M&A and Investment Banking

Lecture 11 – Distressed Situations

1

Distressed Situations

Introduction

Distressed M&A Scenario

Sell Side Corporate/Creditor

Buy Side

Legal Issues

2

3

Valuation Deal Initiation Bankruptcy

Process Experience with Potential Buyers

Speed

Current Knowledge of

the Sellers Industry

Global Reach Deal Execution Inherent

Conflicts of Interest

Distressed Situations Definition: Mergers and acquisitions where the target company is “distressed”.

Distress for these purposes generally signifies that a company is having difficulty in dealing with its debt -

either servicing its interest and principal amortization payments, addressing covenant breaches in debt

instruments, paying or refinancing debt at maturity, or raising additional debt to address liquidity needs

Distressed M&A vs. Healthy M&A: key topics to be addressed

Introduction – Definition

4

Distressed M&A is more likely to create value in a downturn than in an upturn. The severity of

the 2008 financial crisis appears to have accentuated the distressed M&A effect, with higher

returns for both acquirers and targets in 2008 than in downturns during the previous 15 years

Returns from distressed M&A for both acquirers and targets 2008 downturn vs. 1992-2007 downturns

Introduction - Returns from Distressed M&A in the

Global Financial Crisis

Source: The Boston Consulting Group, 2009. Be Daring When Others are fearful: Seizing M&A Opportunities While They Last Notes: A downturn year is

defined as one in which worldwide GDP growth was below the average for the period 1990 to 2007. Distressed M&A is defined as a transaction whose

target EBIT margin is below the sample median for targets. (1) Average cumulative abnormal return was calculated over a seven-day window centered

around announcement day (+3/-3).

0.0

(2.4)

Distressed M&Ain 2008

Distressed M&A in Previous Downturns,

1992–2007

50.4

20.3

Distressed M&Ain 2008

Distressed M&A in Previous Downturns,

1992–2007

N = 30 N = 149

2.4%

N = 31 N = 157

30.1%

Acquirers CAR(1) (%) Targets CAR(1) (%)

Typical Challenges

Undercapitalised balance sheet

Inappropriate capital structure

Changing industry conditions

Declining operating performance

Declining cash flow

Risk of losing key management

Significant liquidity constraints

Stretched payables

Management distracted “fire fighting”

Total debt > Enterprise value

Covenant/debt repayment defaults

Stakeholder conflict

Senior lender aggression

Restricted access to existing capital

Limited access to new capital

Threat of insolvency proceedings

5

Time

Lo

wEnti

ty V

alu

eH

igh

Amount of shareholder value

preserved

Deal Timing

Distressed M&A Scenario - Typical challenges and

Deal Timing

Success Stressed Distressed Insolvent

Cash Flow Good Cash Flow Poor

Potential covenant

breach

Credit rating

downgrade

Profit warning

Board still in control

of strategy

Covenant breaches

Creditor pressure

Expensive re

financing

Equity value

negligible

Creditors in control

of strategy

Insolvency

practitioner

appointed

Strategy is to realise

assets and contain

liabilities

6

It is crucial to consider where a distressed company falls on the leveraged pendulum

Distressed M&A Scenario - Focus on Deal Timing

Management &

Employees

Distressed Corporate

Creditors

Distressed

Investor Secured

Unsecured

Operational

Shareholders Regulatory

Pensions

Tax

Listed

Private

Private

Equity

Suppliers

Customers Landlords

Credit

Insurers

7

The stakeholder can be varied in a distressed situation M&A. Depending on the stage of distress, shareholders

may have less influence than in a normal course transaction; management may be accustomed on the buyer’s way

of doing business or have concerns about its role. Furthermore, the buyer should bear in mind the fiduciary duties

of the board, as well as the influence of lenders, key customers, suppliers and trade unions. Indeed, competing

influence are a key issue to deal with in targeting a distressed corporate

Distressed M&A Scenario - The Stakeholders

8

The financial strength of the acquirer

The acquisition is more likely to be a success if the buyer is healthy and has an above average profitability, in order to convince the market that it can turn around a distressed target. This aspect is also crucial if considering the resources and management focus required in the postmerger integration phase

The cause of distress in the target

Targets with financial problems but that have not yet run into operating problems (e.g.: breaking the debt covenants but remaining profitable) are easier to turn around through recapitalization

Even when the target has operating problems, the buyer’s returns from the acquisition will be higher if it also has capital structure problems, that the buyer can sort out. In such cases, the market expectations will be depressed making the target more attractive. In addition, this would facilitate hard restructuring strategies since the alternative -bankruptcy- will be evident to government, labor unions, regulators

