Clients often ask about the benefits of acquiring distressed assets through the bankruptcy process. At a high level, there are some key benefits including the ability to obtain assets "free and clear” and to control the liabilities that may be rejected or may be assumed going forward, post-acquisition. A buyer might want to assume those liabilities that would ultimately be advantageous from both an economic and operational standpoint, thereby creating value on day one. Additional advantages include having:

• A more limited pool of sophisticated buyers, disclosures, and diligence governed under the supervision of the court
• The ability to control the closing process through Motion/Order
• Protections that may be available through the bankruptcy, such as staying under the court’s jurisdiction for a period of time

The buyer also has the ability to accept or reject certain contracts or conditions, efficiently and effectively saving time and money. However, not all distressed asset acquisitions are conducted through a formal bankruptcy process. Many distressed asset acquisitions are performed out of court through a more traditional acquisition process using advisors, accountants, and lawyers.

In this Q&A, Debra Henderson Morgan, Managing Director of the Restructuring and Dispute Practice at CohnReznick, and Ioana Iorga, Managing Director of Transaction Advisory Services at CohnReznick, discuss the benefits and pitfalls of acquiring or investing in distressed assets:

Debra Henderson Morgan: On the transaction advisory side, what are some of the benefits of acquiring a distressed business outside of the bankruptcy process?

Ioana Iorga: The majority of our distressed acquisitions assignments occur “out of court” through a traditional acquisition process. Benefits from acquiring a business outside of the bankruptcy process are highly situation specific and may include structuring advantages, better pricing by perhaps avoiding a competitive bid situation, and avoiding potential reputational risk associated with a bankruptcy filing.

When a company files for bankruptcy protection, transactions are subject to court confirmation (approval), and may also fall under public scrutiny. Typically, when a bankruptcy is filed, the following documents are also due at filing: a schedule of assets and liabilities; a schedule of income and expenses; a schedule of contracts and leases; and a list of current debt, financial records, and other financial information.

In bankruptcy, a purchase can be structured as either an asset purchase where the buyer purchases all or some of the assets of the business or as an equity/ownership interest purchase. Equity transactions may include companies structured as corporations, partnerships, or limited liability companies. There may be tax advantages as well as business reasons for keeping the entity in place, such as the cleansing or the assumption of liabilities of the acquired company.

Structuring an acquisition as an asset purchase offers a buyer greater flexibility and the ability to control specific assets it buys to fit its strategic needs, tax benefits (e.g., asset “step-up”) that could be secured. Further, it provides the Buyer the ability to only assume certain specified liabilities, eliminating the potential risk of assuming any unknown liabilities. However, there are also complexities involved in an asset versus equity purchase, such as reassigning or renegotiating certain customer contracts, and revaluing and retitling other assets from the Debtor to the buyer.

In terms of tax implications of an asset versus equity purchase:

• In a taxable asset acquisition, a buyer generally does not inherit the seller’s pre-closing income tax liabilities. However, a buyer may inherit non-income tax liabilities (e.g., sales and use tax, property tax, unclaimed property). The tax attributes of the Debtor generally remain with the Debtor entity. But, the buyer may take a step-up to the tax basis of the assets acquired in an asset deal.
• In the event of a taxable equity acquisition of the stock of a C corporation, a buyer generally inherits any pre-closing tax liabilities of the Debtor. The tax attributes of the Debtor generally carry over to the Buyer including certain tax credits and net operating losses (NOLs), subject to certain limitations under the Internal Revenue Code (e.g., Section 382). Upon acquisition of stock, unless certain elections are available and made, there generally will not be a step-up to the tax basis of the target’s assets.

When looking at a stressed or distressed business, a buyer should always consider the level of “stress” the company is experiencing. A stressed company may often have some liquidity or operating concerns but does not require an imminent sale. In contrast a distressed business has moved past this stage and may be experiencing cash flow or operating issues that would impact its ability to continue as a going concern. In the latter case, the timeline for the buyer to perform their diligence is much more compressed.

Debra Henderson Morgan: How does your team guide clients who are purchasing outside of the bankruptcy process? What advice do you offer?

Ioana Iorga: Conducting proper diligence and preparing post-acquisition strategies are key tasks for us. Buyers, including distressed investment funds, may deploy either debt or equity investment strategies to buy distressed companies at various stages of the acquisition process. Their goal is to obtain control of a company at a discounted price and then restructure that company.

When buying a controlling stake in a distressed business, buyers will spend significant time and capital to stabilize the business, transform its operations, and improve its free cash flows. If the distressed asset can be turned around, then the return on investment can be substantial, given the discounted purchase price. Buying distressed assets can also help Buyers to strengthen their market positions. Many distressed assets with tangible value can serve as collateral for future financing needs.

We typically advise clients to immediately focus on three main areas after acquiring either a stressed or distressed business: integration, cost containment, and working capital management. Many of our clients are also looking to leverage their existing infrastructure and synergies to make the assets profitable. Our professional team can both guide the clients through the intricacies of a transaction, restructuring of assets, unlocking tax benefits, structuring, and modeling and also facilitate the performance improvement process post-transaction.

Debra Henderson Morgan: There’s certainly a great deal of value to be realized when acquiring distressed assets given the potential discount arising from the bankruptcy process, as well as the value of the asset in the market. However, it’s not for the faint of heart; the process can be more difficult, expensive, and timely for an inexperienced or ill-advised buyer. Transactions often have a lot of “hair” on them, and it takes capital, the right management team, and the right bench of trusted partners, including financial advisors and attorneys, to navigate the process and implement the value creation. Ioana, what are some of the trends that you’re seeing in distressed investment funds on the transaction advisory group side?

Ioana Iorga: We are seeing a lot more distressed investment funds cropping up over the past year and some inherent challenges these funds must deal with. There’s often a high risk associated with these types of investments. However, the benefit of purchasing a distressed business could outweigh the risk with proper preparation. A lot more of our clients are investing time and efforts in pre-transaction diligence, including financial, tax, operational, IT, and pre- and post-transaction performance improvement, finance transformation, free cash flow, and management.

Debra Henderson Morgan: You raise an important point and I'm so glad to hear that your clients are making smart decisions as they work through the merger or acquisition due diligence process with CohnReznick, as well as creating a plan for post-integration after closing. Regardless of how companies come together, due diligence, regulatory considerations, and complex legal instruments are key factors that should be independently considered with the help of experienced professionals. It is paramount to prepare for, design, and implement an effective integration plan with key stakeholders – both pre- and post-acquisition – to execute and achieve the business plan and create value.