The 2023 outlook: Insolvencies and distressed M&A

Rebecca Archer

Welcome to Navigating the New Normal, Grant Thornton's podcast exploring trends in business and the marketplace. I'm Rebecca Archer, and today I'm joined by Graham Killer, Partner and Insolvency specialist and Cameron Bacon, Partner and Corporate Finance expert at Grant Thornton.

Today we're talking about insolvencies and distressed mergers and acquisitions and how we can expect 2023 to shape up. Welcome Graham and Cameron.

Graham Killer

Thanks, Rebecca.

Cameron Bacon

Thanks, Rebecca.

Rebecca Archer

Now, we've just come out of a year full of increases to interest rates, to the cost of living, to the costs associated with doing business – and that's of course, continuing into 2023, possibly also now heading into a recession this year. What is on the horizon for 2023? And 2024?

Graham Killer

Rebecca, I might kick off on that question – and I suppose it's a really interesting question and 2023 and 2024, in my view, is difficult to predict. We know that we're moving into a more difficult trading environment – without a doubt – and I suppose the way I like to look at it is kind of looking at the headwinds. What are the headwinds that the markets facing right now?

And probably there are three key headwinds I would look at trying to look at what the prediction is – we look at consumer confidence as first one. The Westpac Melbourne Institute recent survey placed it lower than the GFC, actually, to get a weaker reading, you probably need to go back to the 1990s. You then look at that weak reading, but then you'll look at in reality, and just look at consumer spending at the moment, and there seems to be this disconnect between that consumer spending, as consumers are still spending, and this index, and that's because of that built up cash through COVID.

Consumer confidence is obviously impacted by a number of factors, you know, employment is a positive. On the other side, you know, general cost of living, as you mentioned, is increasing. You've got house prices starting to fall in some areas, that impacts negatively, and then you’ve got this fixed interest rate, debt cliff, a lot of people locked in their loans during COVID. So, you know, the true impact of consumer confidence won't actually come through to 2023 back end, or 2024, as that fixed interest rate clip comes off. You know, the survey also, interestingly said that major purchases of households, actually is the lowest in 48 years, or the fourth lowest score in 48 years – that’s a really low score on the ground, that consumer confidence, but we're not seeing that yet in the market.

Second of all, I suppose that interest rates are talked about. Interest rates are continuing to rise, and I don't recall a time when consumer confidence is plummeting, and interest rates keep rising. So, we've got this very interesting position right now in the market. So, in March, the RBA increased to 3.6 per cent and that's the highest we've seen in the last 10 years – and there's predictions that will continue. And we've seen this global uncertainty in the last few weeks, but the banks overseas and central banks continue to increase rates despite that uncertainty.

So that probably leads me to the last headwind, I probably think is important is inflation and cost pressures. We've seen businesses facing significant increases in their cost basis from wages, rent, and more generally, just general price increases. So, when you look at those three headwinds, we're kind of heading into this perfect storm in the back end of 2023/2024. As consumer demand falls, whilst business costs increase, resulting in margin squeeze. And I think that margin squeeze is the real issue, and that's what's going to impact profitability. So very difficult to predict, but certainly moving into tougher conditions.

Rebecca Archer

In light of those conditions – and thank you so much for such a thorough overview of what things are looking like – how can businesses plan ahead? I mean, what's the outlook for them? How do they sort of get their heads around what to put in place in the next 12 to 18 months, for example?

Graham Killer

Even with those headwinds I talked about – the good news is that most businesses through COVID-19, were able to adjust their cost base and benefited from those emergency low interest rates. So, they built up this significant cash reserves. So, we're actually starting this period in actually generally a fairly good position, and Cameron will probably touch on it later – there’s still plenty of cash out there in the market. So, businesses are sitting on plenty of cash.

