The current financial distress, significant market volatility, and depressed valuations will result in many corporates not being able to sustain its business on a standalone basis and may also face potential insolvency issues. On the other hand, this will create business opportunities for corporates and private equity (PE) funds with high levels of “dry powder” to invest in businesses facing liquidity crunches and impending debt obligations.
Even before the outbreak of the pandemic, distressed M&A was on a rise in India with the introduction of the Insolvency and Bankruptcy Code, 2016 (IBC). A record growth of about 70% in M&A activity in 2018 was spurred by distressed deals. Further, from January 2015 to April 2019, seven major deals, totaling $23 billion in deal value, were finalized, primarily in the power, cement, and steel industries.
Other deals concluded during the pre-Covid-19 era were driven by the growing need to focus on core businesses and the necessity to improve profitability against the backdrop of a looming recession risk. The temporary suspension of the initiation of insolvency proceedings under the IBC in India has been a step in the right direction and is expected to result in a surge in schemes of ‘compromise or arrangement’ between companies and their creditors or shareholders, including debt restructuring under the framework provided in the Companies Act, 2013. Even before the pandemic hit the global economy, the Government of India had laid the grounds for improving ease of doing business and implement reforms such as the new framework on the issuance of shares with Differential Voting Rights (DVRs) and the enactment of the Code of Wages, 2019.
In this ‘new normal’, deal making in distressed assets is a beacon of hope for the sluggish economy to create synergies and economies of scale. With the plethora of disinvestments in the stimulus package announced by the Government of India, investment in such distressed assets of public companies may also be on the rise. However, potential hurdles may create road bumps in such enticing transactions.
The foremost challenge is the standard due diligence exercise, which may not be undertaken since most transactions are likely to be on an ‘as is, where is’ basis. Also, shortened time frame, limited access to diligence materials, and potential labour problems will add to the pressures. Moreover, this uncertain time until the crippling Covid-19 abates may be ruled by an absolute shift from physical due diligence to virtual data rooms. Secondly, the timeline for negotiation may be curtailed to avoid further impact on the target’s business relations, thereby impacting the deal value. Thirdly, potential operational, regulatory, and litigation risks of the target may be a deterrent. Lastly and typically, the procurement of extensive warranties from sellers of distressed M&A assets may be impeded, particularly if a company is already in the insolvency process.
Some of these drawbacks can be resolved by appropriate restructuring of transactions, assessing the viability of options, obtaining Warranty and Indemnity (W&I) insurance, ensuring adequate risk allocation, prioritizing the time factor in the contract to capture the time value of money, and obtaining adequate consent for transactions that are subject to change in control provisions.
A common mechanism used in advanced economies for the resolution of distressed assets is a pre-packaged insolvency. In such cases, the potential acquirers and the stakeholders of the potential target reach an agreement prior to the initiation of the insolvency proceedings. By introducing the pre-packaged insolvency process in the Indian context, the government will be able to expedite distressed M&A transactions, as the process helps acquirers respond proactively to the current challenges.
In the case of large-scale distressed M&A triggering the thresholds specified under the Competition Act, 2002, the approval of the Competition Commission of India (“CCI”) is required. Corporates considering consolidation amidst the Covid-19 crisis may be able to take the defense codified in Section 20 of the Competition Act, 2002 where the CCI looks into the “possibility of a failing business” for the purposes of determining whether a combination would have an appreciably adverse effect on competition in the relevant market.
Notwithstanding the prevailing challenges, the pandemic provides a unique opportunity for certain companies to expand their business by acquiring distressed assets to further penetrate the market, and an attractive investment opportunity for PE funds to leverage on the lower valuation of distressed companies. This may provide the much-needed impetus to the current business opportunities in the country and worldwide and, in so doing, bring a measure of relief from the trying ills of the COVID-19 scourge.
Rupinder Malik is Partner, and Subrana Saha, Associate at JSA)