How to invest in the recession
While the recession will undoubtedly hurt a good many people, those (albeit relatively few) private investors and buyers of businesses who have ready cash to invest stand to make handsome profits as they take advantage of increased opportunities to buy 'undervalued' businesses.
For them, choices as to which investment to make, how to make that investment, and timing will be key. Of these three key decisions, the 'how' requires closest professional support, and this article considers some of the issues shrewd investors should consider.
Buying an insolvent business is very different from buying a solvent one
- Insolvent and unprofitable businesses often have significant hidden costs that can come back, often several years later, to haunt the buyer. The list of such potential costs is long, but typically includes unrecorded customer disputes; underutilised assets to which excessive liabilities are attached; unprofitable products or services where there are significant discontinuation costs; unrecognised tax liabilities, such as on misreported director drawings; and contingent exposure under property leases. The full list goes on and on!
- Investors are generally unable to call on indemnities for such costs from the owners or management of the business or any insolvency practitioner dealing with the company.
- Restoring a business to profitability often has significant cost implications. If it didn't, the current owners of the business would probably have already done it.
This means that buyers of, or investors in, insolvent businesses should:
Assess the level of risk in their investment
It is essential that a thorough due diligence is done, whichever acquisition route is followed - Investors truly have to fully understand the business, not just the potential for greater upsides but also the potential for significant downsides. Investors should not rely on assurances or warranties given by the directors or owners of the business - it is in their interests to say what they think the investor wants to hear in order to get the deal through. In practice directors almost always understate the issues investors may have with the business.
Make sure that the risk involved is reflected in the price paid and in the way that the purchase is structured
Investors should always allow themselves some considerable margin for error - in practice nothing works out as well as they would hope when it comes to buying an underperforming business. As the issue of of the structure of the deal is so important, the remainder of this article will focus on some of the key issues we see time and time again.
Structure of the investment
Ask yourself these questions:
1. Should I be buying the shares in the company or the business and assets?
There is nothing to stop investors buying the shares of an insolvent company, the investor will simply have to restore it to solvency by pumping more cash in, typically by increasing the share capital. However the main drawback to any such 'share deal' is that not only does the investor take on the known insolvent position of the business and thus all of its recorded debts, they also take on any unrecorded and unascertained debts. At the time of the deal most investors simply have no real idea what hidden liabilities may or may not lie in the business.
If a business and asset purchase is the route to be taken, the investor takes on only those liabilities that they agree to take on or by law have to take on. It is not unusual for a purchaser to take on debts owed to key suppliers in order to maintain important trading relationships. Other liabilities, such as certain employee liabilities under TUPE, cannot be avoided by law: the investor has to take them on. Such a 'business and asset deal' can give the investor more certainty as to what they are taking on than a share deal - but this is no reason to limit the due diligence exercise, investors should still search out potential liabilities they may be forced to take on at a later date for commercial if not legal reasons.
There can sometimes be advantages to buying the company's shares. For example there is a much easier transition to the new management - all pre-existing contracts, such as with suppliers, customers, finance companies, etc remain in place. Yet again, investors should review all such contracts as part of their due diligence, as some may contain termination provisions, or require pre-existing guarantees to be replaced should there be a change of ownership. Again, it is a case of the investor understanding exactly what they are taking on.
Serial investors often have a model route for buying into businesses. These models do not always fit the specific circumstances of the target business: it is important that both sides recognise that fit is important.
2. Do I really want all of the business?
Often purchasers want to cherry pick, taking the best bits of the business while leaving someone else, either the existing management or an insolvency practitioner, to clear up the parts they do not want.
There are several issues here. Leaving the clearing up of the unwanted remnants of the business can be a diversion of precious management time post acquisition. Management have difficulty valuing the 'best bits' and often wish to distance themselves from the sale process in order to avoid any accusations of having somehow benefited unfairly from the sale - management may prefer the deal to be completed by an insolvency practitioner because he, unlike the directors, has no long term interest in the outcome, and he will, in employing his own valuer to value the business, be able better to explain the rationale for the deal to suppliers and other creditors. Completing a sale through an insolvency practitioner can not only protect the directors from criticism that in some way they failed to comply with their duties, including those under the Insolvency Act 1986 and Companies Act 2006, but can also simplify the overall scheme. And, as you will see later on in this article, it can also save the investor money.
3. Should I defer some or all of the purchase consideration?
Deferring part of the price paid, particularly if the sum is dependent on trading results achieved post acquisition, will reduces investors' risk. As typically vendors look to maximise what they receive in certain cash on day one, the vendor's and purchaser's preferred outcomes can be poles apart.
Another option is to introduce cash into the business on a secured basis, rather than as share capital or unsecured loan. There are several implications of this should the company go into formal insolvency sometime later on: make sure that you discuss your options with the appropriate professionals beforehand.
If the business is insolvent and in need of a cash injection, the investor is often helping the vendor 'avoid' potential exposure to the bank under personal guarantees. Most investors like to see some input from the vendor post acquisition if only in making introductions to customers and suppliers. Under these circumstances, it is not unreasonable for you to defer some, if not much, of the purchase price as arguably the shares have little or no value at the time when you release your cash and deferring payment will secure the vendor's cooperation.
4. Have I explored the tax consequences?
If an investor buys the shares in the company and it has tax losses, the losses can be used going forward, against profits of the same business. If the assets are bought instead, the benefit of such tax losses are often lost.
Take advice from a tax specialist as this is very much a simplification of a much more complicated situation.
5. What are the true costs of this purchase?
Putting the company into a formal insolvency process and buying the business and assets from an insolvency practitioner can enable potential investors to reduce the working capital requirement of the business and thus the amount of cash they need to invest. In the right circumstances a 'Pre-pack', where the insolvency practitioner completes a sale of the business and assets immediately after his appointment, may be the best way to put the business on a soundest possible footing going forward, but here too there are further issues, with pre-packs coming under ever greater scrutiny.
Stop, think and plan
In summary, shrewd investors considering buying an underperforming or insolvent business, will stop, think, and then re-assess exactly what they intend doing and how before committing. That way they will maximise the profits from, and reduce their risk on, the increasing number of opportunities they will surely get as the Recession bites deeper.
Date: 23rd January, 2009
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