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Auto Industry Challenges Drive Opportunities for Turnaround Professionals

General Motors announced on November 26, 2018, its intention to end production at five plants in the United States and Canada by the end of 2019. Press coverage focused primarily on the immediate and direct expected loss of jobs. Political commentary and reaction were also prevalent, given the federal government’s prior bailout of the auto industry, notwithstanding the repayment of the bailout funds.

The plant closures, however, may only be the tip of the iceberg, as the auto industry undergoes systemic changes to adjust to changing consumer preferences. These include a global transition away from sedans in favor of SUVs, crossovers, and pickups; movement toward more environmentally friendly vehicles, such as hybrids and all-electric vehicles; and the use of global ride-share programs, such as Uber and Lyft. These systemic changes may generate new and increasing opportunities for turnaround professionals experienced in addressing issues involving automotive manufacturing.

The structure of the current automotive manufacturing system includes two unique qualities that add pressure to an already overstressed environment: the prevalence of sole sourced suppliers for key components and overreliance on just-in-time inventory supply.

The first issue, the role of sole suppliers, is relatively straightforward. Vehicle production requires a multitude of unique components, many of which are produced by only one supplier known as an original equipment manufacturer (OEM). Some of these parts may be so specialized that there is no market for the component outside the existing supply chain, thus limiting motivation for competition.

Limited or nonexistent demand outside the supply chain may restrict the willingness of competitors to spend money on research and development just for the chance to replace an existing supplier’s role in the supply chain. For others, the component part may be based, at least in part, on specialized, patented technology, essentially blocking alternative suppliers from entering the space due to risk of intellectual property infringement. Further, many vehicle components are subject to rigid safety standards, including a comprehensive regulatory approval process, adding extra layers of complexity, expense, and delay before a replacement may be considered.

Whatever the reason, the result is the same—the production of any number of vehicle models may include key components which can only be made, at least in the immediate future, by a single supplier. Should that supplier falter due to financial distress or other reason, the result may be a slowdown or production stoppage of the entire line while a replacement part can be obtained.

The second issue is just-in-time supply. Automotive manufacturing suppliers typically produce specialized components for use in a particular vehicle or class of vehicles. Should the original demand for such components diminish, there are likely no alternative buyers for existing inventory or work-in-progress. Similarly, the ultimate consumer of such parts, the vehicle manufacturer farther up the supply chain, typically has no need for such components beyond its own rigid production requirements.

The result is that none of the participants in the supply chain desire or benefit from any inventory surplus, and the party left holding the bag with excess inventory at the end of the day will ultimately suffer the loss. To reduce such risk, suppliers typically produce on a just-in-time basis, only producing enough components to cover immediate and certain demand, rarely accumulating much more than a one- or two-week inventory buildup.


 

Viewed in the short term, accommodation funding may be the only way to prevent a full production stoppage and can be used as an invaluable stopgap while a replacement supplier is arranged.

 


While running on such a lean basis may work in good times, such a limited inventory creates great risk for the manufacturing process on a systemic level, as a shortage or stoppage by one supplier can cause an immediate supply deficiency. When such a deficiency is created by a sole supplier, the result can be a complete stoppage for the vehicle manufacturer.

Recognizing the precarious nature of this system, agreements in place between vehicle manufacturers and their suppliers typically include incredibly harsh penalties, as much as $100,000 to $150,000 per minute that production is shut down, for any supply-side interruptions which result in a manufacturing disruption higher up the chain. Such penalties, of course, may have little effect if the supplier’s failure to produce is a result of its own financial distress and would likely only add further distress to an already bleak balance sheet.

Accommodation Funding

The double-headed beast created by sole suppliers and just-in-time inventory production should create unique opportunities for turnaround professionals across the spectrum as the automotive industry continues to adjust to accelerating changes in consumer demand. The transition away from sedans will result in short-term losses for certain suppliers which produce components for both sedans and other vehicles, and the resulting stress may lead to cash-flow deficiencies and delays, layoffs, or shutdowns.

