Transcript 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-

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
© Tenzor Ltd 2009-2011
www.tenzor.co.uk
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Who and Why Do Distressed
M&A?
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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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Strategic Value Drivers

Buying “Cheap”
– Typically driven by distressed seller
– Timing is critical
– Limited due diligence
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Navigating Insolvency process
– Loan to earn
– Pre-Packs
– Winning capital structure battles
– Heavy reliance on legal process
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Strategic Value Drivers
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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”
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Operational Improvements
– Management Change
– Integration/Synergy
– Specialist Turnaround Strategies
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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?
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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
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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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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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Operational Due Diligencecore 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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Practical Example- What Can
you find in a warehouse PCBA
PCB
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What Do you see in Warehouse?
–
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What do you see in Accounts?
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Working Capital problems
What do you see in Manufacturing:
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Two similar boards (one of which is PCB and one is assembled) are on the
warehouse shelf
Delays, quality issues
What do you see in Customer Service
–
Quality Issues
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Question to ask – Why? And
Is there a link?
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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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Industry structure and Supply
Chain
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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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Supply Chain- Distribution of
Risk and Reward
Component
Manufacturers
Component
Distributors
Contract
Manufacturers
OEM
Customers!
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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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?
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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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Working Capital Analyses –
cont.
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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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Working Capital Analysescont
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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?
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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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CAPEX/ Development Costs
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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
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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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Value is in the eyes of the
beholder
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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
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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
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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 againstshorter term is easier.
 “New Financial Engineering”- how to reduce the risk in
transactions
 Still, constrains on supply of ABL credit.
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Credit Insurance and Receivables Financing
Trade Receivables
Europe
UK
US
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% Insured
35
30
5
% Financed
5
6
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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Working Capital Management
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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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Redesigning the Model Distribution example
Credit Insurance?
Factoring?
Securitisation?
What credit limit?
Sell
purchase
Supplier
Payment
Risks:
Distributor credit risk
This risk may be
highly concentrated
Customer credit risk
(if distributor has
little capital)
Product liability (any
case)
Distributor
Provides:
Marketing/Sales
Logistics
Service
Working Capital
Finance?
Risk mitigation???
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Diversified risk?
Low concentrations?
Single vs. multi tier?
How do you finance
receivables in EM?
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Distribution example
Credit Insuranceeasier to obtain?
Invoice discounting?
Factoring?
We are in Europe!
Sell
Supplier
Provides:
Marketing/Sales
Logistics
Service
Collections?
Performance risk
mitigation?
Distributornow agent?
Low working
capital needs!
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Diversified risk?
Low concentrations?
Single vs. multi tier?
No need to finance in
EM?
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Why Do You Need Working
Capital-Business Model?
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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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Supply Chain and Turnaround
Financing
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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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Practical Implications for Companies
in Russia/CIS
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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
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Examples of possible deal
structures
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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
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Buying distressed Russian exporting Company
– Very difficult to refinance locally
– Invest at distributor level-refinance through payment
terms
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Why Vertical Integration?
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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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Supply Chain-its importance to
creditors and turnaround investors
Company’s working capital needs depends from business modeland 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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Vertical Integration- Working
Capital Implications
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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: +447775708426
 E-Mail: [email protected]
 Web site: www.tenzor.co.uk
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