Leading successful turnarounds
May 2014 | COVER STORY | BANKRUPTCY & RESTRUCTURING
Financier Worldwide Magazine
Executives and managers caught up in dealing with future strategy and everyday crises can be oblivious to major dangers until it is too late. It can happen to any firm. The first step toward turning around a failing company is to admit there is a problem. Only then can remedial strategies be put in place. History has shown us what can be achieved by firms that were once considered write-offs. But what can we learn from these successful turnarounds, and what effective remedies are available to business leaders once they have faced up to the reality of their situation?
When a company enters a financially challenging or distressed situation, early intervention makes reversing its fortunes far more likely and provides the best hope for a successful outcome. A quick response, however, requires that firms, investors and creditors are aware of the red flags which can herald a company’s descent into distress. “The first warning signs are operational concerns such as falling sales, declining margins, continuing substantial operating and net losses, declining cash and an increased reliance on debt – rather than available cash from operations – to fund the firm’s needs,” says Bruce S. Nathan, a partner at Lowenstein Sandler LLP. “A rapid increase in funded debt and reduction in capital expenditures are usual symptoms. Another warning sign is where the firm has excessive debt and inadequate available cash to pay a substantial upcoming interest or principal payment, imminent expiration or maturity of the firm’s loan facility or other debt, or an outstanding covenant or other breach and entry into a forbearance agreement. If the firm has issued public securities, drops in the prices of the firm’s stock and bonds are additional warning signs of distress.”
However, often such financial indicators are secondary to the real issue and can be predicted by those keeping a close eye on the day to day operations of the firm, says James Sprayregen, a partner at Kirkland & Ellis. “There are the usual financial metrics with respect to early warning signs such as missing loan covenants or coming close to them. However, there are often governance, organisational and operational issues that do not so distinctly manifest themselves, as in the situation of missing a covenant. I believe those are more important to address and need to be dealt with by the board of directors or senior management with alacrity.”
From a creditor or investor’s perspective, sudden changes in the leadership of a company, or the resignation of members of the board can signify underlying issues within the firm. An increased reliance on insolvency professionals, law firms known for their bankruptcy expertise or investment banks celebrated in the insolvency field are also danger signs. The downgrading of a customer’s publicly traded debt to ‘junk status’ by a credit agency such as Moody’s, Fitch or Standard & Poor’s should certainly set alarm bells ringing. Stockholders concerned about a firm’s performance may be frustrated by a lack of data, but information can be sought from a number of sources. “There are many sources of information that are available to identify high risk accounts,” says Mr Nathan. “Creditors can conduct a free internet search for a defined term, such as a debtor’s name, that will search internet databases and provide an email containing the search results. The debtor’s own website can provide a significant amount of helpful information. Creditors can also obtain information from their trade associations and credit groups, from other vendors dealing with the debtor and claims traders and insolvency professionals who provide lots of free information about the debtor’s financial distress.”
Large companies might also have an ‘investors’ section of their website that contains information about management, operations and financial performance. An increasing number of sites provide the option for creditors to register their email address to receive timely press releases and other notifications issued by the company – companies will generally send email notifications when they file reports with the Securities and Exchange Commission (SEC) or other regulatory bodies, for example. For customers that are not publicly reporting, creditors should consider requiring the debtor, from the inception of their relationship, to provide the creditor with its financial statements, and supporting information, on a periodic basis.
Facing the issue
The last few years have taught us the no firm is impervious to the fluctuations of the market or to radical shifts in the business environment, and those that seem the most secure can be the highest risk. While they may seem perfectly stable, firms that have been in business for many years are often uniquely positioned to fall foul of unexpected events and their success can make them blind to a slow build-up of crippling issues. Bad management and an overreliance on comfortable business strategies have disadvantaged many of the largest firms, forcing them to address their inadequacies and reassess. Corporate leaders cannot afford to drop their guard at any time, and are unwise to ignore the obvious warnings. However, firms have been guilty of both in the past. “There is no question that ‘denial’ is a major element of delayed restructurings,” says Mr Sprayregen. “There is often an inclination to believe that good times are just around the corner or just over the next hill and that the company’s problems are like everyone’s problems in the industry, that is a macroeconomic issue, rather than a company specific or microeconomic issue. My experience is that executives who can proactively take on a restructuring are in the minority.”
When it becomes apparent that a company is slipping into a crisis situation, firms must act, but what exactly can they do? Major firms such as Apple have proved that even in the direst of circumstances, victory can be snatched from the jaws of defeat. In the second quarter of 1997, Apple reported a net loss of $708m. By the time of his death in 2011, Steve Jobs had transformed the firm into one of the globe’s most valuable brands. On regaining his position as CEO, Mr Jobs took the firm back to basics, launching the iMac line in 1998 to strengthen the firm’s modest customer base. After the iMac’s success he took a risk by entering the digital music market, and from there the foundations of the firm’s resurgence were laid.
