This is one in an occasional series of roundtable discussions by Certified Turnaround Professionals (CTPs) on issues impacting the turnaround, restructuring, and distressed investing industry. In this installment, Robert Handler, CTP, Commercial Recovery Associates; Bernadette Barron, CTP, Barron Business Consulting; Jeff Hyland, CTP, CTI Industries Corporation; and Dave Mack, CTP, Pathfinder Group LLC, discuss issues that arise in typical situations advisors are brought in to address. Handler moderated the discussion.
Handler: We’re going to talk about a typical situation that many of us encounter when we are brought in to review, assess, and execute a restructuring plan.
Let’s set the stage. A law firm, one of your regular referral sources, is concerned about the long-term prospects of its biggest client, a midmarket manufacturing firm. The first generation has been managing the business for the past 30 years and is nearing retirement. The chairman is not certain whether anyone in the second generation is capable or willing to take over the business.
In addition, even though the company remains profitable, its margins have been eroding, it has not met its sales targets for the past three years, its cash reserves have disappeared, and it has stretched its vendors to 90 days to maintain cash levels. All of this is causing the bank to be concerned about the company’s ability to repay its loans. The company has asked its lawyers to assist in evaluating the company’s options. On the lawyers’ recommendation, the company has hired you as its chief restructuring advisor to develop a strategic plan.
You prepared the standard 13-week cash flow budget and extended it to 26 weeks. The budget shows the company can, without making any changes in operations or personnel, maintain its current overhead, service its line of credit, and keep vendors within 90 days outstanding. The bank has agreed to work with the company (and you) for the next 26 weeks so long as there is no material default.
Mack: It absolutely is an important step. After you have assessed the immediate needs, which are dealing with the bank and the cash flow of the business, now you can take a step back and look at questions like: Where is the company going? What’s going on in the marketplace? What is the capability of its employees? What are the controls? All of these things fit into a strategic assessment of where the business is going.
Hyland: I find that the valuation is critical. That’s because I use a forecast and the valuation as a velvet hammer. I use it in situations where the company is doing well or even when not doing well. If the value of the company is below the outstanding liabilities, it dictates a certain action. If a company is valued even lower, such as below the outstanding bank debt, it may dictate an even more draconian approach.
It reminds me of one time I was working with a manufacturer that had a CEO who was reluctant to make any significant changes. Once he understood the company’s value, which could have required him making good on his personal guarantee, he enthusiastically supported all of the changes I had suggested. It was a good choice on his part. Ultimately, he walked away with millions of dollars after we fixed the company and were able to sell it.
Handler: I tend to agree. It’s one of the first things you need to do so all the stakeholders have a realistic view of what they have and what they may expect to get if there is any sort of restructuring process. And I mean all of the stakeholders: the owners, bank, vendors, and employees. If they are critical to the operation, they need to participate in the future of the company. It’s a very important first step.
Barron: I also tend to run a liquidation analysis early in the process so I know how much the secured and unsecured creditors will receive if the company is forced into a liquidating bankruptcy. Not only does it help me in negotiations but also, I get a better sense of the security behind collateralized loans and often find assets I can offer as additional security or finance to get immediate cash.
Hyland: When do you share your valuation with employees, who probably know there is a problem but do not realize the size of the problem? Are you scaring them off? And are you scaring off suppliers by demanding a current discount versus a potential 100 percent loss if the company doesn’t make it?
Handler: I’m not suggesting you do it all at once. You dole it out as part of your strategic plan to what extent you want to get these stakeholders on board. At some point when you reach critical mass about decisions being made, you have to let key actors know sooner rather than later. I would rather have their cooperation sooner rather than fight with them later.
Mack: These managers and players already know where the business is—they probably know better than the owners—and they have likely tried to get certain things changed for years. They are going to be happy to hear the process has started, and they will cooperate. Will you tell them exactly what the possibilities are? I don’t think so. I think you’ve got to bring the owners along in this process so they see the status and valuation of the business. I agree with both of you: the valuation is pretty important.
On the other hand, we all know that value ultimately is set by the market, but knowing the direction and estimated value is critical. The valuation should take into account deferred maintenance, the market position of the company, and the coming investments the company needs to maintain its position and grow its position.
Handler: No question about it. And if you get to a situation where you are able to market the company, you’ll find out sooner rather than later what the value is, and that’s going to be valuable information to all of the stakeholders.
I want to get back to one point: we’ve all been in the situation where we’ve been brought in by management and, lo and behold, you get on the shop floor and many employees have just been waiting for this opportunity. This happens because they have recognized sooner than management that there have been problems, and there is an opportunity for them to be addressed.
Hyland: I have not had a lot of luck in approving pricing from vendors that are extremely stretched. You are going to have to pay them down some to get better pricing. However, most of the time you can still stretch accounts payable in the short term because there is still some elasticity with vendors. While this may not be a viable long-term strategy, it can bridge a short-term gap.
