Restructuring / Distressed M&A Interview Questions & Answers (Part 2)

21.Normally in a sell-side M&A process, you always want to have multiple bidders to increase competition. Is there any reason they'd be especially important in a distressed sale?

Yes - in a distressed sale you have almost no negotiating leverage because you represent a company that's about to die. The only real way to improve price for your client is to have multiple bidders.

22.The 2 basic ways you can buy a company are through a stock purchase and an asset purchase. What's the difference, and what would a buyer in a distressed sale prefer? What about the seller?

In a stock purchase, you acquire 100% of a company's shares as well as all its assets and liabilities (on and off-balance sheet). In an asset purchase, you acquire only certain assets of a company and assume only certain liabilities - so you can pick and choose exactly what you're getting.

Companies typically use asset purchases for divestitures, distressed M&A, and smaller private companies; anything large, public, and healthy generally needs to be acquired via a stock purchase.

A buyer almost always prefers an asset purchase so it can avoid assumption of unknown liabilities (there are also tax advantages for the buyer).

A (distressed) seller almost always prefers a stock purchase so it can be rid of all its liabilities and because it gets taxed more heavily when selling assets vs. selling the entire business.

23.Sometimes a distressed sale does not end in a conventional stock/asset purchase -what are some other possible outcomes?

Other possible outcomes:

• Foreclosure (either official or unofficial)
• General assignment (faster alternative to bankruptcy)
• Section 363 asset sale (a faster, less risky version of a normal asset sale)
• Chapter 11 bankruptcy
• Chapter 7 bankruptcy

24.Normally M&A processes are kept confidential - is there any reason why a distressed company would want to announce the involvement of a banker in a sale process?

This happens even outside distressed sales - generally the company does it if they want more bids / want to increase competition and drive a higher purchase price.

25.Are shareholders likely to receive any compensation in a distressed sale or bankruptcy?

Technically, the answer is "it depends" but practically speaking most of the time the answer is "no."

If a company is truly distressed, the value of its debts and obligations most likely exceed the value of its assets - so equity investors rarely get much out of a bankruptcy or distressed sale, especially when it ends in liquidation.

26. Let's say a company wants to sell itself or simply restructure its obligations - why might it be forced into a Chapter 11 bankruptcy?

In a lot of cases, aggressive creditors force this to happen - if they won't agree to the restructuring of its obligations or they can't finalize a sale outside court, they might force a company into Chapter 11 by accelerating debt payments.

27.Recently, there has been news of distressed companies like GM "buying back" their debt for 50 cents on the dollar. What's the motivation for doing this and how does it work accounting-wise?

The motivation is simple: use excess balance sheet cash to buy back debt on-the-cheap and sharply reduce interest expense and obligations going forward. It works because the foregone interest on cash is lower than whatever interest rate they're paying on debt - so they reduce their net interest expense no matter what.

Many companies are faced with huge debt obligations that have declined significantly in value but which still have relatively high interest rates, so they're using the opportunity to rid themselves of excess cash and cancel out their existing debt.

Accounting-wise, it's simple: Balance Sheet cash goes down and debt on the Liabilities & Equity side goes down by the same amount to make it balance.

28.What kind of companies would most likely enact debt buy-backs?

Most likely over-levered companies - ones with too much debt - that were acquired by PE firms in leveraged buyouts during the boom years, and now face interest payments they have trouble meeting, along with excess cash.

29.Why might a creditor might have to take a loss on the debt it loaned to a distressed company?

This happens to lower-priority creditors all the time. Remember, secured creditors always come first and get first claim to all the proceeds from a sale or series of asset sales; if a creditor is lower on the totem pole, they only get what's left of the proceeds so they have to take a loss on their loans / obligations.

30.What is the end goal of a given financial restructuring?

A restructuring does not change the amount of debt outstanding in and of itself -instead, it changes the terms of the debt, such as interest payments, monthly/quarterly principal repayment requirements, and the covenants.

31.What's the difference between a Distressed M&A deal and a Restructuring deal?

"Restructuring" is one possible outcome of a Distressed M&A deal. A company can be "distressed" for many reasons, but the solution is not always to restructure its debt obligations - it might declare bankruptcy, it might liquidate and sell off its assets, or it might sell 100% of itself to another company.

"Restructuring" just refers to what happens when the distressed company in question decides it wants to change around its debt obligations so that it can better repay them in the future.