You know, the corporate market performed very well and continues to make very good profits. So, I think the concern for me is that mid-sized business market rather than the larger corporates where I think the concern is going to be, because going into these uncertain times, it's the management team that don't have the experience. You know, it’s been 15 years or so since the GFC. So, a lot of people haven't had the opportunity to manage into a recession or potential recessions. So, it's more those businesses in that mid-market space where they don't have the management teams experience to handle the challenging times, which I think is one of the biggest issues.

You know, how do you protect yourself? Right now, it's more important than ever, to understand your business. You know, businesses with a clear strategy, detailed forecast built on key drivers, you know, having that timely financial information – that’ll be a competitive advantage, because they’ll move a lot quicker than the competitors who are slow to react. And in uncertain times, it's about speed to reaction. It's around that scenario planning. You know, we're working with businesses at the moment, and sitting there talking to them as, ‘what if’ – what happens if this revenue does fall or cost rise? What are the levers we're going to pull today to make this change, not wait to the circumstances actually arrived, but actually working with them so they're well planned, and they’re already known. It's taking the emotion out of the decision, I suppose, so that it's actually a strategy – it’s a strategic decision. It's not a knee-jerk emotional decision. So, plan – scenario planning, and have a clear strategy is what's going to be important going forward.

Rebecca Archer  

It sounds as though some businesses will definitely face difficulties, what should they do?

Graham Killer

I suppose the most important thing, in my view, is to seek advice and seek advice early. And this is where management teams need to understand where their strengths are, and where the areas that they need to work with someone collaboratively – so bringing someone onto that team because no, not every management team has the full suite of skills. So, the earlier you act, the more options available to yourself, and the better place you'll be to deal with the challenges and headwinds that are confronting us.

Rebecca Archer

And what are some of the early warning signs that Directors should maybe be looking out for?

Graham Killer

That's an interesting question. So, as we're sitting here today, it's clear that there's so many challenges out there. We're getting obviously a lot more engagement in the advisory – in the restructuring space right now. Businesses have to have a strong foundation to absorb the challenges ahead. So right now, if I had significant ATO debt – even if that was subject to a repayment plan – question is will they be able to continue to meet those repayments? So, if you're starting at a time of headwind and you've already got a significant ATO debt, that's a concern.

Business profitability is starting to decline. If businesses are already incurring losses today, then that's a real concern. Paying creditors later than normal – and then I suppose if you haven't amortised, your bank debt during COVID-19, and some businesses obviously had to take out additional debt through that period because every business was impacted differently. Will they have enough trading profitability, or surplus cash flow to amortise that debt? That's probably the key warning signs. You know, there's lots of other warning signs out there, you know, I could list off another 20. But you know, they're the ones that start off if you have significant ATO debt, profitability is already declining – especially if you're in losses – you’re paying creditors later than normal. I'd start to be concerned today.

So, I suppose just finalising and looking at those early warning signs. You know, whilst businesses might be profitable, you know, the Directors may find that they actually won't generate significant profits through 2023 24 to repay some of the legacy debts built up through COVID, and they might actually need to consider a formal insolvency process to deal with some of the structural issues. So, in rare cases, Directors may need to seek that formal restructuring process through Voluntary Administration into a Deed of Company Arrangement, just to give them that outcome that they need to solve the built-up issues through COVID-19.

Rebecca Archer

Cameron, if we can turn to you now, I'm wondering if you think this will be the year of distressed mergers and acquisitions? What's the current state of play for M&A activity in Australia right now?

Cameron Bacon

Thanks, Rebecca. I think to answer that in in a couple of different for you all. First of all, I’ll focus on the difference between distressed mergers and acquisitions and normal M&A. Normal M&A occurs where shareholders willingly choose to undertake a transaction. For example, where private shareholders choose to sell the business for succession planning reasons, or where a corporate wishes to exit a non-core asset. Distressed M&A can occur where shareholders are seeking to sell to avoid an insolvency event, or where a sale is required by Financiers, where they're effectively enforcing their security position. Distressed M&A is often undertaken in an accelerated fashion, because of the need to promptly find a buyer for those assets.

