Distressed M&A is one of the most complex and high-stakes areas of investment banking. Unlike a typical acquisition where two healthy companies negotiate a deal, distressed M&A involves buying companies that are in financial trouble, often in or near bankruptcy. The process is governed by unique legal frameworks, the timelines are compressed, and the risks and rewards are amplified on both sides of the transaction.
If you are recruiting for restructuring investment banking or any group that touches distressed situations, you need to understand how distressed M&A works. This guide covers the key concepts, transaction structures, and considerations that define this space.
What Is Distressed M&A?
Distressed M&A refers to the acquisition of a company (or its assets) that is experiencing severe financial distress. This typically means the company is unable to meet its debt obligations, is in default on its loans, or has filed for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code. In some cases, the company may not yet be in bankruptcy but is clearly headed in that direction: this is known as a “zone of insolvency” situation.
The acquirers in distressed M&A transactions are often private equity firms, strategic buyers looking for bargains, or hedge funds that specialize in distressed investing. The sellers are typically the company itself (through its management or a bankruptcy trustee), the company’s creditors, or a combination of both.
Why Distressed M&A Is Different from Regular M&A
Several factors make distressed M&A fundamentally different from a typical M&A transaction.
Compressed Timelines
Distressed companies are burning through cash and losing value rapidly. Every week that passes without a resolution can erode the company’s asset base, customer relationships, and employee morale. This creates enormous time pressure on all parties to negotiate and close a deal quickly. Whereas a typical M&A process might take six to twelve months, a distressed sale can be completed in a matter of weeks.
Multiple Stakeholders with Competing Interests
In a healthy company sale, the primary negotiation is between the buyer and the seller (i.e., the company’s shareholders). In distressed M&A, the stakeholder landscape is far more complex. Secured lenders, unsecured creditors, bondholders, trade creditors, employees, pension beneficiaries, and equity holders all have claims on the company’s assets, and their interests often conflict. The bankruptcy court plays a central role in mediating these competing claims.
Valuation Uncertainty
Valuing a distressed company is significantly more challenging than valuing a healthy one. Traditional valuation methods like DCF analysis become less reliable when the company’s cash flows are declining, unpredictable, or negative. Comparable company analysis may also be less useful because healthy peers are not an appropriate benchmark for a distressed business. Liquidation analysis, which estimates the value of the company’s assets if sold piecemeal, becomes a critical valuation floor.
Legal Complexity
Distressed M&A transactions that occur within the bankruptcy process are governed by the Bankruptcy Code, which imposes specific requirements around notice, bidding procedures, and court approval. The legal framework adds layers of complexity that do not exist in regular M&A.
Section 363 Sales: The Most Common Distressed M&A Structure
The most common way to sell a distressed company (or its assets) in bankruptcy is through a Section 363 sale, named after Section 363 of the U.S. Bankruptcy Code. A 363 sale allows the debtor to sell assets outside the ordinary course of business with the approval of the bankruptcy court.
One of the most important features of a 363 sale is that the buyer acquires the assets “free and clear” of most liens, claims, interests, and encumbrances. This is a huge advantage for the buyer because it means they are getting clean assets without inheriting the company’s pre-existing liabilities (with limited exceptions, such as certain environmental liabilities or successor liability claims). This “free and clear” feature is a primary reason why buyers prefer 363 sales over out-of-court acquisitions of distressed companies.
The Stalking Horse Bid
In many Section 363 sales, the debtor (or its advisors) will negotiate a deal with an initial buyer before the formal auction process begins. This initial buyer is known as the “stalking horse bidder.” The stalking horse bid establishes a floor price for the assets and sets the terms that other bidders must beat.
The stalking horse bidder takes on risk and expense by doing due diligence and negotiating a deal early in the process, knowing that other bidders may outbid them at auction. To compensate for this risk, the stalking horse bidder typically receives certain protections, including a breakup fee (usually 2-4% of the purchase price) and expense reimbursement if they are outbid. These protections must be approved by the bankruptcy court.