The relative size of the acquirer and the target

Bigger buyers acquiring smaller targets will have more success since this carries less risk and is easier to finance – and the market will recognize it in its response to the announcement

The core sectors of the acquirer and the target

Distressed acquisitions outside the acquirers’ core sector are marginally more successful than acquisitions within the same sector. Because of overconfidence, buyers making acquisitions in their own sector are more likely to overpay

Distressed M&A Scenario - Success Factors

Source: The Boston Consulting Group, 2009. Be Daring When Others are fearful: Seizing M&A Opportunities While They Last

9

Timing

Given the diminishing value of a business under distress, the timing of the sale is crucial to preserve the shareholder value

Valuation expectation gap

Seller expectations vs. Buyer offering

Alignment of shareholders – control of equity

Access to capital

Debt market

Refinancing

Equity markets

Public to private transactions

Debt/equity trading during the period

When companies enter a period of financial distress, the original holders often sell the debt or equity securities of the issuer to a new set of buyers: hedge funds, brokerage firms, mutual funds, private equity firms, and specialized debt funds

Investors in distressed securities often try to influence the process by which the issuer restructures its debt, narrows its focus, or implements a plan to turn around its operations

Selling shares vs. Selling business and assets

Managing cash flow / liquidity

Sell Side - Corporate: Acting for Shareholders

10

Key issues

Enhanced value compared to insolvency outcome

Deal structuring:

Debt and/or equity

Pre packs: the assets of a company are sold immediately after it has entered administration, therefore all of the group’s trading subsidiaries will continue to trade with no interruption to their businesses.

Managing “out of the money” creditors / shareholders

Monitoring cash flow and bank exposure

Relative security and tactics for hold out

Perspectives Bank / Secured lender Distressed investor / Creditor committee

Sell Side - The Creditor Perspective

11

Acquisition Strategies

Asset vs. equity purchase: usually buyers prefer asset purchase because it protects them form contingent liabilities and may allow a selection of the assets the acquirers are interested in

Loan-to-own: the investor acquires debt securities in the hopes of emerging from a corporate restructuring in control of the company's equity

Event driven: exploit pricing inefficiencies that may occur before or after the bankruptcy event

Valuation

Valuation of distressed companies is less defined than in normal transactions. Market based methods such as Comps and Compaq are often less relevant, especially where value creation will depend on the turnaround plan

A more reliable valuation is offered by the use of multiple approaches, e.g.: a combination of post closing earnings or free cash flow, valuation of possible synergies and tangible asset backing

Other relevant analysis to be performed include: assessment of the level of distress and impact on enterprise value; funding the turnaround; value-break analysis

Due Diligence focus

Sustainable earnings (and impact of distress)

Pre and post deal cash flows

Post deal funding requirement

Normalized working capital

Identifying debt and debt-like items

Impact of insolvency

Downside risk protection

Buy Side - Key Issues

Legal Issues to Consider

12

Directors’ responsibilities

Fraudulent trading: the company has carried on business with intent to defraud creditors

Wrongful trading: unlike fraudulent trading, wrongful trading needs no finding of “intent to defraud”. In such case, directors have continued to trade a company past the point when they knew that there was no reasonable prospect of avoiding insolvent liquidation and they did not take every step to minimizing the potential loss to the creditors

Risk of challenges to transaction

Transactions at undervalue

Preferences in buyer selection

Risk to asset values arising from contractual rights / obligations

Insolvency legislation

Case Studies: Safilo

13

The Safilo Group is second-largest worldwide manufacturer of eyewear products. Founded in 1934 in Italy by G.Tabacchi

established itself as a major player. In 1987 Safilo was listed on the Milan Stock Exchange. In 2001, through a LBO, the Tabacchi

family delisted the company and re-listed it in 2005

The financial difficulties originate in the 2001 LBO that resulted in a significant financial burden that was not improved by the

2005 IPO (which, however, raised €314m). Moreover, the increased level of competition, wrong strategic decisions, poor

execution and the economic crises resulted in a mounting level of debt against a weakening financial and business performance

and therefore quasi bankruptcy

This situation lasted for one year (since H2 2008), until the intervention of HAL Holding, a diversified Dutch holding company

with investments also in the optical retail business. In March 2010, the capital increase of Safilo led to the entry of HAL as the

new reference shareholder. At the end-2009 HAL had a NAV in excess of €5.4bn and a market cap of €5bn. The €220m

investment in Safilo was relatively small.

