Beware of the distressed opportunity: when cash finally runs dry

CFOs should dissect revenue and cash flows carefully when looking at distressed companies.

Submitted by Mary Driscoll, republished from Big Fat Finance Blog, arming finance professionals with innovative ideas and best practices to create value.

Over the next six months, we can expect to hear a lot about beleaguered businesses being snapped up by stronger companies looking to buy some good old-fashioned strategic value. The M&A experts predict a rising tide of so-called “distressed opportunities,” sometimes called good businesses with bad balance sheets. CFOs assessing one of these - maybe a storied brand in an adjacent market - should dissect the revenue and cash flow drivers with great care. Some will be overly tempting, and the pressure will mount to make a fast bid.

As numerous reports have noted, America’s largest companies amassed hefty stockpiles of cash during the recession. They had the scale, in terms of cash flow, to keep the ship afloat while they quickly threw excess inventory and capacity overboard. They were able to make deep cuts in operations without losing momentum. A number of them had the financial moxie to refinance expensive debt by issuing newer, lower-priced debt.

All that cash is now making investors - especially the hot-money types - cranky. They grudgingly accepted lousy returns during the downturn, a time when everybody lost money. Now they want to make up for lost time, and a lot of idle cash is just one big bull’s-eye.

At times like this, the CFO’s highly discerning nature makes a bee-line for the hidden contradictions. To wit, some of these distressed opportunity deals will be so wounded by recession that they’ll stand no chance of getting back in fighting shape once the economy rebounds for good. But the seller’s bankers won’t say that. They’ll go on and on about “the price is right” and valuations for solid assets at rock-bottom levels.

So, the CFO will ask: If the opportunity is really so great, why does the owner want to throw in the towel now? Could it be that owners should have filed for bankruptcy last year but managed to limp along just fast enough to escape the Grim Reaper? Maybe capital providers were able to do some fancy footwork to avoid pulling the plug last year - but now the jig is up? Perhaps the company cannot generate enough cash flow to pave the way to a balance sheet restructuring? Could it be that the owner is a private equity fund that can’t wait any longer to clean up its portfolio and get on to the next round?

Deal documents will contain rigid legal language about the potential risks for the buyer. That provides only so much comfort. Figuring out whether to buy an asset that’s packaged in the glowing verbiage of “distressed opportunity” is both art and science. The science part is always hard: assessing how much to pay for somebody else’s estimate of future cash flows. But the art part is even harder: assessing the true nature of the business opportunity, with strategic risks appropriately reflected in growth and earnings targets. If the deal folks won’t let your team do meaningful due diligence on the strengths and weaknesses of the business - and that can mean going out and talking to employees, customers, and suppliers engaging each other at the front lines of the business - then the board shouldn’t let all that cash burn a hole in its proverbial pocket. After all, there are plenty of opportunities to look at.

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