As a direct business investor in the private equity, alternative lending or even intermediary spaces, opportunities will undoubtedly be lost when the debt schedule outweighs the value of the target.
Traditionally, opportunities in distress would have to meet additionally high thresholds in your private valuation or lending model because of the costs and inefficiencies involved with resolving outstanding obligations.
Deal flow is often impacted for many reasons, including:
- The inefficiencies of attempting global resolutions are prohibitive.
- LOIs are often discarded by distressed sellers who are not incentivized.
- Lending opportunities may have attractive AR and assets, but none available to collateralize.
In this article, you’ll learn how “distressed” can become “pristine,” through a single, streamlined transaction that divorces core enterprise value from debt. The debt is eliminated through liquidation of business assets into pristine, debt-free entities in 45-60 days. By result, you can re-evaluate opportunities regardless of the debt schedule.
For the direct business investor, deals will be streamlined and scaled because:
- The need for complex short sales or ABCs is eliminated.
- The goals of a 363 sale can be met far more quickly and without risk.
- Acquisitions can be entered at the attractive cost of the assets, not the note.
- Lenders can assume first position without regard to subordinate secured creditors.
- All parties, including sellers, purchasers and secured creditors are incentivized.
Understanding Business Debt Elimination as a Path to Preserve Value
At first, “eliminating business debt” might seem to imply a business that is simply not satisfying its creditors.
It does not.
Instead, it refers to what must be done ethically and rationally when a company no longer has the resources to reasonably pay what was originally contracted.
In the context of insolvency and default, business debt elimination can be understood as a resulting benefit from an alternative form of business asset liquidation that preserves underlying business value, operations and jobs, when repayment is no longer an option.
All direct business investors have one thing in common: they seek to extract and leverage value. The traditional methods of dealing with business debt have made it difficult or prohibitive to do so in too many instances.
“I’ve come across three companies so far this year where there was so much leverage there was nothing left for the owner to walk away with…and no way to sell the company. I think (debt elimination) is a huge opportunity. I really do.”
Mike Kendall, Kendall Capital Group
Business owners are generally ethical and honorable people who are compelled to meet their obligations. When they can, they most often do. However, the reality is that every year, approximately 180,000 entrepreneurs file bankruptcy, and many thousands more fail to meet their obligations and face insolvency.
The vast majority of those businesses that collapse under the burden of unsupportable debt (and are liquidated in the bankruptcy system) still have underlying core operational value that otherwise could have and should have been preserved—along with the associated jobs and economic activity.
“There are still some fundamentally sound businesses that have had a series of mistakes or bad circumstances…and they have employees…and so if you care about the employees, this is a way to reposition those companies to perpetuate those jobs.”
John Howe, Business Transition Strategies, NHBS
Even more irrationally, approximately 75% of Chapter 11 filings fail to reach a successful discharge. The inefficiencies and costs of multiple objections and subsequent legal proceedings make it almost impossible for the owner or CEO to complete the bankruptcy plan successfully. The double bind created for insolvent owners positions them between the trap of stacking new debt on the one hand, and on the other, a bankruptcy system which fails to preserve owners or businesses the vast majority of the time.
In the private equity space, many LOIs will go unreturned because the acquisition cannot offer a successful path to exit. Therefore, a seller left facing a string of personal guaranties has no incentive to sell their business before filing.
Preserving Value, Extracting Value
Regardless of the circumstances that brought about the distress, the core business value remains. With so many thousands of companies being liquidated, all of that underlying business value is being needlessly destroyed on a massive scale, along with the opportunity and economic activity associated with it.
This destruction is a legacy result of a failed bankruptcy system—and of the irrational means of liquidating business assets that stems from it. It represents a deep and hidden tragedy in our economy. But it doesn’t have to.
“We see distressed companies a lot…that are underwater with more debt than they have value. Often, they get liquidated. I just have to walk away. If we eliminate that debt, it would be a tremendous benefit to those companies and everyone involved.”
