Strategies vital for success of global acquisition deals

United States-based hedge and private equity funds rely on the stability of the laws of the US to make acquisitions of distressed companies, deleverage them and improve operations with the goal of selling them for multiples of the original purchase price.

Funds are willing to commit billions of investment dollars because the US Bankruptcy Code is a stable set of laws that allows participants to understand the risks and rewards.

While few barriers exist to buying US companies and their assets, there are only a handful of China-based funds that actively participate in the distressed market. One such fund is Sailing Innovation US Inc, a partially government-sponsored collaboration between Chinese investment firm Sailing Capital Overseas Investment Fund LP and Chinese conglomerate Sanpower Group. But there is no reason why more China-based funds cannot also participate.

Perhaps the most widely known strategy is a "363 sale", which authorizes a debtor to sell assets "free and clear" of all liens, claims and liabilities. This strategy was used by General Motors Co and Chrysler Group LLC to sell their businesses to the US government during the 2008 market collapse. The hallmark of a 363 sale is an open auction where any willing buyer can make a bid, usually measured against a so-called stalking horse bid from a purchaser preselected by the debtor. Because the stalking horse bidder has usually expended resources conducting due diligence, it will often enjoy certain court-approved bid protections.

But an open auction is not the optimal vehicle for the other bidders. Not only is it possible to pay too much for assets, the other bidders will need to pay their own expenses. The recent 363 sale of specialty retailer Brookstone Inc provides a relevant case study. Before filing for bankruptcy, Brookstone selected SBP Acquisition, an affiliate of Spencer Spirit, as the stalking horse based upon its offer valued at $146.3 million. Brookstone then filed for bankruptcy and commenced a 363 sale seeking approval of SBP as the stalking horse bidder and a $3.7 million breakup fee.

At the auction, China's Sailing Innovation appeared with a bid of $173.4 million in cash, new notes and assumed liabilities and was declared the winner after a single round of bidding. The bid was surprising since in January 2014, Brookstone's chairman stated that it was unlikely a sale would result in more than $100 million. Whether the purchase price is more than what Brookstone was worth will be determined by the market over time.

But SBP and Sailing had other strategies they could have considered to acquire control of Brookstone.

Funds may consider acquiring all or a controlling share of a target company's undersecured debt from existing holders at a discount to par. Upon the company's default of any of its debt obligations, the fund may negotiate with the company to convert its debt into new equity.

Once a deal is reached, the fund may require the company to install a new fiduciary to improve the company's business operations.

US debt securities usually require unanimous consent by the lenders to convert their debt to equity. If unanimous consent cannot be achieved, the Bankruptcy Code will bind nonconsenting holders to a plan of reorganization so long as one-half plus one in number and two-thirds in amount of those holding the same security vote in favor.

Funds may also consider buying a company's fully secured debt. Upon default, the fund may consider foreclosing on the assets outside of bankruptcy. Here, the fund is not taking control of the company's operations, just certain assets. Should the company seek bankruptcy protection prior to the consummation of the foreclosure, the bankruptcy code provides significant protection to secured creditors.

Buying debt backed by a pledge of a parent company's stock in operating companies is another option. Upon default, the lender may foreclose on the equity interests virtually immediately. Upon foreclosure, the lender will own the equity of the subsidiaries, but will not cleanse the company of any liabilities, including any subsidiary guarantee of parent obligations.

These are only a few examples of the strategies US funds consider when evaluating whether to make an acquisition of a distressed company. But before an acquisition is made, funds conduct their own analysis. Funds will also consult with legal counsel to analyze the governing debt documents and help identify other legal risks and hire independent financial advisers to test the fund's models and potentially provide court testimony.

The US distressed investing market is mature and those that participate need to understand and follow the rules of the game. Investors that do not can be penalized. But those who successfully navigate them, and use the proper acquisition structure, can reap rewards measured in multiples of their initial investment.

Ted Osborn is a partner at PricewaterhouseCoopers (Hong Kong) and Geoffrey Raicht is a partner at Proskauer Rose LLP (New York). The views do not necessarily reflect those of China Daily.

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