Turnaround professionals experienced in the industry can assist, often through negotiated accommodation funding. In simple terms, accommodation funding recognizes the captive relationship of the consumer of specialized automotive components—i.e., up-the-chain auto manufacturers that rely on continued production by their suppliers—to prop up such suppliers in times of distress to ensure an uninterrupted supply of parts. Such funding is typically arranged by increased pricing for a set future duration to overcome the supplier’s financial shortfalls.

For example, if a supplier typically sells a particular component for $100 per unit, accommodation funding may be arranged whereby the supplier will receive $150 per unit, with the additional price treated as a short-term loan to stabilize the company. In addition to merely covering the costs of continued production, accommodation funding may also support the supplier in connection with expected Worker Adjustment and Retraining Notification (WARN) Act obligations and expenses, unpaid employer taxes, and other operational expenses.

The long-term ramifications of such accommodation funding are obvious, including further negative movement on the supplier’s balance sheet and additional cost for the up-the-chain manufacturer. However, viewed in the short term, accommodation funding may be the only way to prevent a full production stoppage and can be used as an invaluable stopgap while a replacement supplier is arranged.

Turnaround professionals can play a vital role in both recognizing the need for accommodation funding and reacting quickly to help structure arrangements before production is halted. Given the prevalence of just-in-time production, an agreement with up-the-chain consumers must be reached in an incredibly short period of time. It is thus imperative that a distressed supplier act quickly to engage a turnaround specialist, one experienced in the industry who can seamlessly engage with the key constituents to make arrangements before time runs out.

It should be noted, in addition, that key constituents are not limited to the supplier and the OEM that may be providing accommodation funding, but will also include the supplier’s existing secured lenders. Turnaround professionals must quickly assess how such lenders currently interact with the OEM and address how the relationship will be affected or altered as a result of the accommodation funding. This could include negotiation of a variety of intercreditor and/or subordination agreements among the parties.

Negotiating accommodation funding may seem like traditional distressed funding on steroids. In a matter of days, if not hours, professionals must create a detailed run-cost analysis, usually covering at least a three-month period. This, in turn, must be coupled with a presentation to the manufacturer/financing source detailing the shortfall and how much additional cash will be needed to avert disaster.

Caution: Distress Ahead

As the global market continues to shift, it is likely that there will be distressed suppliers throughout the market. Accommodation funding is, in most cases, merely a short-term answer, so long-term solutions must also be explored. While the long-term fallout from industrywide changes can only be appreciated fully with the benefit of hindsight, substantial opportunities for financial restructurings, including both in- and out-of-court workouts, are likely to exist for professionals in the turnaround and restructuring industry.

Jeffrey C. Hampton

Jeffrey C. Hampton

Saul Ewing Arnstein & Lehr LLP

Jeffrey C. Hampton is a partner in the Philadelphia office of Saul Ewing Arnstein & Lehr LLP and chair of the firm’s Bankruptcy and Restructuring Practice. He is also 2019 TMA Global president. He concentrates his practice on restructuring matters, including Chapter 11 bankruptcy proceedings, out-of-court workouts, loan restructurings, corporate reorganizations, and general insolvency law. In addition to being an attorney, Hampton is also a licensed CPA.

Michael L. Gesas

Michael L. Gesas

Saul Ewing Arnstein & Lehr LLP

Michael L. Gesas, a partner in the Chicago office of Saul Ewing Arnstein & Lehr LLP, focuses on bankruptcy and restructuring matters. He represents creditors and commercial debtors in corporate and business reorganizations, as well as liquidation proceedings, compositions, assignments for the benefit of creditors, asset acquisitions and sales through the bankruptcy court and other forums, workouts, contract negotiations, and related representation and litigation.

Aaron S. Applebaum

Aaron S. Applebaum

Saul Ewing Arnstein & Lehr LLP

Aaron S. Applebaum is an associate in the Philadelphia office of Saul Ewing Arnstein & Lehr LLP. He represents debtors, creditors, committees, and trustees in complex bankruptcy cases. Applebaum also has experience assisting clients in bankruptcy litigation, including preference and fraudulent conveyance adversary proceedings, declaratory judgment actions, and other contested matters.

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Manufacturing
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