Greg Carpenter, M&A Business Advisors
Business debt elimination is both a process and result of a far more rational means of liquidating business assets. It preserves the core value of a business in distress or default while safeguarding the continuity of operations. It also means that value can be extracted, transferred or collateralized—thus, all parties can benefit.
It does not mean “not paying what the business owes when it can afford to pay,” it means “preserving the underlying value of a business when it cannot afford to pay.”
Reorganization Creates a Win-Win for all Parties
So, what is business debt elimination? In short, its an alternate means of liquidating business assets at the point of failure—when debt has become unsupportable—and when the value of the operation is outweighed by the debt on the balance sheet. Instead of liquidating assets at auction (and thereby destroying the core value of the business), assets can be liquidated into a purchasing entity.
To understand this process requires an understanding of Article 9 of the Uniform Commercial Code. This provision is designed for the protection of first position secured creditors—in essence, the banks. At the point of insolvency or default, it allows the senior creditor to transact (liquidate) their collateral in a private, out-of-court sale in order to recover what they can.
Importantly, it also eliminates all subordinate liens and obligations. This is to the creditor’s benefit because, in order to transact on their collateral, a potential buyer requires assurance that they are receiving those assets free and clear. In short, Article 9 of the UCC creates the means for the first position creditor to sell their collateral efficiently. But unlike in bankruptcy, this collateral does not need to be sold off at auction.
The Article 9 transaction affords the first position creditor the option of liquidating business assets into a new or existing purchasing entity instead. When assets are liquidated into a purchasing entity rather than at auction, the ongoing concern value is preserved.
So why is the Article 9 reorganizational transaction not understood more broadly? The simple answer would seem to be that lawyers and advisors are trained in bankruptcy, and conventional lenders are trained in scheduling new debt.
However, when billions of dollar’s worth of business value are being destroyed needlessly every year, along with many thousands of jobs, it’s incumbent on every owner, investor, transactionalist and advisory professional to understand the value-preservation afforded by an Article 9 reorganization. It’s simply more beneficial for all parties involved.
“I was really surprised to learn that this process has something in it for everybody—including the second level of lien holders that actually don’t get paid on their liens—but because they’re going to preserve the ongoing business and it will be a new entity probably with better management, they can keep the customer.”
Greg Carpenter, M&A Business Advisors
Preserving ongoing concern value through an Article 9 liquidation benefits the business owner by circumventing bankruptcy. Additionally, performance-based incentives can be allocated from the purchaser back to the distressed seller to create a path to exit successfully and, by result, a route to closing for investors.
Beyond the benefit to distressed owners, investors and alternative lenders, a liquidation that preserves ongoing concern value actually benefits all parties, including secured creditors and vendors—which may seem counter-intuitive.
The first position secured creditor receives their valuation of the collateralized assets without the time, cost and expense of having to go through the auction process. Subordinate creditors are dealing with toxic assets on their books at the point of insolvency. When the first position creditor removes subordinate liens from underlying assets through an Article 9 short sale, subordinate creditors can write those toxic assets down quickly and efficiently while taking advantage of the tax write-offs associated with their failed investment. Vendors, who would have taken a loss on outstanding obligations regardless, may benefit by establishing a relationship with the purchasing entity, rather than losing a business relationship as well.
Rethinking Business Debt and Insolvency
The Article 9 short sale transaction will necessarily mean an ownership change. However, for the distressed owner, this offers a far better alternative to seeing the core operation destroyed, along with incurring the costs and negative results of a bankruptcy filing and personal liquidation.
“I recognized the value immediately…it allows us to bring a business owner out of a really bad situation, and when everybody wins, that’s the best model.”
Troy Tucker, Blue Sky Business Resources/Committee Chair, M&A Source
In fact, because the core operation is preserved, owners can negotiate an opportunity to earn from the new purchasing entity via a form of employment or consultancy agreement as part of an incentive structure affording them a path to resolve all personal guaranties (an additional benefit to subordinate creditors). At the same time, this path can uniquely allow insolvent owners to meet their ethical obligations to the employees they hired. And when the core operation is preserved, so is the possibility of earning re-entry into an ownership position in the future.