A place where I have had a lot of success is finding better pricing and extending terms by changing vendors. I’ll find a different vendor that provides the same if not better quality.
Barron: I agree; when you can get a new supplier, it is terrific. My experience has been to work with the existing vendors primarily because they have an interest in keeping the receivable on their side in good standing with their lending facility.
Handler: I’ve had a similar experience in a variety of businesses where the vendors want to keep the company going. And if you’re open about the company’s issues and where you think the company can go, they will want to work with you. We have had many situations where we have been able to get better pricing by going COD or cash in advance on new orders, while gradually working down the old. But going forward, the company is now getting better pricing on its raw materials. The smart vendors are going to work with you because they see an opportunity to not only keep a customer in place, but also to keep their receivables viable and ultimately get paid.
Mack: Evaluating operations is also critical. You ultimately have to work with the operating team to understand how their systems operate, the costing, what their supply chain looks like, how they get their orders. How much visibility to customer orders and expenses do they have? Are they buying the right materials in the right amounts? And what is their whole planning process?
There is a day-to-day assessment and data collection that needs to occur to determine if there should be fewer SKUs and which products are profitable. In fact, another opportunity is to go with the sales and manufacturing people to the customer to find out firsthand what their issues with the client are. A lot of times when a company is having issues, they pull back and try to stay away from the customers, which hurts the long-term relationship.
Handler: I agree. This is part and parcel to the initial assessment. You find out who the critical vendors, products, and customers are, and that gets your focus and attention pretty quickly. You’ll be sitting with these vendors sooner versus later. You’ll want to make them feel like partners, so they know they have a stake in the outcome.
Hyland: Bob, when you talk about your second point of increasing the cost of manufacturing due to quality issues as it relates to old equipment, I think that is one of the last things you’ll address due to the need for capital investment. The good news is by replacing old equipment you can save money on a month-to-month basis. I know one situation where the cash cost of the new equipment was equivalent to the expenses from poor product produced from this manufacturer in just one year. So, there was a one-year payback. It was a complete no brainer, especially when you considered that the equipment manufacturer financed the entire cost of the new equipment. It became a pretty easy decision.
Handler: One of the problems is old equipment frequently remains in place because of inertia. Even though it has been fully depreciated, the managers never saw a need to replace it since it was still working. However, working does not equate to functioning profitably.
Mack: I focus, in addition to this, on the strategic positioning of the company. Where is the company going? What are the capital needs? What is going on relative to technology and disruption? These questions bring up more questions. Do you need to bring new money in? Should you sell the business? Do you have the capabilities? Is there an in-between time period that you should be assessing to figure out if you could do it alone as an independent? I would say that’s working with senior management and the owners and less with operating management. It’s finding out where this thing should go.
In the vast majority of the assignments I get into, new capital is really needed. Whether there is a cleansing or not a cleansing, there is a need for capital because they’ve fallen behind so greatly that they need to have that injection in some way, shape, or form in some period of time in the future.
Handler: To Jeff’s point, is this something that you’d do later rather than sooner in the process? In other words, you had mentioned it’s more of a strategic decision, but it’s something that will require a lot of capital investment or planning. It’s not a short-term fix; it’s maybe something you’d address later in the process versus sooner.
Mack: You’re going to look at it in the very beginning so it goes to the assumption of this particular deal that we’re talking about, you’ve already done some of that up-front. But I think there is a deeper dive there when you’re talking about products and what they’re doing and their positioning and deferred capital investments. At some point you look at all of those things together and you say, “We can tweak this here and there, but X number of years down the road we have to be a buyer or a seller.” You have to keep your eye on that, and that may help you make the decision earlier rather than later. Value in some cases keeps going down, just by the nature of the disruption in the marketplace. Timing is important when thinking about these things.
Hyland: A change of product mix is part of the fun. Increasing the revenue and attacking the business model is more of the fun part to me versus just taking costs out. I have changed the product mix multiple times in client situations. What I do is focus on the SWOT (strengths, weaknesses, opportunities, and threats) analysis, see where the company fits in the market and with their competitors, what their competitors are doing, what the sales people talk about relative to their customers. If they’re going to sell one particular type of product, maybe they can sell two.
Then, once we talk it through and figure out, “Boy, it sure would be great to have this,” or “By the way, we can’t make money on that product,” we will exit from that product line. Maybe it means selling equipment, like what Dave was talking about. Maybe it means moving in a different direction, but you have to make money. Then what we’ll do is determine if you find it on the outside, or do you find it on the inside? We need to make these changes and we will have this product to add to our portfolio of products we’re selling. Do we need to go to the outside and become a distributor for someone? Do we need to acquire somebody? I’ve done it multiple times that way.
