Timing is everything, and bargain-hunting investors are indicating that now could be a good time to acquire troubled assets. Certainly, the mergers and acquisitions market is uncrowded right now. U.S. deal volume in the third quarter was the slowest period by dollar value since the third quarter of 2004, according to The Wall Street Journal. Meanwhile, there is no shortage of potential acquisition targets. With large declines in the global markets, stock prices are at below-average levels, based on a 10-year price-to-earnings average. And the number of troubled assets available for sale continues to rise. Opportunistic companies with healthy balance sheets and access to cheap sources of financing may be in a good position to execute on long-term growth strategies. 

Timing the market is a notoriously difficult task, however, especially in today's volatile environment. Corporate buyers face additional complexities when trying to identify the right moment to purchase a distressed asset.

First, there is the basic question of timing for maximum value. During the bankruptcy process, a company's value might fluctuate based on how it and its liabilities are transformed. While shedding liabilities might increase the value of its operating assets, the company may also be losing valuable employees and customers.

For example, when Bank of America Corp. agreed to purchase Merrill Lynch & Co. over a weekend in September 2008, the company paid a 70% premium. In an interview in Fortune magazine, Bank of America CEO Kenneth Lewis said that he didn't want to wait until Monday morning when Merrill might have faced bankruptcy, since it would have put Merrill's coveted brokerage business at risk. But other buyers have found that waiting for a bankruptcy filing seemed to pay off. Barclays plc was initially interested in purchasing Lehman Brothers Holdings Inc., but walked away when the Federal Reserve wouldn't backstop Lehman's risky mortgage-backed securities, according to The Wall Street Journal.

However, one week after Lehman Brothers filed for bankruptcy, Barclays was able to purchase Lehman's North American investment bank — which was still relatively intact — and headquarters for just $1.7 billion. Similarly, NRDC Equity Partners LLC, the investment group that owns the retailer Lord & Taylor LLC, was considering making a bid for the jewelry retailer Fortunoff Holdings LLC in January. NRDC ultimately decided to make its bid several weeks later, after Fortunoff filed for bankruptcy.

Corporate buyers examining troubled targets need to consider several issues that might counterbalance the lower price paid during or immediately after a bankruptcy proceeding. First, an acquirer will need to give up a substantial amount of control during the bankruptcy process. In addition to negotiating with the target itself, acquirers typically have to engage with numerous other parties, including creditors, must have the purchase approved by the bankruptcy court and have to deal with the uncertainty of "topping bids."

But companies with expensive union contracts, exorbitant debt or other unfavorable contracts may be more attractive to buyers since these contracts and debt agreements may be renegotiated. For example, General Motors Corp. filed for bankruptcy court protection on June 1; just one day later it announced that it was in advanced talks to sell its Hummer brand to Chinese industrial company Tengzhong Heavy Industrial Machinery Co. Ltd.

Acquirers have several other timing issues to consider, including the target's cash-burn rate. For instance, a young software or biotechnology company that often relies on outside capital to fund research and development for product commercialization may need to put itself up for sale because it is running out of cash and having trouble obtaining new financing in the current environment. Buyers need to make sure that the target has enough cash on hand to make it through a closing so that it can, in effect, survive the acquisition.

Luis Custodio, vice president of corporate development at IBM Corp., said: "It is critically important to triangulate the target's balance sheet, cash burn rate and deal timeline to ensure cash sufficiency and avoid preclosing surprises. But, it is also prudent to include protective terms in the definitive agreements that allow both parties to reasonably deal with a cash shortfall event."

Very often a company has valuable intellectual property that makes it an appealing acquisition, including personnel critical to future product development. But a financially troubled company — or even one that is adequately financed but sees its stock price drop significantly — may have difficulty retaining key employees, especially during a merger negotiation. It is therefore usually beneficial to consider an expedited due diligence and closing process. Even in this market, as part of their acquisition and integration strategies, buyers must have processes in place that will give key employees incentives to stay.

Another issue for buyers of troubled companies to consider is the status of customer and supplier relationships. It is not uncommon for troubled targets to stretch vendor payments beyond acceptable levels, for service to suffer and for customer relationships to be negatively affected.

The potential cost of mending these damaged relationships, including the need for immediate access to working capital, needs consideration in valuing the company.

The cost of an acquisition is often more than its price tag alone, though good planning and due diligence can help estimate this as accurately as possible. The risk of bankruptcy in a deal process can often change the dynamics of negotiation and the anticipated timing, though buyers should be aware of the added complexity of an already risky process.

Today's market contains many buying opportunities for companies that have healthy balance sheets, access to capital and profitable strategies. In today's market, however, buyers need to consider how timing their purchase will affect the value of the acquisition. There are both benefits and disadvantages to purchasing assets or companies in Chapter 11. And even in situations where targets have not filed for bankruptcy, acquirers must understand the added risks of losing customers and employees if they wait too long to make an acquisition.

Derek Watson is a principal in the transaction services practice of KPMG LLP.

Reprinted with permission from The Deal.