Investing in distressed businesses – opportunities in the new environment


Our team: Jeremy Whiteson


Despite suffering the worst recession since the Second World War, rates of corporate insolvency in England and Wales are low by historical standards. Looking back over the last 25 years, the rate of liquidations as a percentage of active registered companies peaked at 2.6% in 1992, and stood at an average rate of 1.2% over the whole period. In 2010, however, the rate stood at 0.7%. Why is this and what are the implications for businesses?

Explaining the paradox

It is true that formal insolvencies tend to peak when an economy is recovering from recession – a time when many businesses are suffering the strain of an increase in trade, and prices of realisable assets are on the rise. It is also true that low interest rates mean that many weak companies can survive for longer. However, those factors do not explain the extent of the reduction in corporate insolvencies. This reflects deeper structural changes in the recent downturn in the way that distressed businesses are dealt with in England.

One major change is the reduction in power of banks and HMRC, being two of the major catalysts for the start of corporate insolvency procedures.

The power of banks has been eroded by political pressure after what was seen as their gung-ho behaviour in the recession of the early 90s. This erosion of power was then formalised in amendments to the Insolvency Act 1986 (the principal statute governing corporate insolvencies) which increased the level of influence of the debtor company and unsecured creditors. These changes brought a gradual decline in the liquidation rate. The banking crisis of 2008-9 (and onwards), which has led to large swathes of the banking system falling into public hands, may have further restricted banks’ insolvency actions for fear of provoking public outrage and additional legal restrictions on their powers.

Similarly, HMRC has increased the availability of "time to pay" and other schemes designed to improve the position for distressed businesses.

Other structural changes include the increasing cost of the insolvency process and the lack of funding (largely due, again, to the weakened position of banks) and, perhaps as a result of this, poor asset values being achieved on insolvency realisation.

What happens to distressed businesses?

As a result of these trends, many troubled businesses are left to limp forward in a zombie-like state. Some may see this as a cause for celebration and a reflection of sensible policies which avoid the trauma of business collapse. However, it also stores up problems for the future.

Problems with zombie companies

Many businesses are left undercapitalised with little prospect of growth, development or earnings for stakeholders in the foreseeable future. They are vulnerable to a rise in interest rates or an increase in trade which may finally blow them over. In the interim, the position of creditors who innocently extend credit to the business may be worsened and directors may leave themselves exposed to the risk of personal liability for wrongful trading or breach of other legal duties.

The opportunities with zombie companies

However, the situation is not entirely bleak. Many of these businesses have valuable assets or good business prospects if capital structures are reorganised or business plans refined.

Landlords, trade and other creditors, accustomed to taking a passive stance while banks and HMRC drive an insolvency process forward, can now take a more active stance. Insolvency is a competitive process where, by definition, there are insufficient assets to satisfy all debts. Choosing and driving forward a procedure of a creditors’ choice may significantly improve the outcome for them.

From the perspective of the distressed business, they too may benefit from the passive approach of key creditors and allow them to initiate constructive solutions.

Investors, either alone or with incumbent management, may see an opportunity to invest in some fundamentally sound businesses in need of an injection of additional funding.

The techniques

There is a range of structures for rescuing distressed businesses, depending upon the extent of the distress, the nature of the assets and the legal position of existing creditors (and in particular whether they have security).

Pre-pack administrations (where the purchase agreement is negotiated before the administrator is appointed and completed immediately on his appointment) are used where the rescue involves some but not all of a business’s assets, or its debts have become so high that not all can be borne by the business going forward, even in a restructured state. These have become increasingly common over recent years, despite additional regulation with the introduction of the SIP 16 disclosure regime. Opposition has been voiced and lobbyists have demanded legal restrictions. However, for the moment, they remain a popular restructuring tool.

Voluntary arrangements allow a debtor to negotiate a rescheduling or compromise of debts with creditors. Those arrangements bind all creditors, once approved by those together holding not less than 75% of debts by value who vote on the proposal. These have been popular where businesses wish to minimise damage to reputation and trading links, and where a positive vote can be secured. They have been used regularly for retail groups with multiple landlords unable to negotiate appropriate compromises with each landlord individually, and for professional football clubs.

In simpler cases, it may be possible to renegotiate the position with key creditors outside of a formal insolvency process. Where negotiations are being conducted with one class of creditor (for instance, banks of a multi-banked debtor), it may be possible to agree a standstill to allow a breathing space for renegotiation.

In less distressed circumstances, where all creditors can be paid in full, an accelerated M&A share sale or an injection of new share capital, debt or convertible debt securities into an existing corporate structure may be sufficient.

The funding market

The success of these strategies often depends on a stronger funding market. A number of specialist funds have been launched and, as other opportunities dry up, an increasing number of investors are drawn to the higher returns which these opportunities can generate. The funds committed to this market so far are insufficient to assist the majority of businesses, particularly in businesses where there are few easily realisable assets in the business which the funder can fall back on if the planned restructuring fails.

Conversely, property heavy trading business such as football clubs, hotels or nursing homes may not meet the criteria of many distressed investors. It is hoped that private equity and other investors chasing higher returns will increase commitment to the distressed business market for the benefit of debtors, creditors, investors and the economy as a whole, and make 2012 the year when distressed investment funds reach the mainstream.

Jeremy Whiteson, Partner, Fladgate LLP (jwhiteson@fladgate.com)

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