Mack: Jeff has it exactly right. The assessment is done fairly quickly along with the 13-week cash flow; you’re really going to be learning the deeper you go. You have a reprieve from the situation by the bank at that point. You’re looking at this information and are really able to dig in and find out the truth—find out how the relationship is with the customers and what the strength of the team is, and really start to dig into the issues of disruption that are probably out there. You can assess that by working with management and ownership to come to a conclusion on the general direction in the company and how much cash is needed to execute on these things.
Hyland: We completed a fairly in-depth SWOT analysis using both internal and external sources. The Ws and Ts crushed the Ss and Os. However, there was one strength that the company had that was awesome, and no one really focused on it or talked about it. They had a repair part for their machines that was unique to their machines. They had a captive product that I would define as similar to a razor that requires a specific razor blade made only by that manufacturer. While it was not a product extension, it did impact pricing, which is another marketing issue. We immediately initiated a 40 percent increase on the repair parts, and that was a major contributor to the company becoming positive cash flow after debt service.
Handler: How did you stumble upon that? How was that revealed to you?
Hyland: It was one of the questions that we were asking during the brainstorming that we did in front of everyone. Obviously anytime you’re in a manufacturer, you certainly want to know what happens with the repairs to your equipment in the field. Do you have a repair workforce? Do you call ABC Company and they repair it? What parts do they have, and where do they get them? As soon as someone said “We’re the only one that manufactures those. They have to get them from us,” I thought, “Wow, there is a good opportunity.” It happened while I was standing in front of a whiteboard with a magic marker in my hand.
Mack: I’ve had a different experience. The customer says, “We have difficulty doing this,” and it’s pretty clear to the engineer, the sales person, and myself that this is something that we can do; this is a problem we can solve for the customer. That’s an opportunity. And the other one is data collection. It’s all the data analysis. People have this idea that this is what’s profitable, this is what isn’t, and [an analysis is] done one time every three years. You collect the data and find something completely different. Those things are the difference makers to what we do, the methodical aspect of helping these people.
Handler: I think what we’re all revealing is when you engage management, the employees, and the people on the floor on a day-to-day basis, without this crisis mentality, people bubble up the ideas that they believe can help the company that [were] never brought up before. They’ve never had the opportunity to bring it up. In your situation, Jeff, a number of people knew about that one key part, but no one previously saw it as critical to the long-term success of the company. They were never given the opportunity to raise it to everyone else in the room.
Barron: I agree. One of the most important contributions we make to a client and their stakeholders is to get the actual facts and communicate them so informed decisions can be made.
Barron: That is the hardest situation, especially when you have older owners who are afraid to retire. Usually I’m able to convince them to bring in a new financial person. Once I can get that new financial person on my team, it is oftentimes easier to make other changes within management. Sometimes you can buy out the retiring management, but sometimes you have to find a way to send them home.
Hyland: For me, when preparing a succession plan, I try to keep the support of the first generation because of their commitment to their children. If you have full control, it’s different and you may be successful in changing the roles of family members.
I like your suggestion about starting an investment banking process. If you have the authority to start the investment banking process or get them to agree to it, the inevitable low valuation you will receive can be used like a velvet hammer to effectuate change. The investment bankers as a group may say this is not our opinion, this is what we’re getting from the market. Your valuation is low because of these reasons. Some of these reasons [involve] how the company is being managed. The management team needs fresh blood.
You let the market deliver the difficult message that may help with a better result. Just doing a report and telling the bank and the attorney that these are the problems are not enough. I think life rewards action. The passive-aggressive approach of just doing a report is akin to being worthless.
Barron: You also have ethical considerations because your client is really the company, and you have to avoid giving information to the bank and vendors against their wishes. I totally agree about not simply preparing a report. Eventually you will have to resign, either by choice or because they stopped you. If you really can’t make relevant changes, it is time to go home.
Hyland: I’ve resigned before.
Handler: If the horse isn’t willing, why waste your time? I also generally favor the investment banking process. You get an independent third-party group to come out and kick the tires. Bring the market in to kick the tires, and it gives management a very clear picture of where their company stands in the marketplace. And it makes your job as the advisor a lot easier because all of the sudden, the options for restructuring the company become a lot clearer. This is what we have to address to create or preserve value for the company going down the line if we want the owners to be able to cash out at the end of the day.
Mack: What I would be measuring or asking myself is, is the situation improved by our continuing involvement? Our job is to get the best outcome we can despite our client’s missteps or decisions. Time sometimes has ways of resorting the client bringing ownership and management back to the suggestions we make.
Hyland: One of the other things you had originally talked about is presenting this to the chairman and the family members and corporate counsel. I would fall back on my three Cs—compassion, clarity, and conviction. If you have those three things, you’re going to be forthright and explain exactly what the situation is and not sugarcoat it. If you have to have those conversations, you have to have them. But I certainly wouldn’t be wishy washy.
Handler: I agree and that’s the stock in trade we bring to all of these situations. We need to maintain our reputation as being independent advisors to the company. We’re not necessarily beholden to the company, and we are going to be independent about what our opinion is about the company’s mission and whether that mission can be achieved.