Distressed acquisitions are neither for the faint of heart nor the linear strategist. Opportunities in this arena are founded upon external and internal forces: business cycles, poor management, precipitous market changes, fair-weather lenders, undercapitalization and all too often, fraud. These tumultuous forces can disrupt a middle market business's key business relationships, its high quality performance, market share and reliability. In the face of these challenges, management can convulsively react under the pressures to find liquidity, to sell the business and to assure its survival. As a business deteriorates, its systems, people, energy, entrepreneurship and vision often are diminished, depressed, and sometimes lost, in the face of overwhelming forces.
The current marketplace for distressed acquisitions of middle market enterprises remains highly competitive. The prospects for high returns are frequently a function of the ability to discern and close an opportunity with speed, creative acumen and strategic positioning. In a marketplace of fierce, often predatory competitors and slash and burn mentalities, it is essential to proceed with an interdisciplinary approach to an acquisition that out-flanks the field because of its focus, dimensions, measured urgency and collaboration.
In an effort to enhance strategic positioning to achieve favorable acquisition objectives, we offer the following observations to those who seek to distinguish their efforts and results:
1. Incremental Positioning
A business's decline can be gradual or precipitous. In both instances, management can suffer denial, unpreparedness for change and resoluteness that it can solve its own problems. Historical determination or entrepreneurship, on which the business was founded and grown, rarely will absolve it of its challenges. As a business or sector stumbles, the early entrant, whether as advisor, lender, collaborator, joint venturer or investor, can provide incremental support and direction to the declining business. In so doing, the interested party can incrementally assist, guide or direct management or ownership to acknowledge their needs, thereby, through trust or resources, gaining incremental control or ownership of an enterprise that might otherwise fail.
2. Core Due Diligence
Traditional due diligence has focused on the business's books and records; assessing assets, on- and off-balance sheets liabilities, costs, customers and contracts. While this review is elemental in the acquisition process, it can fail to identify the upside in a middle market transaction - its "promise" - the talent, operational systems, methodologies, know-how, unfulfilled plans that may define its new prospects, vision and direction. This "promise" can be buried in the weary onslaught of problems, undercapitalization and the inability of management to see or cultivate it. In a world of commoditized businesses, it is the discovery of the unpolished gem of the "promise" buried in a distressed middle market business that is the true core objective of such an acquisition and, correspondingly, the due diligence process.
3. People Due Diligence
Equally important in the discernment of hidden value is "people due diligence." Standard due diligence will focus on the scrutiny of management. However, in the search for the "promise," the prompt identification, motivation and retention of critical middle managers, rising stars, high performers, multi-functional team players and holders of institutional or operational know-how can preserve the intangible talents and energy that will drive the business renewal and enhance the prospects of achieving the "promise." Particularly, non-management employees have often suffered the indignities of management by fear, deprivation and silence. Their re-engagement can be a simple task if the acquirer marries its vision for growth with honest communication, performance-based incentives that evoke repressed energy and imagination and the earnest assurance of business stability through investment, direction, leadership and shared enterprise.
4. Intellectual Property, Know How And The Keys To The Control Room
Intellectual property takes myriad forms in middle market businesses. Not every idea or innovation is accompanied by a patent, copyright or proprietary formality. In a middle market operation, there is "know-how" in the heads of the engineers or research and development workers, whose projects went unfunded or ignored, and in the 30-year employee who instinctively can troubleshoot operations from an experience-set and recite the experiments and ventures that did not work. These unsung resources are hungry for a role, reinvigorated morale and an opportunity to contribute to a thriving enterprise. Like critical senior managers, they need to be identified, retained and remotivated.
A business decline occasions wide disappointments, unfulfilled expectations, declining performance and, at times, lies that management, employees, vendors and customers have tolerated or come to expect. To overcome this syndrome and gain an advantage in the acquisition and integration process, the buyer must act promptly, with impeccable credibility, superior performance and consummate integrity and reasonableness, to assure that the repressed promise is unlocked and that those who can facilitate its realization are engaged as collaborators and allies in the business renewal.
6. Effective Integration
Effective integration and implementation of a vision are the most difficult parts of any acquisition - and the place where many acquisitions fail. The "promise" and the optimism inherent in a vision for change can be lost where the vision is not formulated pre-acquisition and feverishly ministered, communicated and nurtured post-acquisition through capitalization, long-term investment plans, collaborative teamwork and self-confidence. If the acquisition fails to prove and implement timely, credible, energized change, the business will repeat its calculated withering and die.
7. "Bidder" Protection
In competitive acquisition arenas, the fastest, fiercest, smartest, most strategic bidder must insist on investing in the process, beyond the initial stages, only if its substantial contributions (to either the competition or the market of ideas) are protected. These protections can take conventional forms: exclusives, no shop contracts, breakup fees and bidding increments favoring a stalking horse and the speed of the deal. There is also a tier of secondary protections that further enhance the entrenchment of the stalking horse. These include, but are not limited to, interim or specialized financing secured by critical assets, control over key intellectual property, licensing agreements or assumption of critical support functions by the buyer in the development, manufacturing or distribution of the business product. Finally, aside from these formalistic protections, there is an invaluable hedge for the strategic acquirer in securing personal or professional alliances with management, key customers, vendors or aligned industries. It is these intangible elements of an acquisition strategy that can demonstrate that a bid is the "best" although not the highest. These also have the patina of future success emblazoned on them.
With shrinking liquidity in the middle market, there will be a proliferation of middle market businesses in need of rescue. The bankruptcy system has unfortunately proven, in its transaction costs or its harshness on this business segment, that it may not be suitable, except with respect to enterprises in dire distress, to enable restructuring or orderly, cost-effective dispositions. Sophisticated restructuring and turnaround advisors have turned to creative, out-of-court devices - workouts, structured foreclosures, receiverships and assignments for the benefit of creditors - to sell or recapitalize distressed middle market businesses. The acquirer who can forge a strategy and team that has legal acumen, business resolve and the ability to engage management, employees, customers and vendors in a collaborative vision where all stand to improve their future, will effectively and profitability unlock the "promise" of a distressed middle market company.
James J. Tancredi is a Partner in Day Pitney's Hartford office. His practice involves distressed assets, bankruptcy and creditors' rights, mergers and acquisitions and joint ventures as well as real estate and various aspects of energy and utility law. Joshua W. Cohen is of counsel in Day Pitney's New Haven office, practicing in the area of bankruptcy and creditors' rights.