Conducting due diligence on distressed acquisitions

With inflation soaring and the rising cost-of-living contracting household spending, small business owners looking to move into growth mode during 2022 may struggle to do so organically. This is where distressed acquisitions can be so valuable, offering an ideal route to inorganic growth... providing you can identify the right opportunities.

Business distress is currently rife in the UK, driven by a multitude of factors including inflation, supply chain issues and pandemic-related debts. With limits on insolvency proceedings having been lifted by the government, insolvencies are rising rapidly.

Many businesses that have fallen into insolvency will be viable operations that were previously generating profits and will still have a strong demand for their services. As a result, a sound turnaround plan should be enough to return them to solvent trading and, eventually, profitability.

Finding these opportunities (among the many insolvent businesses that likely cannot be turned around), however, will require a keen eye and a solid due diligence process. The challenge becomes how to perform proper due diligence within the tight time constraints of an insolvency process, with administrators under pressure to find a buyer for the afflicted company as quickly as possible.

Due diligence on a distressed acquisition, then, is about knowing what to look for and asking the right questions, with speed being of the essence. Having a framework in mind before you even begin finding targets will be crucial. Here are the key steps.

Why is the company in distress?
The first question to ask will always be, why is a given company insolvent? Did it fall into administration as a result of external factors, such as supply chain issues or a wider downturn in its sector or the overall economy? Or was its collapse attributable to internal factors, such as poor cashflow?

Determining the factors behind a company’s collapse will help answer perhaps the most important question during a distressed due diligence process – can the company be turned around? If the problems are too deep-seated and serious to be resolved, then walk away from the deal. If not, then you can move onto the next stage with greater confidence.

Assessing records
When buying a distressed company, the best way to ascertain its viability is to examine its historic performance. Take a look at Companies House filings, annual reports and confirmation statements to get an idea of its financial status.

Key things to look out for could be revenue growth or decline over recent years, whether it was turning a profit or loss prior to entering distress, any outstanding liabilities, creditor information and late filings, which could indicate historic struggles.

In the current climate, a distressed yet viable company may have shown strong performance and profitability up until 2020, before seeing its business impacted by the pandemic and/or COVID-19-related debts.

Mitigating risks
As we’ve mentioned, distressed acquisitions come laden with inherent risk on the buyer side and, on top of this, due diligence must be performed quickly. The danger is, then, that there may be gaps in the due diligence process that become apparent later on. For that reason, you should take steps to mitigate the risks of any oversights that may occur.

Buyers in distressed acquisitions are often exposed by a lack of warranties. There are numerous ways to mitigate this, most obviously exploring the possibility of getting warranty and indemnity insurance. In cases involving an insolvent business, however, this can be difficult to obtain.

If this is the case, the buyer can seek to use the situation to try and negotiate a lower price with administrators or structure a deal with deferred considerations, although this could be a risky strategy that may put administrators off.

A buyer may also look to insert a termination clause into the transaction, enabling them to pull out of the deal should certain factors come to light prior to the acquisition closing. Although, again, this is unlikely to appear to administrators.

Other considerations
In a distressed company acquisition involving share purchases, buyers should also examine financing arrangements and tax issues at the business, along with the change of control provisions. When acquiring distressed assets, it will be important to examine any associated contracts or leases and, if necessary, contact the suppliers.

Other areas of an insolvent business to look at during due diligence will be its employees (were any staff made redundant through the insolvency process?), IT infrastructure and insurance.

While distressed acquisitions are risky, acquiring a viable company out of administration can be a great way to generate growth in your own business by implementing a turnaround strategy that enables you to tap into the target firm’s latent profitability.

The key when making distressed acquisitions is determining whether this is possible. In this regard, a solid due diligence process, conducted efficiently within a short timeframe, is perhaps the most important part of a distressed acquisition.