Once the stalking horse bid is in place, the bankruptcy court approves bidding procedures and sets a timeline for other interested parties to submit competing bids. If competing bids are received, an auction is held, and the highest and best bid wins. The court then holds a hearing to approve the winning bid.
Credit Bidding
A unique feature of distressed M&A is credit bidding. Secured creditors, those whose loans are backed by a lien on the company’s assets, have the right to “credit bid” at a 363 auction. This means they can use the face value of their debt as currency to bid on the assets, rather than paying cash. For example, if a secured lender is owed $100 million and the assets are being auctioned, the lender can bid up to $100 million without putting up any additional cash.
Credit bidding gives secured lenders significant leverage in the auction process. In many cases, secured lenders use credit bidding as a way to take ownership of the assets, effectively converting their debt position into an equity ownership stake in the restructured company.
Out-of-Court Distressed Acquisitions
Not all distressed M&A transactions go through bankruptcy court. Some distressed companies are acquired through out-of-court processes. In these situations, the buyer negotiates directly with the company and its creditors to purchase the business or its assets without a formal bankruptcy filing.
Out-of-court transactions can be faster and less expensive than in-court processes, but they come with significant risks. The buyer does not get the “free and clear” protection of a 363 sale, which means they may inherit certain liabilities. The buyer also cannot use the court’s authority to reject unfavorable contracts or leases, which is a tool available in bankruptcy.
The Role of Investment Banks in Distressed M&A
Investment banks play a critical role in distressed M&A on both sides of the transaction. Banks advising the debtor (sell-side) are responsible for running the sale process, marketing the assets to potential buyers, and maximizing value for the estate. This often involves identifying and reaching out to strategic and financial buyers, managing the data room, coordinating due diligence, and negotiating the stalking horse agreement and bidding procedures.
Banks advising potential acquirers (buy-side) help their clients evaluate the opportunity, perform due diligence on the distressed company’s assets and liabilities, develop a bid strategy, and navigate the legal complexities of the bankruptcy process. Some banks also advise creditor committees, helping them evaluate the fairness of the proposed sale and advocate for their clients’ interests.
The restructuring groups at major banks, such as the groups at Houlihan Lokey, PJT Partners, Lazard, Evercore, and the bulge brackets, are the primary teams involved in distressed M&A advisory.
Key Considerations for Buyers in Distressed M&A
Buying a distressed company can be an attractive opportunity: the buyer can acquire assets at a significant discount to their going-concern value. However, there are critical considerations that buyers must evaluate carefully.
- Due diligence challenges: Distressed companies often have incomplete or unreliable financial records. Management teams may be demoralized or uncooperative. The compressed timeline leaves less time for thorough due diligence.
- Integration risks: Key employees, customers, and suppliers may have already left or may be at risk of leaving. Restoring confidence in the business post-acquisition is critical.
- Liability exposure: Even in a 363 sale, certain liabilities may follow the assets. Buyers need to carefully assess potential successor liability, environmental claims, and other risks.
- Financing availability: Financing a distressed acquisition can be challenging because lenders may be reluctant to extend credit for a troubled business.
- Competitive dynamics: Other bidders, including credit bidders, may drive up the price beyond what makes economic sense.
Distressed M&A in Investment Banking Interviews
If you are interviewing for a restructuring role, you should expect questions about distressed M&A. Common topics include: how a Section 363 sale works, what a stalking horse bid is and why it is used, how credit bidding works, the difference between in-court and out-of-court distressed acquisitions, and how valuation differs for distressed companies.
You should also understand how the capital structure (specifically the priority of claims) affects who gets paid in a distressed scenario. Knowing the waterfall of claims (secured debt, administrative claims, unsecured debt, subordinated debt, equity) and understanding the concept of the “fulcrum security” are fundamental to restructuring interviews. A strong grasp of how the three financial statements link together and how enterprise value and equity value relate to each other will serve you well in these conversations.
For more help preparing, check out our technical cheatsheet and free resources.
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