Bankruptcy reorganisation: revealing an investment window

By Zheng Guofan, W&H Law Firm
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Most people tend to think of bankruptcy in the narrow sense: liquidation. A string of business bankruptcies in the 1990s perpetuated this idea. Since bankruptcy means all investments go down the drain, why would anyone in their right mind wish to invest in a bankrupt business?

However, with establishment of the bankruptcy reorganisation system, and in particular the gradual rollout of the pre-reorganisation regime, the winds have fundamentally changed in recent years.

Bankruptcy investment is “bargain hunting” in the capital market. In his book The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Howard Marks, co-founder and co-chair of Oaktree Capital Management, said: “The best opportunities are usually found among things most others won’t do”.

Bankruptcy reorganisation: investment window
Zheng Guofan
Senior Partner
W&H Law Firm
Tel: +86 21 2308 8836
E-mail:
gofan4321@163.com

Compared with favoured assets, their neglected peers are often cheaper in valuation as they are unpopular and underestimated. But ironically, the unreasonably low price becomes their unique edge, boasting extraordinary reward-to-risk ratio.

Compared with traditional mergers and acquisitions, there are a number of advantages to investing in bankrupt businesses: low acquisition cost, relatively thorough settlement of debts, court-dominated and supervised reorganisation procedures, and judicial enforceability of the reorganisation investment plan.

While most investors are discouraged by the complexity of legal relationships and debt structures – failing to see the asset value concealed underneath – the time could be ripe for “bargain hunting”.

Determine the type of distressed companies and understand why their assets are snubbed. A cheap and neglected asset is not necessarily bad. A reorganisation investor needs to understand why the company is in trouble in the first place.

Distressed companies can be classified into the following two types:

(1) Companies in a temporary debt crisis. Such businesses usually have good operating conditions, their bankruptcy the result of failed debt scheduling or cash flow disruptions, especially when bank loan acceleration aggravates the situation and triggers a series of lawsuits. These companies have quality assets and sound governance in sectors fitting investment plans. The original shareholder may offer its own shares to attract financial investors, or even enter into a common-benefits debt agreement with them. The investment risk is relatively low.

(2) Companies with core assets. Such companies are usually characterised by incomplete corporate governance structure, sluggish principal activity, and loss of most profitability. There may be little value for reorganisation, but the special “shell resources” or “core assets” are worth salvaging, even though they can be difficult to acquire, dispose of or transfer. Investing in such businesses requires not only a wealth of capital but also high-quality supporting operations that can quickly fit into the debtor’s management system to get the business back up and running. These companies are more demanding on investors and carry higher risks, but they also provide more room for profit.

Determine the type of investment with particular emphasis on investment strategy. Reorganisation investment in essence is the merger and acquisition of equity; in other words, acquisition of equity interests in a bankrupt business through investment.

Such investments are divided into two categories:

(1) Strategic investment, aiming to restore operation. The investor acquires control over a company through equity restructuring, and improves its revenue and profit through sound operation.

(2) Financial investment, targeting capital appreciation. The investor acquires part of the equity in a company through equity restructuring, but does not generally participate in its business operation. Instead, it profits via divestment at an increased stock price after the target company becomes profitable.

Between the two, the former focuses on the potential of the company rather than its current conditions. Strategic investors place their bets on future performance that may or may not materialise, while financial investors look at a company’s current value.

How to identify a viable target before anyone else. Keeping track of investor recruitment information is an important way to gain investment opportunities. However, high-quality assets can be highly sought after, and bankruptcy reorganisation projects are no exception.

When announced to the public, good reorganisation projects will attract bids from many interested investors. Public recruitment is not a statutory procedure. In practice, there are two ways to recruit investors: public recruitment and debtor negotiation.

Staying ahead of the competition requires keeping abreast of information, rather than waiting for announcements.

Investors should not only keep an eye on internet platforms for updates, but also establish a variety of information collection channels. These can include maintaining a long-term relationship with the association of bankruptcy administrators, as well as law firms and accounting firms engaged in the bankruptcy business, and maintaining contact with financial institutions such as banks, asset management companies, securities companies and trust companies.

Use judicial tools to ease the transition from out-of-court restructuring to in-court reorganisation and lock in investor status. Before the target company enters the bankruptcy reorganisation process, the investor should quickly approach it for communication and negotiation so as to engage in pre-reorganisation before judicial reorganisation begins, locking in the investor status.

Traditional reorganisation often calls for an open selection of investors, which seemingly promotes fairness but in fact discourages many highly competitive but prudent investors, due to high uncertainty.

In practice, a strictly by-the-book reorganisation process has demonstrated many inherent limitations and drawbacks, referred to by certain academics as “endogenous defects of the reorganisation system”. With such defects clashing with the periodic pattern of business negotiation, the market requires a more flexible and unrestrained method, which is how pre-reorganisation became embedded into the reorganisation system.

At present, normative documents on pre-reorganisation are being issued nationwide. For example, the Shanghai Bankruptcy Court issued its Procedures for Pre-reorganisation Cases of Shanghai Bankruptcy Court on 27 May 2022, clarifying that “ensuring a smooth connection between out-of-court restructuring and in-court reorganisation procedures” is one of the essential functions of pre-reorganisation.

A good investment is not a simple pursuit of high returns. Sometimes a high level of certainty is the most valued attribute for decision-makers.

Establishment of the domestic pre-reorganisation system greatly enhances the sense of certainty for investors participating in reorganisation investments.

Investors should make good use of pre-reorganisation to achieve their preset investment objectives.


Zheng Guofan is a senior partner at W&H Law Firm. He can be contacted by phone at +86 21 2308 8836 or email at gofan4321@163.com

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