Strategies and Risks that Factor into the Purchase of a Distressed Business

bankruptDistressed businesses have become an area of concern in many markets, including the Healthcare industry.  However, the purchasing of distressed businesses is a continuing area of interest for outpatient market buyers; but does the purchase come with any hidden costs?  The Ambulatory M&A Advisor examines some of the common strategies used when purchasing a distressed business and what types of risks come with these businesses for the buyer.

Brent Hill, partner at the Waller law firm says that the primary risks when it comes to purchasing a distressed business involve third party claims.

“It can be claims from vendors or service providers, but basically, if the business is in distress, they typically manage cash by not paying their payables in a timely manner.  If you are looking at buying a distressed business, you have got to look closely at what their accounts payable look like, and what their outstanding debt is.  Then another area that can be problematic is taxes.  It can be income taxes, it can be state property or sales taxes; or in a worst case scenario, federal payroll taxes,” Hill says.

John Fanburg partner with the law firm Brach Eichler says that with stock and equity comes outstanding liabilities. He echoes Hill’s thoughts on the topic and says he is referring to liabilities involving third party payors, government in the form of taxes, or other liabilities.  Fanburg emphasizes that these liabilities are why a purchase is usually driven by the assets in order to be able to avoid those carry over liabilities,” Fanburg says.

According to Hill, the structure of the transaction strongly determines what type of a risk factor that a buyer faces.

“If you are going to buy the equity of the distressed entity, then you end up taking all of the liabilities that the entity has.  That can be very problematic unless you get some sort of protection from a bankruptcy proceeding if you buy the equity from that route,” Hill says.

“Unless you get some statutory protection, the buyer is going to take all of the liabilities that go with the equity.  You want to make sure that the proceeds you are paying go toward paying off liability since you do substantial diligence to determine what the liabilities are.  Buying the equity in a distressed business is not typical.  You would typically buy the assets of the business and leave all of the liabilities behind.”

Hill states that if a buyer is going to acquire the assets, they need to be aware of what the applicable state law is, with respect to successor liability.  Hill says these state laws vary from state to state.

“In some you can buy all of the assets of the business and leave the liabilities behind and not incur any successor liability from third party creditors or claimants.  The rules and regulations that permit that vary from state to state,” Hill says.

Fanburg says that when dealing with the assets of the distressed business, whatever assets the seller has is pretty much all that they are selling.  In addition to the equipment, furniture, fixtures; they may also sell accounts receivable, Fanburg says.

Jerry Switzer, shareholder with Polsinelli PC, specializes in bankruptcy, reorganization and creditor rights litigation says that buyers may have to deal with issues like post bankruptcy claims as a risk.

“When a buyer is faced with this issue, they must realize that many courts do not have the power to bar liability claims that are unknown at the time of the sale to the potential buyer; thus, these claims becoming the responsibility of the new owner of the business,” Switzer says.

According to Switzer, one of the other main risks to look out for when obtaining a business already in bankruptcy is the cost itself for bankruptcy court.

“Bankruptcy court and the fees that come with it for the company involved can be extremely high,” Switzer says.  “As a buyer, you want to make sure that the business is able to pay for their fees whether it be through a loan they have taken out, or through other means.”

Hill says that post closing; there is always successor liability that can sneak up on an unaware buyer.

“You can’t identify every third party claim.  Those claims can come out of the woodwork and often do when a transaction closes.  You need to have performed your diligence and work to make sure that you can defend against those unknown third party claims. The other item in a healthcare transaction would be liability related to the provider number; whether it is an overpayment issue, or some technical compliance issue,” Hill says.

“Finally, there is the tax liability.  This is just making sure that the company that you acquired is current with its taxes.  Make sure that the taxes have been paid and that you, as the buyer, will not be dealing with a governmental entity on an unpaid tax.  You may be able to avoid the liability depending on the successor liability statutes of a given state, but it can be a real time consuming process to deal with that.”

Some steps that Hill suggests buyers to take in order to avoid risk starts off with committing to a substantial due diligence process.  This is to attempt to quantify and identify all potential risks out there from all payables to liabilities, debts, litigation claimants, tax issues etc.

“You would structure the transaction as an asset transaction to help avoid some of the risk.  Or you could have your seller go through some sort of bankruptcy process and buy them out of a bankruptcy and get protection of a bankruptcy order,” Hill says.

Fanburg adds that when investing in a distressed business, if proper due diligence is not performed, the buyer can acquire the contract issues that the original owners may have been having, and this can be another hurdle for them to sort out.

Buyer Strategies:

Hill says for an M&A strategy buying assets is strategy number one.  For a healthcare business in particular, you have to debate whether you are going to acquire the provider number of the healthcare entity.  In some cases you may be forced to take on the provider number of the entities.

“For instance, if it is an acute care hospital, you may be forced by CMS to take on the provider number.  Even if you do an asset transaction and take on the provider number, you will, as a buyer, be taking on the risk of any overpayments or other liabilities from a government reimbursement point of view related to that provider number.  That’s important to consider when you are in a healthcare transaction,” Hill says.

If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.

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