Considerations of an Out-of-Court Sale: Making a Balanced Decision when Dealing with a Distressed Company
The proliferation of private credit has brought about a new playbook for dealing with restructuring and special situations, and as Chapter 11 costs have skyrocketed, lenders often find themselves pursuing alternatives to in-court processes — often opting for an out-of-court sale.
However, lenders must be judicious of the hidden costs and potential pitfalls outside of the walls of the bankruptcy court, such as 1) the impact of stock sales on transaction costs, 2) the risk of unenforced timing and milestone requirements, and 3) the possibility of value degradation.
In the below article, Configure Managing Director Jay Jacquin explores the possible consequences of seeking an out-of-court sale, presenting elements that should be carefully evaluated when analyzing the cost and benefit of the next steps for a troubled borrower.
Read the full article below.
A Paradigm Shift for Leveraged and Distressed Companies
As private credit has proliferated, taking an increasing share of the lending market from commercial banks, credit funds have created their own path and approach to managing credits. Along with that, they have brought a new playbook for dealing with restructuring and special situations — causing a paradigm shift in the industry.
Broadly speaking, private credit firms have demonstrated a greater willingness to assume outright ownership of a troubled borrower than a traditional bank. However, when private direct lenders opt for the sale of their troubled borrowers, these lenders are frequently pushing for the less traditional route of exploring out-of-court sales, changing what had been a standard approach to restructuring: selling the troubled borrower through an in-court process.
The reason behind the paradigm shift is simple — bankruptcy costs have skyrocketed due to planning costs, professional fees, and “hold up” value sought by out-of-the-money creditor constituencies. The well-worn path of a Chapter 11 filing is increasingly being abandoned due to these issues, often in favor of pursuing out-of-court sale options.
However, lenders need to be cognizant of the less obvious risks and hidden costs inherent to not seeking the protection of the bankruptcy court — and that the path of Chapter 11 was well-worn for a reason. Below are the possible consequences of these alternatives, which should be carefully evaluated when analyzing the cost / benefit of the in-court versus out-of-court sale.
The Pitfalls of the Out-of-Court Stock Sale
Traditionally, a court-supervised sale process involves an asset sale(s) of a distressed entity to maximize creditor recoveries. Asset sales are straightforward and are relatively easier for buyers to diligence, while the bankruptcy process will inherently address all liabilities as part of the proceedings.
However, when a lender wants its borrower to pursue the out-of-court sale transaction, the company is almost forced to transact through a stock sale, since lenders will “want to be done” and not be left having to address any ongoing liabilities –— whether on- or off-balance sheet.
The pivot from an asset to stock sale increases diligence time and risk for a buyer. Full, complete diligence is lengthy, especially when conducted on a beleaguered, over-levered company. The buyer now has to understand every contract, piece of litigation, and potential insurance claim brought to their desk.
This, in turn, drives up the transaction costs, as both buyer and seller will have to bear higher diligence costs in not only producing but also researching and explaining all items. Additionally, the cost of any extra time needed to get to closing because of extraneous diligence will be borne by lenders in the form of additional cash burn by their borrower prior to the sale. Finally — and most importantly — the seller and its lender(s) will have the risk of softness in the valuation and ultimate recovery as described more fully below.
Timing and Milestone Challenges
Another red flag for an out-of-court sale is that process milestones can be less set in stone. In court, the company typically negotiates with the DIP (Debtor-in-Possession) provider (frequently the incumbent lender) on a timeline to conclude the sale process. If the company fails to meet the timeline requirements, the lender can call a default on the DIP and begin exercising other remedies under court supervision.
Out-of-court, there is no “hammer” as it relates to timing. Buyers can — and will — test the company on the sanctity and boundaries of its timeline and push the patience and fortitude of the lender to continue to fund an out-of-court sale process.
This is a particularly acute problem for a company that may operate in a niche industry where there are few natural buyers or in a process that has only targeted strategic buyers. Due to a lack of milestones, there is a greater risk that the process can drag on in ways that would rarely occur within a court-supervised process.
Value Degradation on the Backs of the Lender
Tying back to the added diligence of an out-of-court stock sale, value degradation in the form of added unsecured liabilities is recovery-destructive for the lender. Any last-minute unsecured liabilities identified and assumed by the buyer will be turned on the seller in the form of a purchase price reduction. With an in-court sale, these unsecured liabilities would ordinarily be subordinate to the lender’s claim on purchase price. However, in the out-of-court scenario, the consequence of newly identified liabilities is a lower recovery on the lender’s capital outlay.
Sellers and their lenders should absolutely expect buyers to hunt for “the boogeyman” in every deal, and liabilities that may not even have substance and likely will not come to fruition but are assumed in a stock deal will then be used as fodder to reduce price.
Considering the Above
As out-of-court sales become a more popular path for those dealing with distressed companies, lenders must remember to consider the above downsides of what may seem like an increasingly attractive option to avoid the skyrocketing costs of Chapter 11. With a bankruptcy sale, one can at least estimate a ballpark figure of costs. The cost of the out-of-court sale, as discussed above, can be far more speculative and surreptitiously reduce lender recoveries below what was anticipated.
Although an out-of-court sale may still be the right answer for some situations, lenders would be wise to come to that decision with eyes wide open, being thoughtful about the risk factors, and armed with a balanced evaluation of all options available.
Configure Partners is a preeminent credit-oriented investment bank specializing in debt placement, special situations, and bespoke M&A advisory. Our team of bankers would be happy to discuss any of these trends further and answer any questions you may have concerning next steps for a distressed business.
Jay brings over twenty-five years of investment banking and advisory experience at market-leading firms. Prior to joining Configure Partners, he established the Middle Market Special Situations practice at Guggenheim Securities. Before joining Guggenheim, he was a senior member of the Recapitalization & Restructuring Group at Morgan Joseph TriArtisan for approximately five years.
Previously, he was a Senior Director with Alvarez & Marsal Corporate Finance, prior to which he spent eight years in Houlihan Lokey’s Corporate Finance and Financial Restructuring practices.
Jay holds a bachelor’s degree in Commerce, with concentrations in finance and marketing, from the McIntire School of Commerce at the University of Virginia. He is a FINRA General Securities Registered Representative (Series 24, 7, 79, 63) and a Certified Insolvency and Restructuring Advisor (CIRA).