As the downturn claims more victims, opportunities to snap up failed companies at rock-bottom prices are rising. But beware the hidden traps on the acquisition trail

Listen carefully and you can hear the clinking of coins as cash-rich companies top up their war chests ready to acquire bargain-basement businesses. Until the summer of 2007, the mergers and acquisitions market was a seller's paradise. Cheap and easily available credit meant buyers had few problems raising finance. Banks were more than willing to support acquisitions by both trade buyers and private equity funds. Demand for deals was buoyant and valuations went through the roof. A lot of happy business owners achieved dream exits.

But the financial crisis halted this boom. As credit and confidence dried up, valuations fell sharply. Suddenly, excellent deals emerged if you could find someone willing to sell in a falling market. Today, the bargain basement looks even more enticing. Insolvencies are shooting up, giving cash-positive companies opportunities to pick up struggling rivals at rock-bottom prices.

Buying an insolvent or distressed business can prove a cost-effective route to growth. Graham McMullen, managing director of office equipment and IT services company Admiral Group, has bought bankrupt firms as a way to ratchet up sales and create a more diverse business. "We started off as a photocopier company, providing sales and maintenance," he says. "Our first acquisition was a Leeds-based IT company. It had grown too fast, had run out of money and was placed in receivership. We worked out a fair and reasonable price with the receiver and did the deal."

The acquisition brought new customers while allowing Admiral to widen its offering. Since then the company has bought five insolvent businesses and now includes networking, cabling, IT security and telecoms on its product and service list. As McMullen sees it, buying bankrupt companies means he can achieve a return on investment more quickly than would be the case if he snapped up healthy businesses. "After our first acquisition, we made a return on the investment within four months," he says.

McMullen's focus on struggling bankrupt businesses is not unique. Dragons' Den star Theo Paphitis has famously made a career out of acquiring and turning round troubled companies. But according to Greg MacLeod of MPC Partners, a management team that buys, restructures and sells beleaguered firms, you don't have to be a turnaround specialist to take advantage of the recession. "If you're operating in a certain sector and you know the market and your competitors, there are opportunities. If you can work out why the target has a problem and see a way to fix it, you should certainly consider acquiring the business."

But there are significant risks involved. Peter Baldwin, a partner at law firm Jones Day, points out: "If you buy a company from an administrator there is no contractual protection. The administrator won't give you any warranties or indemnities." In other words, it's a "buyer beware" situation. Once the deal is done and the contract signed, there is no legal redress if unforeseen problems arise. The upshot is that a buyer taking an insolvent business out of administration needs to be sure that there are no hidden and potentially expensive liabilities. These could include claims by staff, penalties under environmental law or demands to repair a pension scheme deficit.

There are other potential pitfalls, too. For instance, insolvencies tend to ring warning bells with some customers and suppliers. If you're buying a bankrupt business mainly to get your hands on the customer base, you could well find that clients have already voted with their feet by the time you take control.

Baldwin advises potential buyers to look closely at major contracts. "You could find that customers have the right to terminate supply contracts once a company goes into administration," he says. That doesn't necessarily mean that all of your customers will up sticks and go elsewhere, but you shouldn't expect anything close to a 100 per cent retention rate. "On average, we retain about 70 per cent of the customers," says McMullen.

And keeping suppliers can be an equally pressing problem. Even those that continue to supply will be wary of extending credit and may demand cash on delivery rather than allowing a 30, 60 or 90-day credit window. That reluctance has implications for the cashflow of the newly acquired business.

"Many suppliers retain ownership of the goods they supply to customers until payment has been made in full," explains David Grant, head of corporate rescue and recovery at the London office of law firm Halliwells. "You may think that the assets you've bought include stock but later find that the suppliers are taking it back."

If you buy the assets of a business, such as a customer database or stock, ownership passes to you and there shouldn't be any problems. But if there are contractual strings attached to that ownership you could find the asset you thought you had is valueless. Ordinarily, you should be able to check all this out as part of the due diligence process, but in the case of businesses bought from insolvency, corners are often cut.

It's partly a matter of speed. Businesses lose value quickly when they are placed in administration, not least because suppliers and customers begin to look elsewhere. So the onus on the insolvency practitioner is to sell the business (or part of it) as a going concern in as short a timeframe as possible.

Nick Dixon has bought two insolvent companies since the early 1990s. The first, Colorgraphic, was acquired in 1992 as the first building block of a wider group that was ultimately sold by Dixon in 1999. Pursuing a similar strategy, he bought printing firm Howitt from receivership five years ago as the starting point for a marketing services group, Lateral. In neither case was he able to conduct lengthy due diligence. "With Colorgraphic, it was three days, with Howitt five days," he recalls.

One way to sidestep the ticking clock of the insolvency process is to put an offer in before the business goes into administration. In these circumstances negotiations can progress without the insolvency procedure reducing the company's value, allowing more time for due diligence. But any deal that is struck could still involve administration under a pre-pack arrangement.

Pre-packs are controversial because they involve companies being placed into administration for a brief period in order to free the buyer of any obligation to creditors. So-called "phoenix deals", which enable management teams to take control, are particularly contentious because creditors see familiar faces remaining at the helm of the reborn ventures while they are asked to bear the financial pain. Pre-packs are also used to facilitate sales to third parties and have emerged as a tool that enables a swift change of ownership.

But how do you find out that a company is in trouble ahead of it being declared insolvent? Grant says it can be a matter of keeping your ear to the ground. "If you study the FT or if you know insolvency practitioners, you can get a heads-up." Equally, a business or its advisers may go public with a sale plan. "Often a company will have been put up for sale prior to insolvency procedures beginning and potential buyers will be in the loop," says Geoff Carton-Kelly, a partner in accountancy firm Baker Tilly's restructuring and recovery practice.

Buyers that have acquired troubled firms stress the importance of fully understanding issues which undermined the business. "We won't buy an insolvent business unless we are absolutely sure that we know what the problem is and what the solution is," says MacLeod at MPC Partners. "For instance, if the fundamental problem is debt, you know the solution is going to be some sort of financial restructuring, and you can work from there."

Equally important is knowing how the insolvent company will sit within your own business plan. MPC's strategy is to buy cheap, carry out the necessary restructuring, add value and sell. In contrast, McMullen integrates the businesses he acquires into his existing group of companies. "Our aim is to run the acquired businesses as going concerns and we retain sales staff. But we do bring all the administration into our head office," he says.

A clear strategy is also essential to striking a good deal on price. "The value depends on what you are prepared to pay at the time," agrees Nick Dixon "and that in turn is dictated by what you intend to do with the company." Carton-Kelly agrees. "You have to look at it from an opportunity/cost point of view," he says. "The value is really what the business is worth to you."

The tricky bit is reaching agreement with the administrator, which is answerable to creditors seeking to get the best possible return. A low offer from a potential buyer is unlikely to go down well with suppliers waiting to be paid. On the other hand, administrators also have a duty to prioritise the sale of a business as a going concern (as opposed to simply liquidating assets) and this can be an aid to buyers.

MacLeod argues that because the buyer is paying less, buying an insolvent company can be much less risky than acquiring a healthy business. "You're not paying for goodwill," he says. "That was a major element in the very high valuations prior to 2007 but as we've seen, the value of goodwill can evaporate. I base offers on the value of hard assets."

And a company bought for a song can go on to achieve great things. For instance, since buying 180-year-old print firm Howitt, Dixon has invested in new technology that adds a digital marketing facility to the paper-based business. Today, the company has over 450 employees, turnover of £54m and plans to grow.

 "We're now looking for further acquisitions," says Dixon.