Business debt elimination can’t be understood solely from the perspective of the benefits to the insolvent owner, however, 0r even from those to creditors or direct business investors.
Destruction of business value is unnecessary. Therefore, it’s unethical as well. Too many jobs and too much economic activity are at stake in the preservation of hard-earned value. Owners, lenders, employees and our nation as a whole must reconceive how business assets are liquidated at the point of insolvency. The potential stimulus offered to the economy as a whole can’t be overstated. The wellbeing of owners, lenders, employees and our role in a global economy depend upon it. There is a better way.
Streamlining Private Equity Transactions
Regardless of your group’s private equity strategy, subordinate creditors create obstacles to closing, they pose risk, and they drain time and money, negatively impacting ROI. Moreover, when a distressed situation involves a complex subordinate debt schedule, the prospect of nearly futile short sale attempts can be prohibitive, or alternately, set too high a bar on your private valuation, negatively impacting “viable” deal flow.
The strategic Article 9 liquidation/reorganization can extract core business value from a distressed situation efficiently and with certainty. This will change the way you assess potential deals, allowing you to focus on value, regardless of the debt schedule. At the same time, the result of this transaction offers a stream of pristine add-ons which can be acquired at liquidated asset valuation.
For the private equity professional, debt elimination prior to or through acquisition is a game changer. By eliminating subordinate creditors pre-acquisition, private equity investors can eliminate any need for complex cramdowns, or nearly impossible short sales, while also completely avoiding the time, risk and costs associated with walking a target through Chapter 11.
Incentives for All Parties in the Private Equity Transaction
The strategic Article 9 sale not only returns maximum value to secured creditors, rendering the transaction frictionless, but it will improve your acquisition posture regardless of whether you invest in equity, assets or debt. For your private equity investment strategy, the benefits are tremendous.
Win #1: Attractive Value
You will enter at the far more attractive cost of the liquidation value of the assets rather than the note.
Win #2: Path to Exit
You will scale your successful LOI deal-flow by incentivizing sellers with a path to a successful exit when they would otherwise be left facing a string of personal guaranties and bankruptcy and therefore, little incentive to close. How? The delta between the liquidated asset cost and the note can be strategically allocated back to your target seller to resolve personal guaranties.
Win #3: Lower Cost
Because your upfront costs are far lower, and the balance of seller compensation is performance-based, your portfolio will benefit from reduced exposure to those acquisitions that fail or underperform.
Win #4: Control
When your strategy involves Chapter 11 or 363 sales, you know how little control you have over the process. It’s lengthy, costly, and comes with the risk of being outbid after months of work. Now you can achieve the same positive result in weeks with full control through the application of the Article 9 short sale.
Win #5: Time is Money
When your acquisition posture is strengthened through the elimination of subordinate debt, you deploy capital more quickly and more efficiently, significantly increasing ROI.
Win #6: Leverage
When your acquisition is debt-free prior to or through the transaction, the entire asset base is available for you to scale your leveraged buyout model.
The Article 9 strategic short sale is simply the most efficient means of extracting and transferring business value in distressed situations. For the private equity professional, this means lowering the cost of entry, minimizing exposure to failed acquisitions, creating exit incentives for sellers, and increasing portfolio ROI, thereby transforming distress into opportunity.
“We recently closed a deal where the owner had to take out a personal loan just to clear the assets so we could transfer them to the buyer. With [an Article 9 reorganization] we would have been able to close it quicker, and a lot easier.”
Scott Mashuda, River’s Edge Alliance Group
A Flow of Private Equity Add-on Opportunities at Attractive Entry Costs
There are three scenarios in which your PEG or even M&A model can benefit from Article 9 reorganizations being transacted in the distressed space.
You have a distressed target acquisition where the outstanding debt outweighs the value of the operation. You bring that target opportunity to Second Wind Consultants who will, at no cost to you, reorganize the target prior to or through your acquisition, to deliver you back a pristine, debt-free enterprise in a matter of weeks. There is no need for ABCs, global settlements or 363 sales. Reorganizations are streamlined, requiring negotiation with only the first position creditor, and generally are completed in 45-60 days.