Currently (August 2014) HAL is the controlling shareholder of the Safilo Group owning 42.2% of the share capital

Rescue Plan

Recapitalization plan aimed at strengthening the Group capital structure

HAL acquired 50.99% of Senior Notes

Safilo sold its non core retail activities to HAL

The lending banks approved the senior debt restructuring plan

HAL subscribed a reserved capital increase in Safilo and guaranteed €250m Rights Issue

New roles and strategy

New organizational framework

New board of directors and new senior management team

Focus on relevant licensed brands (13 brands renewed and one new license agreement)

Focus on Safilo brand portfolio (global positioning, product innovation and distribution, new business segments)

Case Studies: Safilo (Cont’d)

14

SAFILO GROUP SpA

(Italy) 4

OXSOL SpA

(Italy) 4

SAFILO CAPITAL

INTERNATIONAL SA

(Luxembourg) 6

SAFILO SpA

(Italy) 1

Carrera Optyl doo

(Slovenia) 1

Lenti Srl

(Italy 1)

Smith Sport Optics Srl

in Liquidazione (Italy) 3

Safilo Eyewear Industries

(Suzhou) Ltd (China) 1

Optifashion Hong Kong Ltd

(Hong Kong) 2

Tido Ti SA de CV

(Mexico) 2

Safilo Retail

(Shanghai) Co Ltd

(China) 2

Trading and Prod. Company

Royalties Company

Trading Company

Holding Company

Real Estate Company

Financial Company

Service Company

Safilo USA Inc

(New Jersey – US) 3

Safilo UK Ltd

(GB) 3

Safilo Services Llc

(New Jersey – US) 7

Safilo Realty Corp

(Delaware – US) 5

TBR Inc

(New Jersey – US) 5

Smith Sport Options

Inc (Idaho – US) 1

Solstice Marketing Corp

(New Jersey – US) 4

Solstice Mktg

Concepts Llc

(New Jersey – US) 2

QUEBEC Inc

(Canada) 4

Safilo CANADA

Inc (Canada) 3

Canam Sport

Eyewear Inc

(Canada) 3

Safilo AUSTRIA

GmbH (Austria) 3

Carrera Optyl Verbrieb

GmbH in Liquidation

(Austria) 1

Safilo INDIA Pvt Ltd

(India) 3

Safilo France Sarl

(France) 3

Safilo NEDERLAND BV

(Nederland) 3

Safilo BENELUX SA

(Belgium) 3

Safilo GmbH

(Germany) 3

Safilo NORDIC AB

(Sweden) 3

Safilo HELLAS Ottica

SA (Greece) 3

Safilo JAPAN Co Ltd

(Japan) 3

Safilo AUSTRALIA

(Pty) Ltd (Australia) 4

Safilo AUSTRALIA

Partnership (Australia) 3

Luxury Trade SA

(Luxembourg) 4

Safilo ESPANA SL

(Spain) 3

Safint BV

(Nederland) 4

Safilo PORTUGAL

Lda (Portugal) 3

Safilo SWITZERLAND

AG (Switzerland) 3

Safilo do BRASIL

Ltda (Brazil) 3

Safint EYEWEAR de

Mexico SA de CV

(Mexico) 3

OPTIFASHION SA

(Turkey) j.v. 1

Safilo FAR EAST Ltd

(Hong Kong) 3

Safilo SOUTH AFRICA

(Pty) Ltd (South Africa) 3

Safilo KOREA Ltd

(South Korea) 3

Safilo CIS Llc

(Russia) 3

Safilo HONG KONG

Ltd (Hong Kong) 3

Safilo SINGAPORE

Pte Ltd (Singapore) 3

Safint Optical

Investments Ltd

(Hong Kong) j.v. 4

Elegance

International

Holdings Ltd

(Hong Kong) j.v. 4

Safilo Optical

SDN Bhd (Malaysia) 3

Safilo Trading

(Shenzen) Co Ltd

(China) 3

Safilo Eyewear

(Shenzen) Co Ltd

(China) 3

(Treasury Shares) 9.07%

SAFILO INTERNATIONAL

BV (Nederland) 4 Safilo AMERICA Inc

(Delaware – US) 4

SAFINT Optical

UK Ltd (GB) 4

90.93%

100%

75%

100%

75.60%

100%

100%

100%

100%

60%

100%

100%

100%

100%

100%

49.70% 100% 2.5% 0.01%

99.99%

16.50%

0.02.4%

83.50%

93.976%

88.50%

99.995%

33%

100%

100%

100%

100%

100%

100%

100%

70%

100%

100%

66.30%

99%

99%

99%

99%

50%

100%

100%

100%

100%

51%

100%

51%

23.05%

100%

100%

100%

61%

100%

100%

100%

50.30%

Group Structure before HAL Takeover (FY2009)

Only 3T S.p.A.

