Corporate Advisory: Hostile takeovers during times of illiquidity Pt 1.

As interest rates rise, the circulation of currency slows down and liquidity becomes a bigger issue for businesses. More and more businesses, that are unable to get bank funding or private lending, are resorting to selling equity in their businesses at a discount.

This article will be pivotal in helping you identify opportunities to buy equity at a discount as an investor. It will also provide you with some guidance on how to protect your interests and exercise an aggressive takeover. Simultaneously this will help business owners identify situations where a hostile takeover could be taking place, and how to defend themselves.

To be clear, to acquire anything at a discount, investors must be willing to do work!

For the purposes of this article when we mention an equity acquisition, we are refencing at minimum a 26% and upwards stake. As 25% is the threshold for key minority shareholder rights.

Corporate advisors are seeing more calls for help

As part of our corporate advisory, we are seeing more and more businesses who are open to selling equity and or partnerships.

The reality is that this was always going to happen, it was just a matter of who and when!

Cheap money, inflated asset prices and high debt levels always meant the economic system was going to be vulnerable to any movements in interest rates or economic slowdowns.

Identifying good investment opportunities with bad situations

As corporate advisors, who see a deluge of businesses who are highly illiquid. The majority of these businesses were always due to collapse because of bad operators kept afloat by cheap credit in the economic system and industry booms!

From our corporate advisory experience, the best acquisitions happen when investors are purchasing equity in businesses, in industries they understand, with very strict shareholder agreements! Typically, larger businesses are buying equity in smaller businesses that can be vertically or horizontally integrated with theirs.

Having solid shareholder agreements, including conditions specific to shareholder and board resolutions is critical to maintain control, if the principal entity is not acquiring 100% of a target. A few examples of this include the total remuneration of directors (both direct and indirect), debt covenants and permitted use of funds.

Good business that are cashflow poor, are where opportunities sit for equity to be purchased at a discount. Typically, these businesses can’t get bank funding / private lending, or they don’t wish to add further debt to their books. This means their only option is to sell equity in their business at a considerable discount to investors. The caveat to this, is that these businesses are not on a path to liquidation!

In an environment where funds are illiquid, those with cash are king!

Devil’s advocate – A valid corporate advisor argument for not buying equity

Just as there are numerous opportunities for an investor to buy equity in businesses at a discount due to them having cashflow issues. There are also very valid arguments, that we provide to our clients, that they shouldn’t buy equity, and rather they should wait for the target business to enter liquidation!

As part of our corproate advisory services, we look at the requirements of the principal client and what they seek to gain from the target. If there are parts of the business that can be salvaged post liquidation, then patience is a virtue that is handsomely rewarded!

If however, the value of the business and what our principal client is seeking can only be gained via the target staying intact, then it makes sense for an equity play to occur!

Such examples are service based businesses, where key personnel including the director, may have strong client relationships / supplier relationships and where the brand is embedded in the psyche of customers. Another example is if a business has key intellectual property, that other parties may compete for if the business went into liquidation!

Lastly and most importantly, is that the principal client / investor may not wish to take on active management of a business.

Aggressive Heads of Agreements & Memorandums of understanding

One of the things investors can do, (we have advised on the defensive aspect of this as well) is to put forward a legally binding heads of agreement that contains a phased purchase of shares, with an initial payment for a tranche of shares on signing the HOA, contingent on a shareholder agreement being agreed to in a specified time period!

If agreement cannot be reached on the shareholder agreement by the specified timeframe, then the investor has the right to clawback the initial tranche of funds paid to the target business! This creates both a carrot and a stick for the business needing urgent liquidity and allows deals to be negotiated very quickly.

Because the target entity must refund the initial tranche of funds, if a shareholder agreement can not be reached within the specified time period, it means they are more inclined to be agreeable to certain terms the investor may require in the shareholder agreement!

The shareholder agreement is key, as a number of things can be put into the agreement that will effect shareholder and board resolutions, as well very favourable terms regarding the shares the investor is acquiring.

Naturally severe penalties would apply to the target business, if a shareholder agreement could not be reached and the business couldn’t repay the funds within the specified time period. These penalties extend beyond financial terms!

For example.

The purchasing principal may have a HOA, agreeing to purchase equity in 4 tranches for 25% of a company, with each tranche being $1M paid over 4 months. Tranche 1 would be paid on signing the HOA, that would stipulate the shareholder agreement must be agreed to within 30 days of signing the HOA.

Upon singing the HOA, the first tranche would be paid to the target business. The investor and target business would then have to come to full agreement about the terms of the shareholder agreement.

If after 30 days, they have not agreed on the shareholder agreement, then the target business must refund within a specified period the $1M. If the target business is unable to do this, then penalties would apply at severe detriment to the target business.

To speak to us about your next acquisition, divestment or shareholder agreement you can contact us here.

To read more about our corporate advisory services click here.