The past two years of economic turmoil have affected companies across all industries in different ways. Some have been significantly impaired, falling into financial distress, bankruptcy or even outright liquidation. Meanwhile, others have weathered the storm and some have even flourished. As a result, companies that withstood the worst of the economic turmoil now have the opportunity to acquire companies that did not fare so well. Doing so provides an opportunity to expand market share, acquire strategic assets and even eliminate competitors.

For the companies that have experienced significant declines, a distressed sale often represents the best option to shed significant debt (which might or might not be personally guaranteed) and allow the business a chance to move forward without the baggage of financial distress. However, buying a distressed business is considerably different than purchasing a healthy one. Buyers that are prepared can uncover tremendous value, but buyers that are unaware of the potential issues can find their low-priced deals turning very expensive very quickly. While there is no easy path to success in purchasing distressed companies, following best practices and avoiding common pitfalls can improve the odds.

Define acquisition objectives and goals
Any successful acquisition, whether it involves a distressed business or a healthy one, begins with preparation. It is important to define the goals and objectives of the acquisition and to specify the criteria through which to filter prospective target companies. As with anything else, it’s important to understand what you want to buy before going to look. The objectives should be clearly articulated — perhaps targeting specific geographies, products or capabilities — and documented to maintain integrity. Likewise, criteria such as the size of the deal, whether the management team is intact, and other considerations should not only be put in writing, but also ranked according to their importance. When reviewing distressed opportunities, many companies mistakenly ignore their own goals and objectives because of the incredibly low price of the target company, the risk of someone else doing the deal, or the fear of missing out on a valuable opportunity. Important criteria are often ignored for the same reasons. However, losing sight of your objectives and goals can be a huge mistake. If a target company does not meet the acquisition objectives, chances are it will underperform expectations and potentially steal management attention from the core business. Under the worst circumstances, such a deal can even destroy value in the acquiring company.

Perform due diligence
It is very tempting when purchasing a distressed business to forgo certain aspects of due diligence. Particularly when the purchase is through a § 363 or secured party sale, some buyers are inclined to believe that the process wipes away all past sins of the target company. While this is true in some respects, many issues do not disappear. Doing proper due diligence and knowing exactly what it is that you are buying are critical in order to prevent unexpected, but foreseeable, issues from destroying value. In addition to financial due diligence, which is as important in a distressed transaction as in a healthy deal, suppler, customer relationships, management or ownership and employees areas deserve particular focus.

One of the key benefits of acquiring a distressed company is the ability to purchase the assets free and clear of all liens — including amounts payable to suppliers. Unlike typical M&A transactions, in which normal working capital liabilities (amounts owed to suppliers for purchased raw materials, parts or services) are assumed by the buyer and paid in the normal course of business, many types of distressed transactions allow the buyer to leave those amounts with the old entity and start afresh. From a valuation perspective, this is important because it theoretically means that the company can generate profit from its inventory on hand while buying new material on credit for a few months.

However, relationships with suppliers need to be addressed up front well before the transaction closes. In some cases, suppliers are commodity dealers, and target companies have many alternative sources. Therefore, buyers can simply ignore existing relationships and establish new terms with new suppliers after the deal is closed. In other cases certain suppliers might provide critical parts for which there are few or no alternative providers; this is typical in the automotive industry. Under these circumstances, buyers would be wise to work with existing suppliers before the deal closes to ensure continuity of supply. Any disruption can raise costs exorbitantly or even shut down the business completely.

In any business, customers are the most important asset. In a distressed transaction, evaluating customer relationships is critical but not easy. Depending on the type of business, customer relationships can range from single-source purchasing contracts to being just one of many suppliers to serving the general public. In distressed situations, customer relationships can be strained as a result of supply disruptions or negative public perception. In any case, a buyer needs to understand the reasons behind the strained relationship and take action to mend those relationships. In some cases the relationship can be recovered by simply providing assurance that the business will be properly capitalized and capable of meeting supply requirements going forward. In other situations, particularly when the business is retail in nature, the negative publicity surrounding financial distress may require a more concerted effort to repair the company’s image in the market.

In many middle-market companies, the shareholders also are often management, and as such are critical to the day-to-day operations of the business. In a typical deal, the buyer structures the purchase to retain necessary management, including the selling shareholder, for a period of time. Doing so ensures continuity of management and minimizes disruption to the business. Further, if the business is successful, this strategy ensures that those who led the business to success will remain, at least for a while. However, retaining senior management in a distressed transaction is often not a viable option–whether out of concern for past performance or because of the nature of the transaction itself. It is therefore very important to identify either an external management team that is very familiar with that type of business or junior managers that are capable of taking over operational control. In either case, there is an added dimension of risk.

Finally, but certainly of great importance, employees form the backbone of any successful business. Employee morale can be destroyed quickly once a business is in distress. Often the employees at distressed companies have forgone pay raises and have been asked to take on more responsibility because of hiring freezes and layoffs. At the same time, the core rank-and-file employees often lose confidence in senior leadership during times of distress, and recapturing that confidence is a challenge. A buyer must be aware of the employee situation at the target company and make plans to address any shortcomings. For example, if salaries and hiring have been frozen, a buyer might need to budget for immediate pay and headcount increases. Further, morale-building events might also be part of the plan. The costs of these and other initiatives need to be considered as part of the evaluation process.

Attrition should also be expected in a distressed transaction, both at the rank-and-file as well as management levels. While voluntary departures are by their nature an unforeseeable challenge, a buyer needs to expect some attrition and plan accordingly, both from a logistical standpoint — e.g., making use of recruiters — and a cost standpoint.

Identify the right transaction structure
U.S. law provides several avenues to promote the purchase of distressed assets, including options both in and out of bankruptcy. Identifying the right transaction structure to accomplish specific goals is very important, as are other considerations such as cost. For example, many new acquirers of distressed companies automatically assume that a § 363 bankruptcy sale is the best avenue. However, filing for bankruptcy carries significant costs and opens up other areas of risk. In certain situations, the same objectives sought through bankruptcy can be met out of court, thus reducing costs substantially. Working with your attorney (preferably one with bankruptcy experience) and a qualified financial advisor (again, preferably one with significant knowledge of distressed transactions) can help guide you to the best structure that meets your objectives.

Distressed transactions can present a huge opportunity to generate value. But along with that potential comes a lot of risk. Buyers looking to acquire distressed companies must be fully prepared to face the complexities of the process and to commit the significant resources necessary to succeed. Hiring knowledgeable advisors is also highly recommended; they can help fill in gaps in a buyer’s knowledge and lend their considerable experience to many types of situations. By preparing upfront and retaining proper counsel, the acquirer positions themselves for the greatest chance at success.

Erik Egerer is a manager with Grant Thornton Corporate Finance. This article was reprinted with permission from Grant Thornton.