(Tabacchi)39.893%

HAL Holding NV

2.082%

Diego Della Valle & C. S.a.p.a.2.059%

FIL Limited2.020%

Other Shareholders

53.946%

Shareholding Structure

Source: Company Reports

1%

1%

1%

1%

Case Studies: Safilo (Cont’d)

15

Group Structure after HAL Takeover (FY2013)

HAL Holding NV (Through its Subsidiary Multibrands Italy B.V.),

42.2%

Only 3T S.p.A.

(Tabacchi), 9.2%

Financiere de l'Echiquier,

1.9% CM-CIC Asset Management,

1.9%

Henderson Global

Investors, 1.9%

Norges Bank , 1.8%

Other, 41.0%

Shareholding Structure

SAFILO GROUP SpA

(Italy) 4

Polaroid Eyewear

Holding BV (Netherlands) 4

Polaroid Eyewear GmbH

(Switzerland) 3

Polaroid Eyewear Srl

(Italy) 3

Polaroid Eyewear AB

(Sweden) 3

Polaroid Eyewear BV

(Netherlands) 3

Polaroid Eyewear Ltd

(GB) 1, 3 Carrera Optyl doo

(Slovenia) 1,3

Lenti Srl

(Italy) 1

Safilo Eyewear Industries

(Suzhou) Ltd (China) 1

Smith Sport Optics Srl

in Liquidation (Italy) 3

Treasury Shares 4,799%

SAFILO CAPITAL

INTERNATIONAL SA

(Luxembourg) 6

SAFINT Optical

UK Ltd (GB) 4

Safilo USA Inc

(New Jersey – US) 3

Safilo UK Ltd

(GB) 3

Safilo Services Llc

(New Jersey – US) 7

Safilo Realty Corp

(Delaware– US) 5

Smith Sport Optics

Inc (Idaho – US) 1,3

Solstice Marketing Corp

(New Jersey – US) 4

Solstice Mktg

Concept Llc

(New Jersey – US) 2

QUEBEC Inc

(Canada) 4

Safilo CANADA Inc

(Canada) 3

Canam Sport

Eyewear Inc

(Canada) 3

Safilo ESPANA SLU

(Spain) 3

Safilo AUSTRIA

GmbH (Austria) 3

Safilo FAR EAAT Ltd

(Hong Kong) 3,4

Safilo HONG KONG

Ltd (Hong Kong) 3

Carrera Optyl

Vertrieb GmbH in

Liquidation (Austria) 1

Safilo SOUTH AFRICA

(Pty) Ltd (South Africa) 3

Safilo INDIA Pvt Ltd

(India) 3

OPTIFASHION SA

(Turkey) j.v. 1

Safilo NEDERLAND BV

(Netherlands) 3

Safilo BENELUX SA

(Belgium) 3

Safilo GmbH

(Germany) 3

Safilo NORDIC AB

(Sweden) 3

Safilo HELLAS Ottica

SA (Greece) 3

Safilo JAPAN Co Ltd

(Japan) 3

Safilo AUSTRALIA

(Pty) Ltd (Australia) 3

Safilo KOREA Ltd

(South Korea) 3

Safilo CIS Llc

(Russia) 3

Safint BV

(Netherlands) 4

Safilo PORTUGAl

Lda (Portugal) 3

Safilo SWITZERLAND

AG (Switzerland) 3

Safilo do BRASIL

Ltda (Brazil) 3

Safilo Mexico SA de CV

(Mexico) 3

Safilo FRANCE Sarl

(France) 3

Optifashion Hong Hong Ltd

in Liquidation

(Hong Kong) 2

Luxury Trade SA

(Luxembourg) 4

Safilo Optical

SDN Bhd (Malaysia) 3

Safilo Trading

(Shenzen) Co Ltd

(China) 3

Safilo Eyewear

(Shenzen) Co Ltd

(China) 3

SAFILO INTERNATIONAL BV

(Netherlands) 4

SAFILO SpA

(Italy) 1, 3

Safilo SINGAPORE

Pte Ltd (Singapore) 3

Safilo Optical

Investments Ltd

(Hong Kong) j.v. 4

Elegance

International

Holdings LTD

(Hong Kong) j.v. 4

95.201%

100%

100%

75.60%

100%

100%

100%

100%

100%

100%

100%

100%

50.38%

49.62%

0.01%

Safilo AMERICA Inc

(Delaware – US) 4

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

100%

89.50%

50%

100%

100%

100%

100%

100%

100%

100%

99.976%

100%

100%

99.9%

99%

99.9%%

99.999%

99.995%

0.1%

1%

0.1%

0.007%

0.005%

100%

100%

70%

100%

90%

23.05%

100%

100%

100%

100% 16.50%

100%

Trading and Prod. Company

Trading Company

Holding Company

Real Estate Company

Financial Company

Service Company

0.024%

Source: Company Reports. Consob as of August 2014

99.99%

83.50%

100%

Case Studies: Safilo (Cont’d)