So, in terms of the current state of the Australian M&A markets, we've been monitoring and analysing M&A activity in the Australian marketplace for over 10 years in a report that we call our Deal Tracker report. Based on our last Deal Tracker report, which came out a bit over 12 months ago – I’m going to go back and sort of think about what happened through those COVID times – we did see a decline in M&A volumes in the second quarter of 2020 when we first started hearing about COVID, and that decline was as a result of the immediate uncertainty caused by COVID and lock downs commencing in March 2020.

What we noticed though, pretty quickly is that once investors and Financiers went through a triage process to identify if they were involved in businesses that may be at risk, they then recommenced their M&A activity, and volumes of transactions grew on a quarterly basis from the third quarter of 2020, and I'm talking calendar years now, to the fourth quarter of 2021 to reach record highs. In 2022, volumes were off that record high of quarter four 2021 and they stabilised and ultimately resulted in very consistent volumes of transactions between 2021 and 2022 at around the 1,300 to 1,400 mark per annum.

Over the last few years, we have seen the both the industrial sector and the IT sector have been the most prevalent sectors for M&A activity, and that Australia has also been a very active market for offshore acquirers. About 30 per cent of the deals of Australian assets have been sold to offshore acquirers. We do, however, note that there has been quite a decline in public M&A, or public takeovers, public company takeovers and larger type transactions. So, Grant Thornton focuses on the mid-market, and I do feel that this volume decline that we have seen has really predominantly been at the upper end of the market, and hasn't affected the mid-market quite so much at the moment.

Rebecca Archer

And what about now? Are you seeing an increased volume of distressed M&A transactions in 2023? Or what happened throughout 2022 as well?

Cameron Bacon

I did read a recent Ansarada Global Report – Ansarada is a provider of electronic data rooms that lots of advisors use – and they released their report to say in the fourth quarter of 2022 insolvency-related transactions increased 20 per cent from the previous quarter, and 17 per cent from the previous year in the same quarter.

So, I do note that these statistics are global. In Australia, we've certainly seen some distressed M&A in recent months, but I don't think we're yet seeing it at the levels that's been seen globally, but I can confirm and I'm sure Graham could also, that Grant Thornton is involved in a number of distressed M&A transactions at the moment.

Rebecca Archer

Well, yeah, let's hear from Graham – what are the key drivers at the moment when it comes to distressed M&A?

Graham Killer

I suppose when you're looking at distressed M&A, you're looking for a solution. So, as I talked about earlier, if you've got that declining profitability, Directors have to start to make a choice early – are they able to restructure their business and that restructuring may be through a formal process to restructure the cost base. Alternatively, it may actually be an opportunity for a business to effectively take cash off the table, go through an accelerated or a distressed M&A process to get the best return for shareholders or the best return overall. So, it really depends on sector by sector, but one option on the table, there also always is a sale or an accelerated sale to maximise the value for everyone involved.

Rebecca Archer

Can you tell me why anyone would even invest in a distressed business? What's the appeal?

Cameron Bacon

I guess there's two main groups, Rebecca, who would be interested in undertaking distressed M&A transactions. First of all, for existing industry participants, a transaction, whether it be a normal M&A or a distressed M&A, can really give them the opportunity to increase their market presence or move into new sectors or geographies, or acquire new customers. Also access to machinery or equipment or intellectual property, and it can also sometimes give people the opportunity to, I guess, recapitalise a strong business that had just been suffering under too much leverage. Also, there are specialist distressed M&A acquirers in the private equity markets, who have got a focus on acquiring distressed assets, and then effectively fixing them up if you like, with the intention of selling them for a capital profit.