While not all business turnarounds are quite as radical as Apple’s, they do generally follow a predictable pattern of action. The first step is usually to make sharp reductions in staff in an effort to manage costs. And when it is clear that issues of leadership are to blame for the poor performance of the firm, executives may be pushed out or choose to resign. New leadership in successful turnarounds can come from within the firm, but often newcomers are chosen from outside the company, or even the corporation’s industry. Outsiders can bring a fresh perspective which benefits the firm, and often the very best executives are those who can manage companies in many different industries.
Next, firms often begin to bring their core skills and products into focus, and non-core businesses may be exited. In many cases the firm needs to get back to doing what it does best. It may have overstretched into unfamiliar or unprofitable markets, or simply lost touch with its key customer base. Starting a dialogue with customers can provide insights into their needs and highlight areas in which the firm is failing. While the truth may be hard to swallow, this sort of data empowers organisations to see where their strengths and weaknesses are, and where opportunities can be exploited. Companies very often move back to their roots, as was the case for Starbucks after its stock dropped 42 percent in 2007. Initiatives introduced by Starbucks’ reinstated CEO Howard Schultz included back to basics training, more stringent quality control and scaling back the entertainment division. Today the company has over $10bn in revenue and 150,000 employees.
Of course, not all companies have the option of returning to a profitable market, nor can all be saved in their existing form. Although the world famous Eastman Kodak Co. invented the first digital camera in 1975, the firm was broadsided by rapid developments in digital technology and, once its mistakes were acknowledged, had no hope of catching its competitors. Kodak filed for Chapter 11 in 2012, emerging as a $2.5bn revenue company selling consumer printing, touch-screen technology and movie film.
Kodak’s situation may have been easier to resolve had its leadership faced up to its problems at an earlier point. But even when firms can see a problem, they often do not act. When turnaround experts are engaged, or members of the board swapped out, if the top leadership is paralysed by indecision or denial then positive change cannot take place. Once a company realises that it needs to change strategies, the hardest part is actually making the transition, but business leaders cannot afford to delay. “Deal with it,” stresses Mr Sprayregen. “It may be by changing management. It may mean changing the operational business plan. It may mean refinancing debt. It could be sale of assets. Sometimes it even means purchasing assets. Hiring experienced professionals in this area also is key. But the biggest key of all is action. Inaction, denial and delay are often the biggest problems of all.”
When a firm is sent reeling by a major unexpected event, the initial days of an attempted turnaround may be concerned with simply staying afloat. It can be juggling act allocating resources to the turnaround of the business and satisfying financial or contractual obligations with third parties. Should these obligations go unfulfilled, the entire operation could be for naught. However, there are options to keeping supply and credit lines open, says Mr Nathan. “When a debtor becomes past due on its obligations or upon the occurrence of many of the aforementioned warning signs of financial distress, a creditor that is not obligated to extend credit can always switch to cash terms or seek collateral or third party security, such as a security interest in its debtor’s assets, a letter of credit, credit insurance, put, or a guaranty from a financially viable third party. Even where the creditor is obligated to extend credit under a long term supply contract or purchase order, the Uniform Commercial Code in place in each of the states of the US also offers relief to a seller of goods to a financially distressed buyer.”
Under UCC § 2-609, where there is reasonable grounds for a seller’s insecurity about the other party’s ability to perform under its contract, the seller can send a written demand for the buyer to provide adequate assurance of its ability to continue to pay for the goods. “The buyer must then provide the seller adequate assurance of the buyer’s ability to perform in a reasonable time not exceeding 30 days,” adds Mr Nathan. “The seller can, if commercially reasonable, use this remedy to suspend performing, including no longer extending credit, until it receives such assurance. If the buyer does not timely respond or provide adequate assurance of its ability to pay for the goods, the seller party can treat the contract as repudiated and sue for breach of contract. A seller should consider invoking this remedy to negotiate more stringent credit terms and the buyer’s posting of security.”
Staying on course
In the long term, even a successful ‘turnaround’ may not be enough to save a firm. A company placed back on an even keel will soon veer off course if its underlying problems are not addressed. Previous goals, strategies and values need to be assessed, and the very character of the company may be altered. Most importantly, a company may want to question its previous choices of personnel. People can make the difference to the successful operations of a company, both on a positive and negative note. Weakness in the firm’s management structure should be addressed, and the expertise and attitude of the board scrutinised.
However, tackling such issues may, understandably, be uncomfortable for the organisation. “I am a fan of ‘ripping the band-aid off’ in terms of making changes both to strategy, tactics, operational focus, and most importantly, personnel,” says Mr Sprayregen. “While painful, I have often seen delayed actions in this regard, especially with respect to personnel, be part of the long term decline of a company. This can be done with empathy and dignity and taking care of the people who need to be moved out – but that is an execution issue rather than a strategic issue. Companies cannot always continue to do that which made them great indefinitely. They need to be dynamic and not static, as that is the way of the world.”
Surviving the lean years, and keeping everybody on board and focused, is one of the hardest aspects of a turnaround. But maintaining the momentum is critical. From the board to the shop floor, the staff that a company carries through the turnaround must be committed. It is essential that the business has products that it believes in and that its employees believe in. A workforce that truly believes in the company, its products and its strategic direction is essential for the firm’s continued survival and growth.
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