32.What's the difference between acquiring just the assets of a company and acquiring it on a "current liabilities assumed" basis?

When you acquire the assets of a distressed company, you get literally just the assets. But when you acquire the current liabilities as well, you need to make adjustments to account for the fact that a distressed company's working capital can be extremely skewed.

Specifically, "owed expense" line items like Accounts Payable and Accrued Expenses are often much higher than they would be for a healthy company, so you need to subtract the difference if you're assuming the current liabilities.

This results in a deduction to your valuation - so in most cases the valuation is lower if you're assuming current liabilities.

33.How could a decline in a company's share price cause it to go bankrupt?

Trick question. Remember, MARKET CAP DOES NOT EQUAL SHAREHOLDERS' EQUITY. You might be tempted to say something like, "Shareholders' equity falls!" but the share price of the company does not affect shareholders' equity, which is a book value.

What actually happens: as a result of the share price drop, customers, vendors, suppliers, and lenders would be more reluctant to do business with the distressed company - so its revenue might fall and its Accounts Payable and Accrued Expenses line items might climb to unhealthy levels.

All of that might cause the company to fail or require more capital, but the share price decline itself does not lead to bankruptcy.

In the case of Bear Stearns in 2008, overnight lenders lost confidence as a result of the sudden share price declines and it completely ran out of liquidity as a result - which is a big problem when your entire business depends on overnight lending.

34.What happens to Accounts Payable Days with a distressed company?

They rise and the average AP Days might go well beyond what's "normal" for the industry - this is because a distressed company has trouble paying its vendors and suppliers.

35.Let's say a distressed company wants to raise debt or equity to fix its financial problems rather than selling or declaring bankruptcy. Why might it not be able to do this?

•Debt: Sometimes if the company is too small or if investors don't believe it has a credible turnaround plan, they will simply refuse to lend it any sort of capital.

•Equity: Same as above, but worse - since equity investors have lower priority than debt investors. Plus, for a distressed company getting "enough" equity can mean selling 100% or near 100% of the company due to its depressed market cap.

36.Will the adjusted EBITDA of a distressed company be higher or lower than the value you would get from its financial statements?

In most cases it will be higher because you're adjusting for higher-than-normal salaries, one-time legal and restructuring charges, and more.

37.Would you use Levered Cash Flow for a distressed company in a DCF since it might be encumbered with debt?

No. In fact, with distressed companies it's really important to analyze cash flows on a debt-free basis precisely because they might have higher-than-normal debt expenses.

38.Let's say we're doing a Liquidation Valuation for a distressed company. Why can't we just use the Shareholders' Equity number for its value? Isn't that equal to Assets minus Liabilities?

In a Liquidation Valuation you need to adjust the values of the assets to reflect how much you could get if you sold them off separately. You might assume, for example, that you can only recover 50% of the book value of a company's inventory if you tried to sell it off separately.

Shareholders' Equity is equal to Assets minus Liabilities, but in a Liquidation Valuation we change the values of all the Assets so we can't just use the Shareholders' Equity number.

39.What kind of recovery can you expect for different assets in a Liquidation Valuation?

This varies A LOT by industry, company and the specific assets, but some rough guidelines:

• Cash: Probably close to 100% because it's the most liquid asset.
• Investments: Varies a lot by what they are and how liquid they are - you might get close to 100% for the ones closest to cash, but significantly less than that for equity investments in other companies.
• Accounts Receivable: Less than what you'd get for cash because many customers might just not "pay" a distressed company.
• Inventory: Less than Cash or AR because inventory is of little use to a different company.
• PP&E: Similar to cash for land and buildings, and less than that for equipment.
• Intangible Assets: 0%. No one will pay you anything for Goodwill or the value of a brand name - or if they will, it's near-impossible to quantify.

40.How would an LBO model for a distressed company be different?

The purpose of an LBO model here is not to determine the private equity firm's IRR, but rather to figure out how quickly the company can pay off its debt obligations as well as what kind of IRR any new debt/equity investors can expect.

Other than that, it's not much different from the "standard" LBO model - the mechanics are the same, but you have different kinds of debt (e.g. Debtor-in-Possession), possibly more tranches, and the returns will probably be lower because it's a distressed company, though occasionally "bargain" deals can turn out to be very profitable.

One structural difference is that a distressed company LBO is more likely to take the form of an asset purchase rather than a stock purchase.