Recently reported discussions between the Federal Government and the major Australian banks regarding a possible property loan bail out scheme, known as Australian Business Investment Partnership, have highlighted the growing pressure on many participants in the Australian commercial property market to manage their existing debt obligations and deleverage asset portfolios. Strong market fundamentals led by sustained rental and capital returns are being countered by poor investor sentiment and high levels of risk aversion.
This has resulted in a decline in property valuations and a growth in the number of forced sales by distressed sellers looking to reduce their high debt gearing on asset portfolios. As banks increasingly warn of the large number of commercial property loans at risk, purchasers with access to capital have an opportunity to acquire assets which were either not previously on the market or were otherwise too expensive.
In this article we'll look at:
- the potential benefits to a purchaser in dealing with a distressed seller on a transaction involving unlisted commercial property assets;
- the levels of risk to a purchaser on these types of transactions and how these risks can be addressed through a well-managed due diligence and sale process;
- how a purchaser can restructure an asset to extract maximum flexibility and value; and
- the growing trend in the use of joint ventures by distressed property investors.
Whether the purchaser can effectively balance the risks and benefits of a distressed asset transaction will ultimately decide whether an asset is a winner.
What are the benefits of dealing with a distressed seller?
For most, long-term capital growth and stable revenue streams remain the main drivers in commercial property investment. While recent well-publicised collapses in the value of some of the larger listed property funds have affected market sentiment, the fundamentals of the commercial property market remain solid and continue to provide good opportunities for investors.
This gap between valuations and income and capital yields means that distressed sellers are forced to dispose of assets at a significant discount to reduce their debt gearing on asset portfolios. Importantly, many forced sales are essentially in response to lenders taking a conservative view as to the risks of high debt gearing over portfolios, not the underlying performance of the asset.
Purchasers should look for indicators that sale assets are fundamentally sound and are performing well. Indicators of future growth include long-term anchor tenancies, stable revenue returns and transparency in existing management structures. The assets should also meet the purchaser's investment criteria and fit into its long-term investment strategy, as the current economic uncertainty could mean a lower price return for assets disposed of in the short-term.
What are the risks in dealing with a distressed seller?
The risk in contracting with a distressed seller will depend on the nature of the seller and the type of asset being sold. Purchasers may target particular types of assets to reduce their risk exposure.
Where there are doubts over the long-term solvency of a distressed seller, it is usually preferable to complete the transaction before an administrator is appointed, although arguably a price sought by an administrator could be lower than that sought by a distressed seller. Dealing with the seller's board and management instead of an administrator often means there is greater flexibility in agreeing the sale structure.
Some of the issues that a purchaser will have to deal with if an external administrator is appointed before or during the sales process include:
- the process the administrator must follow when dealing with the asset can cause lengthy delays in finalising the transaction;
- no (or extremely limited) warranties and no indemnities will be given by the administrator in relation to the asset;
- the competing interests of creditors and financiers may impede the administrator in dealing with the asset;
- the act of going into administration may trigger default provisions under existing contracts;
- where the asset is a company that employs staff, there may be staff retention issues;
- adverse tenant and supplier reactions to the appointment on an administrator; and
- an adverse impact on the brand and business of the asset.
All these issues can affect the asset's future value, and should be factored into the decision to continue with the purchase and the price offered. A purchaser should always factor in the risk that a seller may become insolvent during the course of the transaction, or as a result of entering into the transaction, and that an administrator may deem the transaction void for being uncommercial. As such, as part of the due diligence process, the purchaser may need to get some level of comfort with regard to the future solvency of the purchaser, for example, an undertaking that the sale proceeds will be applied to alleviate some of the seller's financial problems with its lenders and creditors to minimise the risk of insolvency going forward.
The need for speed vs a proper due diligence
Speed in decision-making in these types of transactions is crucial. The interests of key stakeholders including financiers, company directors, shareholders and creditors can change relatively quickly. The range of conflicting interests often encountered by a purchaser in a distressed asset transaction makes achieving completion on a deal a particular challenge.
This need for a swift resolution must however be balanced against the need for a proper, thorough due diligence process.