16

894 900945

1,025

1,1221,190

1,148

1,0111,080 1,102

1,1751,122

2002 2003 2004 2005IPO

2006 2007 2008 2009 2010HAL

2011 2012 2013

172

123

147153

162175

126

66

108

123115

122

2002 2003 2004 2005IPO

2006 2007 2008 2009 2010HAL

2011 2012 2013

13

(27)

19

3

38

51

(23)

(34)

1

28 26

39

2002 2003 2004 2005IPO

2006 2007 2008 2009 2010HAL

2011 2012 2013

799825 807

479532 515

570 588

256 238 215183

4.6x

6.7x5.5x

3.1x 3.3x 2.9x

4.5x

8.9x

2.4x 1.9x 1.9x 1.5x

2002 2003 2004 2005IPO

2006 2007 2008 2009 2010HAL

2011 2012 2013

Net Revenues (€m) EBITDA (€m)

Net Income (€m) Net Debt (€m) – Net Debt / EBITDA

Source: Company Reports Notes: (1) Before non-recurring Items

(1)

(1)

(1)

(1)

Case Studies: Parmalat and Risanamento

17

The Parmalat Group is an Italian milk and dairy listed company with

operations in North America, Europe and Latin America

The company traces its root back to Parmalat Finanziaria,

established in 1961. During 2003, it was charged with one of the

biggest financial frauds in the corporate history. The fraud was

estimated to be worth $8.5bn to $12bn in the form of vanished

assets from the books of the company. The extraordinary

administration proceedings preceded the bankruptcy and continued

for the period 2003-05, ending up into the composition with

creditors (basically a debt-to-equity swap part of the restructuring

plan) with which 16 companies were combined to form the new

Parmalat Group which began its operations in 2005

Parmalat S.p.A. was established as the parent company of the new

Parmalat Group. After commencing the business, the new entity

was listed on the Milan Stock Exchange in 2005

As a part of its restructuring activities, Parmalat sold some of its

subsidiaries, engaged and settled damages actions against the

management, auditors, banks and other stakeholders involved in the

fraud. Parmalat was able to recover around €2bn through lawsuits

In 2011, Parmalat, at that time a public company with floating

shareholder base and 1.5bn net cash, was acquired by Lactalis, the

French multinational dairy products corporation. Currently

(November 2012) Lactalis owns 83% of the share capital

Risanamento S.p.A. is an Italian listed company and one of the biggest Italian property developers, part of a large group of companies that also include foreign operations, and in charge of two important urban re-development projects in Milan

In 2009 the company experienced financial difficulties not being able to implement its major urban re-development projects. In the summer of 2009, Risanamento had about €2.8bn net debt, mostly owed to Italian banks. The company went into insolvency and, after almost two months, a debt restructuring agreement was reached with the banks (Intesa Sanpaolo, Unicredit, Banco Popolare, Bpm and Mps) that entered into the equity capital becoming majority shareholders and established a restructuring plan

The debt restructuring agreement eventually reached with the creditor banks consisted of a €500m refinancing package, involving a debt-for-equity swap, the issue of convertible bonds and fresh cash injections, against the surrender of the control of the company to the banks

On June 2013 Zunino Launched a tender offer on the 88% of shares, owned by the Italian banks ISP, Unicredit, BPM, Banco Popolare and MPS, for a consideration of €0.25ps. Once reached the threshold of 30% a mandatory tender offer will be launched on the remaining shares

Rational of the deal: To take control of Risanamento in order to retain control of its French real estate holding, presently the subject of bids from Qatar Holding and investment fund Thor Equities

The offer has not been accepted by the Italian Banks

References

Miller, E.L.J., 2008. Mergers and Acquisitions: A Step-by-Step Legal and Practical Guide. Wiley:

chapter 7

PricewaterhouseCoopers, 2008. Distressed M&A: Beauty is in the eye of the beholder

The Boston Consulting Group, 2009. Be Daring When Others are fearful: Seizing M&A

Opportunities While They Last

Wachtell, Lipton, Rosen & Katz, 2012. Distressed Mergers And Acquisitions

18