How to profit from buying distressed businesses

Now that the "easy-credit" party is well and truly over and businesses are facing uncertainty in the face of a weak UK economy, there will likely be extraordinary opportunities for entrepreneurs to buy distressed businesses.

Before venturing further, it is necessary to understand exactly what a distressed business is.  The Insolvency Act 1986 (Section 123) sets out two primary forms of validation.  The cashflow test;  Where the business is unable to pay debts as they fall due; and the balance sheet test. The value of the business? assets is less than its liabilities, taking into account its contingent liabilities and prospective liabilities. Obviously the degree of seriousness determines whether the business is liquidated or put into administration or receivership.

So why buy a distressed business?

Only buy a struggling business if you understand exactly why the business is currently in trouble, you know how to turn it around, and you have an exit strategy.
The one important myth to dispel is that the purchase of a troubled business is a bargain.  The old adage that "if it looks too good to be true, it usually is" applies here.
Print film in a digital world?  Many industries have a lifecycle that ultimately come to an end.  If the product or service is no longer required at a level of need that enables you and your competitors to make a reasonable profit, why take on that struggling business and try to beat the odds?

Profitable investing in a distressed company is no different than investing in other types of business. It requires selecting a business, that once stabilised, has a demonstrable demand for its product or service going forward, for at least long enough to maximise your return on investment prior to or at your intended exit. 

So you must do your research.  Why is the business in trouble?  Careful due diligence is absolutely critical in connection with a distressed business due to, amongst other things, the likelihood of limited or complete lack of recourse once the business has been bought. 

So here are the important questions to ask:

Is the business overburdened with debt?
Are there any significant liabilities such as an adverse judgement or product liability claim?
Are any tax losses available?
Has the business lost key management?
Are the company's problems merely due to poor delivery or execution?

The ability to maintain the value of contracts going forward is essential.  There may be restrictions on assigning contracts. Insolvency status may invalidate them and previous non-performance of contracts may incur penalties. 

One of the main reasons that entrepreneurs buy businesses is the belief that they will be able to run the business better.  So a buyer needs to be sure that they have what it takes to achieve this.  The business may have been run poorly only because management time was taken up by a problem in the recent past so the current management are not incompetent, just distracted. 

Of course, when buying a distressed business, "time is of the essence", so it is important that you have a full team assembled so that you can go in and get all the information that is required quickly.

An entrepreneur has two possible methods of buying distressed businesses: either he or she can buy it to prevent it going officially insolvent, or else wait until the business is declared insolvent and buy it from the insolvency practitioner.  There are advantages and disadvantages of both methods.  We published an article on how to buy a business out of insolvency in the  'September 2007' edition, which you can access online.  Here we will look at more general aspects of buying a troubled business.

How to find a distressed business.

A proportion of businesses up for sale are in some form of stress, as financial problems are often the catalyst that prompts the management to seek a sale.  In addition to the listings here, you may consider contacting businesses via a trade association membership list, appropriate when a whole industry is in trouble i.e. estate agencies. Specialist intermediaries are particularly useful if they also have considerable turnaround expertise.  If you are known to them, you will usually be treated as an important buyer prospect, particularly if you have previously demonstrated the ability to act decisively and close a transaction in an efficient and timely manner.

Investors should be prepared to sift through many bad opportunities, and also accept that, for the good ones, there may well be a competitive bidding environment.  If this happens, what, then, is the right price to bid?  The "value" of a distressed company is often difficult to ascertain. The right price is going to be different for every bidder, because no two bidders:

- plan to run the business in the same way
- will effect a turnaround and stabilize the business in the same manner
- know  how the business will integrate with the other businesses they hold.
- have the same cost of capital structure.
- have the same growth plans.
- share the same exit strategy.

In the current climate, where lending is drying up, the cost of capital is a key factor.  Entrepreneurs who have large amounts of cash and do not wish to be highly leveraged are at a definite advantage at the moment.

So buying a distressed business can often have distinct advantages over alternatives. Start-ups always require more investment, in time and money, than is typically budgeted for. Moreover, there is often little or no track record of acceptability of the product or service.  Profitable businesses have few reasons to sell other than to generate fast cash in excess of the net present value of the anticipated stream of the future cash. At the moment there are many owners of profitable businesses who are holding out for stretched multiples.  So entrepreneurs who are keen to rapidly expand their portfolio of businesses interests would be advised to take a serious look at distressed businesses. 

Another opportunity that cash rich entrepreneurs can exploit is the possibility that businesses might be divesting assets and divisions in order to improve their liquidity.  According to Michael Garstka, a partner at Bain & Company, asset values are lower than they have been for a long time. "The downturn provides opportunities not just to acquire direct competitors, but also potentially key parts of your distribution networks or even choke points in your industry's supplier chain."

It is generally true that it is advantageous for the acquirer of a private company to purchase the assets not equity of the business for two main reasons - the tax advantages; and the fact that you will not be inheriting all the liabilities of the business.  However, some assets still have liabilities attached to them such as contaminated land clean-up costs.  Also, a purchaser may find him/herself exposed to intellectual property disputes on products.  The entrepreneur will no doubt be under pressure from the seller to buy the entire company, but each situation is different and it is down to smart negotiation and good advice on structuring any deal. 

In conclusion, if you have got what it takes to turn around a failing business, have cash in the bank or the ability to raise finance on good terms, then you are in a winning position.  Cash is king. There are more failing businesses to choose from and fewer serious buyers in the market.  This all leads to the prospect of rich pickings for a smart investor who is in a strong position in the market when the economy eventually picks up.