Existing economic fallout spurred on by the COVID-19 pandemic, Russia’s February 2022 invasion of Ukraine and the resulting sanctions, as well as looming market volatility in the United States have further exacerbated existing financial complications on a global scale. Many entities are moving to capitalize on some of the world’s more vulnerable markets by purchasing real estate and engaging in mergers and acquisitions.
While the opportunities created on such a global scale may be unprecedented, the pitfalls that can cause extensive negative impacts for acquirers are nothing new. It can be easy for companies to be more careless when faced with such low prices and great opportunities, but it’s essential to not let the circumstances blind companies to potential risks.
Organizations must understand the volume and degree of risks present in transactions that may include distressed assets. Let’s explore the potential risks that may arise when acquiring distressed assets, the dos and don’ts of distressed asset due diligence, and the resources and technology available to assist informed asset investigations.
Potential Risks of Distressed Asset Acquisitions
There are extensive risks that can come about when managing the acquisition of distressed assets. Here are some important questions to consider when pursuing a transaction that requires a distressed asset investigation.
Whom can I trust?
Parties in charge of the sale, insolvency practitioners, for example, may not educate themselves about past performance of the asset in the effort to make a quick sale and avoid liability, and therefore are not able to accurately inform prospective buyers of potential risks. Furthermore, where the seller is potentially facing liquidation, they won’t be around to honor any indemnities or other guarantees upon which a buyer might otherwise rely. It’s important to go far beyond the information provided by the seller and conduct deeper distressed asset investigations of your own which may reveal financial and other risks.
What is included in the sale?
A common pitfall happens when companies move forward with distressed asset acquisitions without fully understanding everything that comes with the sale. This can include intellectual property, such as trademarks, patents, and client contracts, as well as physical property, such as premises, machinery, and vehicles. Often, separate legal or physical transactions that involve other parties are required which can slow or even halt the acquisition process. Separate ownership claims (particularly in the case of intellectual property), liens or other encumbrances (including mechanics liens or other claims arising from unsettled debts related to the assets), other unidentified creditors that might have claims to the assets, and other potential impairments should be sought out. Particularly when acquiring assets outside of the United States, a buyer should be very aware of how such claims can form under local law, and conduct diligence as to whether any such claims might exist.
What is fair value?
While fire-sale prices of assets can be attractive, an acquirer can face obstacles down the line if the acquisition is not completed at fair value. When a company purchases distressed assets at a significant discount, if a “transaction at under value” according to the Insolvency Act, depending on the regional jurisdiction, future challenges can be brought against the buyer for insolvency and other debt-related scenarios. These suits can lead to asset sales being unwound, and assets “clawed back.” Even if the buyer prevails and retains the asset, litigation costs can add to the price of the transaction and thus the full cost of the asset. Distressed asset buyers might therefore conduct additional diligence into the nature and extent of the distress itself, as they are buying the assets assuming that—in their hands, with enhanced financial, operational, or other capabilities provided by the buyer—the assets will be more valuable. This assumption hinges on understanding the full extent of the distress—who or what may have caused it, how it has developed over time, and ameliorative attempts that may have failed.
Are the client and other key contracts sound?
When client contracts are included in the sale of distressed assets, dangers can arise regarding the status of contracts and relationships with the clients. In many cases, without performing proper due diligence, including litigation checks at the point of sale, buyers will find out far too late that some client contracts have actually been voided due to nonperformance, insolvency, or other operating covenants. If voided contracts are acquired, they are no longer enforceable for work and payment; in order to continue legally sound work with the client, new contracts must be drawn, which can result in unforeseen costs, as well as less favorable terms compared to original contracts. Similar concerns can arise with employment contracts for employees the buyer hopes to retain, supplier contracts, equipment maintenance, and other asset-critical agreements. Consideration should also be given to any operational entanglements between the seller and the asset that might need to be severed, such as services provided by, or know-how housed within, the seller that is required to operate or maintain the value of the assets being acquired.
Dos and Don’ts of Distressed Asset Due Diligence
While there are numerous steps to take and avoid, we’ve put together some of the most essential dos and don’ts when performing distressed asset investigations.
