October 2020 Vol. 9 No. 10
charlie goodrich

It has taken some time, but the current pandemic has reached the point where distressed investing opportunities are beginning to appear.

Generally, there are three types of buyers for distressed companies: Serial Investors, Newbie Investors, and profitable businesses that view distressed companies as an opportunity to expand.

In today's newsletter, we take a look at each and examine some dos and don'ts regarding their respective approaches.
Please respond with your thoughts and comments.
Charlie Goodrich
Founder and Principal
Goodrich & Associates
In this issue…
Distressed Investing Opportunities Are Back
Heard On The Street
About Us
Distressed Investing Opportunities Are Back
It’s true. For those who have been searching and/or waiting, the current pandemic has reached the point where distressed investing opportunities are beginning to appear.

As I have mentioned previously, when it comes to distressed companies, there are three types of buyers: Serial Investors, Newbie Investors, and profitable businesses that view distressed companies as an opportunity to expand.

Let’s take a look at each…

Serial Investors

These are the pros — the ones who have been around for a while and presumably know what they are doing. Generally speaking, they are of two types: private equity or hedge fund. 

The private equity investor looks to buy a distressed company, fix it, and then grow it, often with distressed investment opportunities.

For example, I spoke recently with an investor that made a bid on a nationwide operator of sports-focused summer camps. His plan involves taking a majority position, backing an experienced operator / founder, and buying up others in an industry filled with players that lack the financial muscle to survive. He intends to dig in, roll up his sleeves, and do some hard work.

In some cases, a private equity investor may buy a distressed business with the intent to repurpose its assets. For example, I advised a real estate investor that was considering making a bid in a bankruptcy auction for an auto parts manufacturer. His plan was to move production to China and then sell the business. His real objective was to bulldoze the factory and build condos in what had become a very desirable property. Yet another spin on this type of investment is buying brand names and then relaunching the brand.

The hedge fund investor, by contrast, wants to buy lots of financial positions in lots of distressed companies. He or she does not want to tie up their time fixing businesses. Rather, they want a good business with good management; one with plenty of upside, but that owes way more money than can realistically be paid back.

The hedge fund investor’s plan involves finding strong opportunities, buying a controlling stake in the “fulcrum security” (more about this concept below), and monitoring progress until the financial win occurs. 

Newbie Investors

Clearly, the two models described above are quite different. So, if you are a newbie distressed investor, figure out now which kind you intend to become: operator or passive investor. Then, get the help you need. 

If an operator, find people with experience in the industry in which you want to invest. If a passive investor, get good legal and financial help, particularly from those well-versed in creditor rights and the related financial analysis.

Businesses Operators Looking to Expand

The final category includes businesses that come to the table with industry experience and that are looking for opportunities to grow and expand beyond their current operation. 

For these businesses as well as investors that intend to operate, it is important to realize that buying a distressed business is very different, in several important ways, from “healthy company” transactions.

First, the target company is typically short on cash and there is rarely time for a robust due diligence process or for the buyer to arrange new financing. The funds must be in hand or existing credit lines must already be in place. 

Second, because there will be minimal (if any) funds left in the company after taking control of the assets, representations and warranties mean little, as there is nothing to back them up. De facto sale terms are as is/where is — “You get what I got and no more.”

Lastly, special care must be applied in how assets are taken control of, particularly if you intend to “operate” the assets. This is where legal counsel from someone well versed in restructuring and insolvency is an absolute necessity.

All that said, once you see the distressed opportunity, how best to proceed?

First, decide if you really need to buy the assets as a going concern. Will it be easier to just pirate customers, the sales force, key employees, etc.? Make this decision before signing any type of non-disclosure or confidentiality agreement.

Next, identify the “fulcrum security” or player. This refers to the liability on the company’s balance sheet that is partially, but not completely in the money. In other words, given what you think the value of the company is today, if the company gets those funds and starts paying creditors, secured lender first, etc., who doesn’t get paid in full, but does get something? That is the fulcrum creditor. 

Then, is the fulcrum creditor one or many? With just one fulcrum creditor (a junior secured lender, for example), that individual typically calls the shots on who buys the assets of the company and it makes sense to cut a deal with that creditor. If there are many fulcrum creditors (trade payables, for example), getting agreement will likely be problematic. Under these circumstances, work with the senior secured lender who likely wants to be paid and leave. Lawyers will take care of how to distribute the proceeds in a manner so that there are no claims against you, the buyer. 

Finally, look for key contracts you will want transferred. Is that feasible, and how much money will the other party demand from you to take on the contract? Can the contract even be assigned to you? Also, look for critical vendors that can’t be replaced, and that might insist on being paid by you for what the old company owes them. Anything that is patented is a good example of that.

A few final tips…

  • Always work with strong legal counsel, well versed in these matters. The legal means of buying distressed company assets in a way that will not get you sued by creditors is beyond the scope of this newsletter. But good legal advice is key in this regard.

  • Use a financial advisor that is experienced in insolvency and restructuring. They will help you go through the process faster and, likely, cheaper. Depending on the size of the target company and other factors, it may also make sense to retain an investment banker with distressed experience.

  • Look at your business strategy first. Are these markets, products, etc., you had already planned on entering? If you are an operator, don’t buy distressed assets solely because they are cheap.

  • If there is no clear fulcrum creditor or senior lender to work with, walk away. Time and money will likely be wasted if you don’t. In the real estate example I mentioned, there was a fight between two different secured creditors and the Pension Benefit Guaranty Corporation as to which creditor was the most senior. Eventually, my client finally listened to me and stopped trying to buy the company!

Overall, for those businesses and investors that survive the pandemic, there will be — and already are — distressed opportunities. Approach with eyes wide open, but do take a serious look.
Heard on the Street
Between the Pandemic and current political turbulence, it is easy to forget how much real progress in just about everything the United States has made since its founding. 

Donald J. Boudreaux, Professor of Economics and Co-Director of the Mercatus Center, both at George Mason University, succinctly summarizes real progress the United States has made over the years.

About Us
Goodrich & Associates is a management consulting firm. We specialize in restructuring and insolvency problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years' experience in this area.

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