Market conditions generate distressed M&A opportunities

The COVID-19 pandemic has caused a spike in Canadian distressed M&A activity that is expected to continue into 2021, as mandatory lockdowns and voluntary quarantines result in major shifts in the way Canadians live, work and shop.

Some investors and strategic buyers have shied away from distressed opportunities in the past because they see them as being especially risky, complicated and contentious. While there is some truth to this, savvy investors know that this field also comes with unique benefits and potentially outsized returns.

What is distressed M&A?

Distressed M&A typically refers to deals completed when the target company is facing insolvency or is already insolvent. Effecting M&A transactions having a real or potential insolvency component is often assisted by the broad and creative tools provided by restructuring statutes and case law. The Companies’ Creditors Arrangement Act (CCAA) is a popular restructuring statute that is often engaged by larger insolvent companies, while receiverships are more common for smaller companies. Solvent and insolvent companies have increasingly used the plan of arrangement provisions under the Canada Business Corporations Act (CBCA) or its provincial counterparts to de-lever balance sheets by way of securities exchanges/debt-to-equity swaps. Most formal restructuring proceedings now involve significant M&A components and activities.

Benefits and considerations

Insolvency statutes and case law encourage creative solutions to complex problems. There are a variety of options and tools that can be utilized in a distressed M&A transaction to achieve a successful outcome. Examples include:

• Introducing court oversight and the involvement of a CCAA monitor or a receiver can significantly reduce acquisition risks. These independent eyes add rigour to the disclosure process and a dealmaking orientation. Judicial oversight and approvals of sale processes and resulting transactions can also reduce liability exposure for boards of directors.
• The target business can be preserved while a transaction is negotiated and implemented. For example, a court can stay the exercise of contractual remedies by counterparties, compel suppliers of goods and services to continue to supply to the business during insolvency proceedings, override restrictions against assignment, and negate consent rights.
• “Pre-packs” may be used to expedite the M&A process—essentially, a restructuring or sale process may be settled before filing, but completion and closing of the transaction is then achieved through an insolvency filing. This allows a company to find the buyer or develop a restructuring plan, and lock up key stakeholder support before filing which significantly streamlines the process.
• Sale processes may be structured to include features such as: i) a stalking horse bid (i.e., a bid that is formalized and then shopped, often with bid protections and break fees/expense reimbursement); ii) an open auction at the end of the process for qualified bidders; iii) credit bidding (i.e., bids by existing secured creditors using their debt as currency).
• For asset purchases, a court can vest title “free and clear” of liens and other interests to achieve a level of title certainty rarely equaled by even the most comprehensive (and costly) legal due diligence exercises.
• Recently, courts have expanded the menu of options with the use of “reverse vesting orders”, which transfer liabilities to a new entity and allow a purchaser to acquire the corporate debtor with its assets (including tax attributes) intact, free and clear of unwanted liabilities (for more details, see “Reverse vesting order issued by Québec Superior Court after first contested hearing”).
• There can also be extraordinary opportunities to re-model the target business. In addition to debt reduction, uneconomic contracts (including leases) can be terminated or left behind, as well as litigation claims and other unwanted liabilities. A purchaser can also "cherry pick" attractive parts of a business with more ease than in the ordinary course.

Outside of a formal insolvency proceeding, there are also significant opportunities for distressed investment through solvent plans of arrangement under corporate statutes such as the Canada Business Corporations Act (CBCA). The CBCA allows a solvent company to restructure public debt and securities under a court-supervised process which does not require a declaration of insolvency.

Parties in an insolvency want a clean closing. Post-closing deal “tails”—complex working capital adjustments, vendor take-back mortgages, and earn-outs and participations—are usually viewed negatively.

Recently, courts have expanded the use of CBCA proceedings to provide a broad stay of proceedings similar to a CCAA stay. They have also shown a willingness to limit shareholder “equity-based” lawsuits to available insurance proceeds and channel such claims so that they are no longer a liability of the company. This provides an attractive opportunity for fresh capital to be invested in a company with a cleansed balance sheet.

There are, however, unique considerations in engaging in a distressed transaction. Key distinctions between typical M&A and distressed M&A processes include:

• Even in “debtor-in-possession” CCAA proceedings, it is not always clear that a company’s management and board are firmly in control. Lenders, bondholders, employee groups and other key stakeholders are often heavily involved and can strongly influence outcomes.
• Confidentiality can also be challenging given the transparency and multi-party nature of most insolvency proceedings.
• Distressed asset sales may deliver “cleansed” assets, but they can also leave behind valuable tax attributes (although share transaction alternatives, plans of arrangement and the novel “reverse vesting order” options exist).
• Distressed transactions often involve limited representations and warranties (reps/warranties), and are often on an “as is, where is” basis, without any substantive reps/warranties.
• There is limited value to any purchaser’s claim for breach of reps/warranties against an insolvent company and generally no rep/warranty insurance available.
• Purchase agreements may be subject to being “shopped” as part of a competitive bidding process and it may be more difficult to provide exclusivity to the bidder. Transactions are subject to court approval and potential appeals, which may add deal risk.
• Restructuring processes can also be costly and unpredictable. Insolvency brings urgency that frequently necessitates faster sale processes and quicker closings.
• Parties in an insolvency want a clean closing. Post-closing deal “tails”—including complex working capital adjustments, vendor take-back mortgages, and earn-outs and participations—are usually viewed negatively.

Current market conditions will offer opportunities across multiple sectors

Some sectors, such as “bricks and mortar” retail and the travel and hospitality industries, have been significantly impacted by pandemic-related restrictions at a time when these industries were already under intense pressure. However, unlike past cycles where specific industries were distressed targets (i.e., forestry, oil and gas, or commodities), the long-term market impact of COVID-19 is likely to affect companies across the spectrum as employers shift their working arrangements to reflect the new environment. This will create numerous opportunities for distressed investment in businesses which have solid fundamentals but require operational and financial restructuring to operate in a post-pandemic environment.