Escaping the equity black hole

With valuations remaining down due to a combination of struggling earnings, reduced multiples, a lack of longer term confidence and poor credit availability, the pricing of available assets remains under pressure. For business owners with no urgent need to sell, and the resources to ride out the continuing economic gloom, this is of little concern.

However, there are still plenty of potential sellers out there who would happily consider a transaction if the terms are right. From owner/managers who are looking to retire or move on and private equity owners who are looking to cut their losses or return cash to their investors, to larger businesses that are looking to divest of loss-making or non-core divisions in order to support the profitable side of their operations. Or the many banks that have taken control of customers through debt-for-equity transactions and who now want to get the asset off their books or are simply interested in seeing their outstanding debt repaid.

A key concern for many business owners in this situation is what is in it for the shareholders. With many businesses still struggling under the burden of excessive debt as a consequence of deals done at the height of the mid-noughties credit boom, there can be little, if any, value in the equity. Even for those businesses that have already seen their existing facilities restructured by the banks, any "right-sizing" of debt is unlikely to have gifted value to the shareholders and with the continued economic uncertainty across the eurozone and beyond, the recovery for such businesses has often been much slower than anticipated at the time the deal was struck.

Obviously, as a minimum, and before considering the interests of the shareholders, there must be sufficient cash in the deal to pay down the secured lenders to a degree with which they are happy and which will enable them to agree to release their security.

However, the lack of additional value over and above this level causes its own issues. Where is the incentive for shareholders to part with their investment? What is the recourse for buyers following a successful warranty claim? For the right deal, and with the right motivations, none of these issues need be fatal if there is a willingness to adapt the transaction terms from those typically seen in more buoyant market conditions and adopt more creative alternatives.

Vendor funding
Vendor funding of deals is nothing new, and arises in a variety of guises. However, there have been several examples in the market over the last year or so of the reverse premium or "dowry sale". This is a transaction whereby the seller is willing to invest cash in the purchaser to fund a known liability in the target or simply to provide positive working capital into the business on day one.

From the seller's perspective, this caps out its exposure to the loss-making element and provides certainty to any on-going exposure to the risk within its retained operations. For the buyer, this effectively provides a sweetener to take on an otherwise unattractive business. Earlier this year, Kesa Electronics made a £50m investment in the purchaser on pure equity terms in connection with its disposal of the loss-making Comet business.

More commonly, deals that provide for some form of deferred or conditional consideration can be attractive to buyers who are uncertain of the future earnings profile of the business, or who want to incentivise a management team to grow the business quickly over the short to medium term. This is unlikely to be an attractive option to all selling shareholders. For example, private equity houses often prefer price certainty and a clean break so they can repatriate funds to their investors. However, again, in the right circumstances this kind of price structuring may help to get a deal over the line when otherwise immediate pricing expectations are too rich for the buyer.

Management incentives
Whilst often not given the priority it deserves as banks and sponsors thrash out terms with which they are happy, getting management on board with any proposed deal can often be key to the success of the transaction. With many management teams having seen the value in their existing investment fall seriously under water, there can often be little financial incentive for them give up their equity in circumstances where the other investors do not have an effective drag.

However, by ensuring that any equity deal for management going forward is an attractive proposition, this can provide the best of all worlds for a buyer: they get management to buy in to the current transaction without having to find more cash on day one and they get a management team that is incentivised to grow the business to the benefit of all shareholders.

Warranty insurance
In any deal where there is little, if any, value in the equity, a buyer is always going to have concerns about recoverability under any warranties that may be given by the seller in the acquisition documents. This is because the maximum amount that is generally recoverable will be the amount paid for the shares. However, the advent of "ground up" warranty and indemnity insurance policies helps to bridge the gap and provides financial recourse for any successful warranty or indemnity claim where there is no or only minimal value in the equity.

With such policies often being priced in the market at around 3-5% of the insured amount and with a number of experienced and reactive providers out there, they provide an affordable way to alleviate the risk of entering into a deal that otherwise provides limited recourse to the sale proceeds without the overriding deal timetable being affected adversely.

Breaking the mould
Try getting any financial investor to give warranties on a sale and you will be wasting your breath. The market is firmly settled and there is common acceptance that this will not happen. So what about getting the lender to bear the risk of recovery under the warranties? Whilst you may expect hell to freeze over before such a deal could be struck, that is not necessarily the case.

Recent experience saw a bank-controlled holding company looking to dispose of its principal trading business. The buyer's valuation for the business came in just below the secured debt amount. However, the bank, as both senior lender and principal shareholder following a debt-for-equity restructuring, was prepared to release its security and allow the business to be sold on terms where only 95% of its outstanding debt was repaid at completion, and which allowed a small amount of value to go to the other equity holders in order to get their buy-in to the deal (with the remainder being placed into escrow by the seller to provide recourse for any successful warranty claims by the buyer).

However, rather than writing off the remainder of its debt, the bank allowed the target to transfer the obligation to repay the remaining 5% of the debt amount to the holding company and simultaneously took security over any receipt by that company out of the escrow in due course – such that any remaining funds were not distributed among the shareholders pro rata, but repaid to the bank. A pragmatic solution, which the circumstances of the deal allowed and where a transaction might otherwise have not been possible.

It can be easy to allow the sometimes overwhelming pull of historic deal drivers to limit your options. However, with a bit of creativity, and advisers who are willing to move beyond the safety of their precedents, your potential deal does not need to disappear into the black hole of aborted transactions.

Graham Cross is managing associate at Addleshaw Goddard.

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