When core business value is preserved through distressed reorganizations, purchasing entities become available to PEGs as target opportunities at the attractive entry cost of liquidated asset valuation. By forming a strategic alliance with Second Wind Consultants, PEGs will be alerted to add-on opportunities that fit their criteria in real time.
Intermediaries can form a strategic alliance with Second Wind Consultants to line-up purchasers of potential add-ons in order to transact on newly reorganized enterprises, creating a competitive advantage for themselves and value for their purchasing clients.
ABLs Assume First Position by Eliminating Subordinate Debt
As an asset-based or factoring lender, transactable collateral is your lifeblood. Yet regardless of how efficient your model is, or how good your reputation and marketing are, deal-flow is inevitably bottlenecked by a simple fact in the alternative lending landscape. Because your target enterprises typically don’t qualify for traditional lending, a disproportionate number come to you on the spectrum of distress, with target assets already encumbered, and therefore untransactable.
“The difficulties often involve how much debt versus receivables (the borrower) has out there. We need to take a first lien position on the accounts receivable, so therefore if there is a current lender that has filed a UCC lien, we need to be in first position and thus have enough to pay them off…”
Nancy Kalman, United Capital Funding
The streamlined Article 9 transaction will create a pristine, transactable entity in 45-60 days, putting you in first position to lend against the entire asset base. By result, you can scale your deal flow by evaluating target opportunities differently, with a focus on top-line factors irrespective of the debt schedule.
Your Target Enterprise is Out of Options
When a target enterprise has stacked a lengthy debt-schedule, it is likely you, the alternative lending professional, are viewed as the last financing option by an owner in distress. In these situations, the owner is most likely out of options, whether or not they realize it. They’ve exhausted the spectrum of conventional and alternative lending vehicles and can no longer capitalize their business. They’re on the brink of an unsupportable position as a precursor to default and insolvency.
The conundrum is that in very many of these situations, the asset base and AR are attractive, yet untransactable.
In most cases, the alternative lender simply walks away. In other cases, lenders will attempt a complex global settlement of the debt schedule in order to assume the first position—if the long term opportunity merits this strategy within their model. However, there is no longer a need to walk away from these situations, or alternatively, to incur the expense and risk of attempting to resolve them through cumbersome, inefficient short sale attempts or negotiated settlements.
“We’d be able to get a lot more deals done.”
Nancy Kalman, United Capital Funding
The MCA (Merchant Cash Advance) Problem
The now ubiquitous presence of Merchant Cash Advance companies scales the problem. Beyond competition, this industry represents a highly-aggressive form of “lending” in which the model is not incentivized by the long-term wellbeing of the business or the “lending” relationship. The probability of default and insolvency is likely an assumed cost within this model, so as to extract as much as possible—through MCA debt stacking—until there is nothing left.
“Over the years this has become a plague against some of these businesses…it’s maybe a couple of times per month where I’ll come across this as a significant problem.”
Chris Lehnes, Live Oak Bank
For the ABL or Factor, it is more common than ever to come across opportunities with attractive assets/AR mired in a lengthy debt schedule often comprised entirely of MCAs.
“In these situations, a reorganization would be of enormous benefit and help, because we’ve absolutely had to turn down deals when we could not take a first position on a lien.”
Nancy Kalman, United Capital Funding
Turn Difficult Deals Into Great Situations
It’s time to re-evaluate your opportunities. Second Wind Consultants has conducted more Article 9 reorganizations than anyone else. Over the past ten years, thousands of businesses have been spared from bankruptcy—preserving ongoing concern value, jobs and economic activity otherwise destroyed through forced liquidations.
Bring Second Wind your untransactable opportunities. There are no fees to the private equity group or lending professional. In a matter of weeks, we will deliver back a pristine entity ready for acquisition, or lending in the first position. Contact Second Wind Consultants today about a strategic alliance that will scale your deal-flow and allow you to offer service and benefit to clients where you otherwise could not.