Graham Killer

A lot of businesses that go into distress or a number of businesses, it may be because of a poor decision, you know, it could be a loss of a major contract, or just management may not have optimised the profitability of that business. So, whilst the current management team or current owners may not have made, been able to make the business successful, it doesn't mean that someone coming in with a fresh lens can't make immediate changes to turn their business into a loss position to highly profitable. And we find that when we're doing turnarounds, and we get involved with clients all the time, you know, businesses that may be losing money. By making strategic change and just making those hard decisions, you know, taking the emotion out of those decisions, you can actually turn an unprofitable business into a profitable business in most cases. The only issue I suppose, is where they've over capitalised – so they've spent too much on a site you know, they lock themselves into an agreement, which you can't actually get out of, but generally speaking, you can always turn around, provided that there is a demand for the product, you can always turn around and business from a loss position to a profitable business – generally speaking.

Rebecca Archer

So Cameron, I'm wondering what considerations need to be made when structuring and of course financing a distressed M&A deal?

Cameron Bacon

Rebecca, things that people are thinking about generally when they're structuring and financing a distressed M&A deal is firstly, generally it's an asset acquisition. So, the risks associated with owning a potentially insolvent company don't transfer to the buyer. Secondly, there are generally no warranties that are provided by the vendor or the administrator or liquidator. Therefore, the assets transferred on an as is where is basis, so there's a greater level of risk that buyers are taking on. And for this reason, these assets are often sold at a discount to their book value.

Graham Killer

To Cam’s points, a couple other points I'd make there is, generally speaking, depends on the type of position, it's an asset sale because of those liabilities or concerns about unknown liabilities. And sometimes, you know, it may actually be that you need to facilitate a sale through a Voluntary Administration process so that – and that can either be through a sale, through Voluntary Administration, or through a Deed of Company Arrangement, and that's to deal with those liability issues. So, it really depends on the circumstances of, you know, whether you need some of those leases in place or those contracts. But generally speaking, asset sales are there but in certain circumstances, purchase may be through a Voluntary Administration process.

Rebecca Archer

Now, I'm wondering what can we expect in the future when it comes to distressed M&A acquisitions, being mindful of the fact that you have said the business outlook is uncertain and no one's really sure what will happen?

Cameron Bacon

I guess first of all, thinking about the non-distressed part of the market and then leading into the distressed part. Graham commented earlier that there is a lot of capital around in the market at the moment. Private equity funds have got significant amounts of capital as do Family Offices, and ASX listed entities who have remained with strong balance sheets generally. So, we do expect continued interest in M&A, particularly in the mid-market space – I think it will be harder at the larger end of town though.

The ASX performed relatively well early in the year before handing back some of its gains through February and March. So, the early parts of the year probably provided people with some confidence to undertake M&A, whereas that may have been diminished a little bit over the last month or so. In terms of key sector themes that we would expect to see from a non-distressed M&A perspective, we would expect both IT and industrials to still be strong markets, digital transformation, ESG and cybersecurity – lots of those sectors have got a number of people looking for new acquisitions or investments at the moment. However, we do expect distressed M&A to also be increasing, but as Graham commented earlier, where businesses have made a poor decision or two in the past, that also may lead to some distressed M&A in, you know, sectors that are actually still quite positive in the Australian economy.

Graham Killer

And I just wanted to add Cam to that point is, even over the last few years, there's always distressed M&A – so we don't have to go into uncertain times. You know, we've been working with clients across the board and opportunities that those that are well positioned with strategy, we've been able to help them actually acquire businesses that, you know, that haven't adjusted to an industry cycle. So there's been plenty of movements of distress, kind of M&A, even during positive growth times where businesses haven't adjusted to their industry impacts.

Rebecca Archer

Graham and Cameron, thank you so much for your time today and sharing your expertise and knowledge about this particular topic.

If people are wanting to get in touch with you who are listening today and interested in hearing more or learning more about specifically what you do and how you might be able to help them, what's the best way for them to find you?

Cameron Bacon

Graham and I can both be reached either on our mobile numbers or direct email addresses or through the Grant Thornton website, as well as LinkedIn.

Rebecca Archer

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