Asset Identification
Do identify all assets that are included in the purchase. Due diligence of any distressed asset purchases should include the discovery of all items that are included, as well as their physical whereabouts, ownership, and any further transactions that need to be completed to finalize the purchase. Some historical review of the same features can discover other potential ownership issues or encumbrances that may have preceded, but could continue to impact the asset currently—for example, potential intellectual property claims by colleagues of an inventor or founder. Failure to understand these elements can slow the purchase process and even result in the acquisition of distressed assets that are not financially or legally viable. For example, if machinery is included in the acquisition, but its ownership is listed under a different party, completion of the transaction may include further negotiations, as well as the physical transfer of the equipment, which can create unexpected costs and liability.
Fair value payment
Don’t trust that simply because prices everywhere are low that property and assets are being properly valued. Companies that fall into this trap may find themselves completing a purchase considered a “transaction at under value,” leaving them open to future legal and financial challenges. In the UK, for example, a transaction can be deemed “an undervalue” under select circumstances, and any transaction that takes place within two years of insolvency will be open to challenge. In order to ensure that you are paying fair value for the acquisition, conduct thorough distressed asset due diligence of past performance and cases of insolvency.
Company relationships
Do investigate the members of the management team, as well as the company as a whole. Unidentified crimes and other unethical actions of executives, even if they were committed before the acquisition, can create risks for the new parent company. For example, if a former C-level executive was involved in financial crime prior to being acquired, the new parent company can still experience residual legal and reputational damage. Thorough due diligence of the entity as a whole can bring to light any potential risks, activities, or patterns of concern for the buyer to address in advance of completing the acquisition.
Streamlining communication between executives on both sides of the transaction is also essential to a smooth acquisition. Particularly when there are language barriers, it’s crucial to apply sensitivity and understanding during critical conversations to clarify exact expectations for distressed asset acquisitions.
Geopolitical significance
Do be aware of geopolitical significance relevant to your transaction. In the midst of global upheaval, especially concerning the Russian invasion of Ukraine, global political understanding and appreciation are essential to a smooth and respectful acquisition. For example, in some jurisdictions, such as China, Indonesia, and Russia, where political interference and disregard for unique local laws can raise red flags and impact the steps of the transaction. Countries have frequently issued sanctions against Russia, as recently as May 2022; this has resulted in the UK cutting off connections with All-Russia State Television and Radio Broadcasting, as well as one Russian steel manufacturing and mining company – the latter accounts for 28 percent of Russia’s railway wheels and 97 percent of its rail tracks. Is political risk insurance in place for the asset to be purchased? Can such insurance be acquired? As such sanctions present new risks all over the world, it’s essential that organizations scrutinize geopolitical events for how they may impact distressed asset acquisitions and investigations. A target company’s management and operational history should also be evaluated for potential bribery, kickbacks, engagement with politically exposed persons, or other activity that could subject the buyer to inherited FCPA liability.
Technology and resources
Don’t try to do it all yourself. Distressed asset due diligence technology and resources are available to help conduct extensive and thorough asset investigations. For example, the team and solutions at IntegrityRisk offer due diligence for all areas relevant to distressed asset acquisitions, including:
- Executive background checks for managing executives and ownership
- Third-party due diligence for verifying supply chain partner compliance
- Beneficial ownership for establishing company and asset ownership and fund legitimacy
- Environmental, social, and governance (ESG) for performing environmental, sustainability, and human rights due diligence
- Full-spectrum due diligence to identify and remediate potential risks in all areas
- Global asset searches and investigative activity to quickly quantify the assets to be acquired
- Geopolitical risk intelligence and assessment to discover where the company primarily operate and what risks it poses to any acquirer or investor
Another important benefit to integrating a comprehensive due diligence solution is proactivity. In some cases, deals may be under very short time constraints, which means that by the time companies begin distressed asset due diligence, it may be too late to establish proper safeguards and processes. By incorporating due diligence software into your systems early on, all of the protocols to successfully assess and manage acquisition risks will be in place.
Advanced Distressed Asset Due Diligence with IntegrityRisk
While the low prices of global assets may be tempting, it’s important for companies to not fall into the trap of nonviable deals. By conducting advanced distressed asset investigations into potential acquisitions, companies can eliminate financial insecurities and liabilities before completing any official transactions. To learn more about global distressed asset due diligence with IntegrityRisk, contact us today.