When to catch a falling knife - the risks and potential benefits of distressed M&A

This report analyses acquisitions of healthy, distressed, and bankrupt firms, and finds no real evidence that the market expects acquisitions of distressed targets to be any more value enhancing or destructive for the acquirer than a ‘normal’ deal. However, it does find that long-term performance tends to be superior.

The global financial crisis led to an increase in the share of acquisitions involving distressed targets.

That another crisis will occur some day is a matter of when, not if, and when it does distressed acquisition opportunities will again emerge. Even without a full-blown crisis, opportunities will arise, whether simply from the normal economic cycle or from industry disruption that leaves a company in crisis mode. Hence the timeliness of the report, How, and when, to catch a falling knife: The Benefits, Risks, and Timing Issues Around Distressed M&A, which analyses past distressed acquisitions in order to better understand how to prepare for the future.

The logic for the need and indeed attraction of such deals is clear. Corporate finance scholars argue that mergers and acquisitions can be effective means for resolving financial distress, which can take place either inside or outside of bankruptcy. Acquisitions of distressed targets are one of three ways to reorganise firms in financial distress (corporate restructuring in a strict sense, and liquidation being the other two).

However, whether it is in the acquirer's best interests to pursue a distressed acquisition is harder to answer. It is not difficult to find examples providing evidence either way. In 2009, immediately post the financial crisis, Premier Oil acquired the distressed OIlexco North Sea. Initially the stock performed well but years later Premier shares were trading at less than half the level they were at the time of the deal, having also under-perfomed the sector by c.50%. It could be that the deal triggered the under-performance but is perhaps more likely this was a case of doubling up on a falling asset, oil.

The timing of distressed acquisitions is covered in this report and the study accounts for more general industry trends to try to answer the ‘cause’ question suggested by the following example. In 2012 the distressed retailer JJB Sports was acquired by its competitor Sports Direct. Five years later, despite what had been a very tough time for retailers in general, Sports Direct’s share price was still up versus its 2012 level and marginally outperformed the FTSE 100 too. Without the JJB Sports deal, would it have done so?

The report finds that:

  • distressed acquisitions have particular characteristics. They tend to take longer to complete and, perhaps counter-intuitively, involve higher premiums. However, they are no harder to complete than any ‘normal’ transaction.
  • Based on analysis of the short-term deal announcement reaction, the report finds no significant reaction, either positive or negative, associated with distressed acquisitions as compared to ‘healthy’ acquisitions.
  • However, if there is a ‘falling market’ then distressed deals are welcomed by the market more than non-distressed acquisitions.
  • In the longer-term, looking three years out, the report's analysis shows that newly-combined firms where the target is distressed generally benefit from an overall improvement in operational performance compared to their combined pre-bid performance (compared to a base case ‘healthy’ acquisition), evidence of better synergy realisation or the benefits of opportunistically consolidating a market.

So, firms that are considering such deals may be advised to be patient. The market’s reaction may depend on the timing but the   payoff operationally could very well be positive.

The full report, How, and when, to catch a falling knife: The Benefits, Risks, and Timing Issues Around Distressed M&A, is available for download at City Research Online.