Often, even the simplest of sale transactions involving a distressed seller does not provide adequate time for a thorough and comprehensive due diligence of the asset. An imperfect due diligence increases the risk that the purchaser will fail to identify deal-breaker issues. Conducting a due diligence in a shorter timeframe also increases the transaction costs which can be significant when the asset structure is complex.
In addition, any warranty or indemnity given by a seller in financial difficulties may be essentially worthless. As such, a purchaser needs to be comfortable that any risks it identifies can be managed or mitigated in a different way. For example, a purchaser could use pricing mechanisms or require moneys in escrow for any future warranty claims, or ensure that identified risks can be controlled or minimised through a change in management post-acquisition, removing the need to rely on warranties and indemnities provided by the seller.
The challenges of restructuring a distressed asset
A purchaser will often need to restructure existing finance and management arrangements, particularly if it is also acquiring shares in a company. An asset sale may reduce the need to restructure and enhance the ability of the purchaser to deal with the asset post-completion.
Purchasers should consider whether finance arrangements are on best terms available and ensure that the acquisition of a highly leveraged asset will not breach covenants with its lenders. Further comfort can be derived by seeking a commitment from existing lenders that refinancing can be obtained and existing securities will not be enforced, including for any breach by the seller arising before completion of the sale.
Ensuring there is clarity and full disclosure of existing management and contractual arrangements by the seller at the beginning of the transaction will reduce risk and unnecessary due diligence costs being incurred on an asset which does not meet the purchaser's investment criteria.
Where sale assets are subject to management rights, careful consideration should be given to "unwinding provisions" in the relevant agreements and whether the rights can be dealt with separately from the underlying assets. Flexible management arrangements will increase the control of the purchaser over the asset post-completion and allow full value to be extracted from the management rights. An effective due diligence will also reveal any "poison pill" provisions and one-off payments which impact on price.
Joint venture opportunities
The difficulties in raising capital and refinancing debt in the current market has also led to an increase in the use of joint ventures by parties struggling to meet funding requirements on property portfolios.
Like any joint venture arrangement, contracting with a distressed seller can be plagued by problems if certain issues are not addressed in the early stages of the transaction. Risks to an incoming joint venture party can be reduced by restructuring existing arrangements and renegotiating key agreements to meet its requirements. Careful consideration of governance and control issues is also key to ensuring the asset is properly managed.
Joint venture parties should be able to exit the joint venture on clearly documented and favourable terms. Typical exit mechanisms include a right of first refusal or a "roulette clause" under which a party can offer to sell its share to the other party at a specified price. The party in receipt of the offer can either accept the offer or reverse the offer at the same price. A robust and well documented valuation methodology is crucial to the effectiveness of such provisions.
However these historical means of exiting a joint venture may not be effective if a joint venture party is a distressed seller, so joint venture arrangements should be flexible and incorporate alternative exit mechanisms to deal with changing market conditions.
Provision for the adjustment of equity ratios can address the risk of one joint venture party being forced to contribute further capital because the other party cannot meet its funding commitments, whether because of insolvency or a general shortage of capital. The risk of one party to a joint venture becoming insolvent can be further dealt with by documenting wider default provisions to ensure pre-emptive rights are triggered in appropriate circumstances. The incoming joint venture party should also ensure it is not disadvantaged by the interests of existing security holders.
While the commercial property market in Australia deals with the uncertainty caused by the wider economic slowdown, the opportunities to acquire quality commercial property assets at a discount from distressed sellers will continue to grow. Purchasers looking to capitalise on these opportunities are faced with a range of risks and benefits unique to these types of transactions. Relevant considerations for purchasers will depend on the nature of the seller and the proposed sale structure.
Purchasers will often be under pressure to conduct the transaction quickly to avoid the risk of dealing with a company in administration or to ensure that the positions of key stakeholders do not change. Sellers will also push for a quick transaction to increase the liquidity on their balance sheet.
Developing a sound due diligence process to address the imperfect nature of information available and identify risk will help a purchaser make an informed decision on whether an asset is a winner.