a distant third choice in the US among investors with 16% of respondents (it was the top sector in the 2009 edition of this report). Recent indicators show recovery in home buying, though the growth in 2002-2006 will not be matched for the foreseeable future.
Distressed investors will be monitoring the US economy and the eurozone closely for indicators on attractive sectors over the next 12 months.
A managing director at an investment bank who chose industrials and chemicals in Asia-Pacific explains: “Manufacturing companies are losing a battle with inflation and will need assistance in the face of stern challenges in what has been, until now, unprecedented growth.”
Balance sheet restructurings are the top targets for acquirers of distressed companies, according to the 65% majority of respondents. These situations are sought for both long- and short-term distressed M&A strategies. As distressed companies struggle to improve financial health, non-core assets will be on the selling block and investors will look to take advantage.
As one private equity director explains: “With the economic downturn as the key driver, you need to think long-term and be patient for the right market conditions to return.”
Over a third of respondents have been among a group of investors who have completed club deals, which primarily were formed before the investment. All respondents who report issues with corporate governance were the most difficult to address. These consortium acquisitions have seen recent popularity in the global energy sector as natural gas prices have remained flat. An 86% majority of respondents say the groups form prior to the investment.
The operational risks of a company in distress have the biggest impact in deciding whether or not to acquire, according to the 63% majority. Respondents note the growing impact operational risks can have on future capital expenditure demand and the potential of catastrophic events on operating performance, market capitalization, and corporate reputation. These types of risks and deficiencies must be priced into the sale, respondents add.
The world’s various economic issues have thrown many curveballs into investors’ decision-making, but the US economy stands out as the most important for the 39% plurality; 34% say the eurozone will have the most significant impact. While the slowdown of China’s rapid growth and Latin American countries like Brazil and Argentina on hyperinflation watch have hurt companies, the market for distressed companies does not match the volume of the US and Europe.
Companies where litigation can play a significant role in the long-term performance are targeted by 37% of respondents. These types of companies are often evaluated by the investor’s legal team on a case-by-case basis. In regards to Latin America, one respondent advises: “When investing outside the US, understanding the bankruptcy code is extremely important. In some countries, it favors the shareholders over the creditors, and this causes serious problems in recovery.”
Respondents are virtually split on the primary source for distressed M&A in 2013 with just over half (52%) expecting more deals to come from inside bankruptcy, rather than outside. According to Debtwire data, 2012 is on pace to see 80 distressed exchanges; roughly 63% are expected to take place in court. This represents the growth of outof- court restructuring, which is noted to be a significantly shorter process, though typically dependent on the company’s capital structure or financial performance.
Chapter 11 reorganizations are expected to be the top distressed M&A transaction type with 58% of the response, followed by Section 363 asset sales. The reliance of debtors on Section 363 sales as a substitute for the more traditional Chapter 11 reorganization process has remained strong, according to respondents. Once thought to be “a thing of the past,” Chapter 11 is still providing opportunities for distressed investors. As one respondent explains: “Kodak’s sale of its patent portfolio has been going on for much of 2012, and is essential in order to obtain financing to bring it out of bankruptcy.”