October/November 2004

Turnarounds & Workouts: What's the Forcast? By: Daniel F. Dooley

Clearly, the trend of large company insolvencies that started in 1999 has come and gone. Most of us in the turnaround industry expect the next few years to have much slimmer pickings.

We won’t spend much time explaining why the cycle of distress has ended. It’s clear to industry insiders that: 1) big company bank-ruptcies, which drive the turnaround industry, are way down; 2) non-performing assets (NPAs) of most lenders are again within fully reserved levels; 3) bank workout staffing is down 25-75%; 4) capital funding returned to the market in late 2003 in all segments—equity sponsors, high-yield bonds, M&A activity, even cash-flow lending; 5) the U.S. economy is expanding in almost all sectors, and; 6) the boom-to-bust cycles of “hot” industries (internet, telecom, energy) driven by technology or regulatory changes have mostly run their course.

So what’s a turnaround consulting firm to do when near-term business is likely to drop by 50% or so? The obvious solutions are being worked by many of us: skill redeployment to front-end M&A work; diversification into services, such as M&A and litigation support; and geographic expansion, mostly to Western Europe, where local laws are evolving toward debtor-friendly rehabilitation.

That said, there are numerous structural changes in the U.S. economy making turn-arounds a growth industry for decades to come. Consider the following phenomena.

1. Interest Rates
Many people believe interest rates are about 200 basis points (or more) too low, based upon history. Greenspan’s dilemma is to move rates up gradually without stalling the economic recovery or unduly harming President Bush’s re-election bid. When interest rates rise, any struggling company now paying more than 5% of net revenue in cash interest will suffer a body blow to its meager profitability and liquidity.

2. High-Yield Bonds
The amount of capital in the market due to high-yield bonds is staggering and continues to grow. This growth is driven by major pension, insurance and mutual fund investors looking to improve fund IRR through higher risk investing in asset pools, where up to 10% of all investments are assumed to default and lose most of their value every 3-5 years. Since the high-yield flood gates re-opened in 2003, one might predict the next wave of distress around 2006, given a likely three-year time lag.

3. Equity Sponsors
After deal sponsors secure commitments for funds, they face a limited window (typically two to three years) in which to invest and deploy or return the money. With the equity markets and M&A activity nothing short of dismal in 2001 and 2002, activity levels started heating up in late 2003 and gained steam in 2004. Many equity sponsors possess significant “use it or lose it” money, so there is a great deal of “use it” buying going on right now which, of course, translates to increasing prices and pressure on lenders to increase allowable leverage.

Additionally, equity sponsors are loosely regulated when it comes to investment accounting. As such, sponsors are generally not eager to sustain investment losses, and frequently provide financial support to out-of-the-money investments to avoid write-offs.

Also of note, many equity sponsors hold troubled companies within their portfolios that they continued to support during the recession. Some of these companies will not make it. The public accountants who audit these portfolios do the investors a disservice by allowing some of these invest-ments to be carried at cost, when clear losses exist. This type of self-serving accounting logic con-tributed to the S&L crisis in the late 80’s andstill overshadows how the Office of the Controller of the Currency (OCC) forces banks to rate and classify NPAs.

4. Continuing Bank Consolidations
With every bank acquisition comes the opportunity to play “purchase price accounting.” Simply put, this allows the new owners to write-off/down, sell-off or workout loans they acquired, and book the losses in excess of current reserves to a “purchase price reserve.” With every bank consolidation comes the rare opportunity to clean the loan slate without P&L penalty. There have been two mega-acquisitions so far in 2004, and numerous regional acqui-sitions that continue to create this workout activity bubble. Bank consolidations will continue for the foreseeable future.

5. Increasing Market Strength of Commercial Finance
There are now huge commercial finance shops, with non-bank roots, that are growing quickly both internally and by acquisition. Examples include GE Capital, Merrill Lynch and GMAC, to name a few. By their very nature, these are less regulated, higher risk/reward shops that tend to be more opportunistic and less structured in approach than traditional banks. Commercial Finance shops plan for loan-workout problems and maintain processes to routinely support this activity.

6. Financial Instruments are Increasingly More Sophisticated
In recent years, we have all witnessed an increase in options, such as mezzanine, sub-debt, Tranch B lending, P.O. finance, import/export finance, stretch financing and others. Each of these instruments has one thing in common: helping companies increase financial leverage. However, when companies use these more sophisticated, higher risk sources of capital, they have less flexibility to “right the ship” and work out their problems on their own.

7. The Pace of Technology Change
As we saw with telecom, the internet and energy distribution, multi-billion dollar industries can spring up in as little as five years. With the increased pace of technology, lightning-quick access to information across the world, and the ability to quickly deploy capital in quantity and exploit econ-omic opportunities, the U.S. economic cycle arguably has been permanently shortened from a 7- to 10-year cycle to less than 5 years. We will witness more “gold rush” industries where “what goes up, must come down.”

8. Public Company Pressure
The U.S. public markets work on a quarterly scorecard—whether we like it or not. We, as investors, simply don’t have the patience to reward long-term performance. This “instant gratification” factor also supports the likeli-hood that U.S. economic cycles will be shorter in the future.

9. New Liquidity from Debt Traders
Investors with huge resources have moved from primarily large public companies into the middle-market. Their primary concern is investment arbitrage. They thrive on insolvency, because banks aren’t permitted by the OCC, as a practical matter, to maximize financial returns on troubled companies. They are forced to sell off non-performing loans to the benefit of debt traders, who often exercise their leverage or push for bankruptcy to maximize their gain at the expense of others. For example, Morris-Anderson was recently debtor’s FA in a public company workout in which senior secured debt held by banks traded at 92¢, while the lower priority junior secured debt held by mezz investors traded at 98¢.

10. China
Last year, we worried about low labor rates in China destroying the U.S. industrial economy. This year, we’re witnessing what happens to world commodity prices (steel, oil, etc.) as China’s state-supported industry grows at an incredible 10% per year, heavily driven by “internal” consumption. The world’s economic power is shifting from the U.S. to China and I don’t think we can stop it. In short, the China factor will foster often unpredictable market upheaval for years to come.

11. Resistance to Train U.S. Managers to Play Defense
The U.S. management development process in both schools and organizations is designed around sales growth and developing critical mass, with management financial incentives designed to match. It’s just like high school— only the quarterbacks, running backs and receivers were idolized because they scored points. The guys in the pits, especially the defensive line, were just players without much opportunity for glory.

As long as reward systems and management recognition is primarily based on revenue and quarterly earnings growth, manage-ment talent within bigger organizations, consulting and education will flow towards the money and the recognition.

Complicating matters is the generally accepted notion that a completely different management skillset is needed to effectively manage a turnaround, as opposed to leading a growth company. The two management skills are perhaps even mutually exclusive.

We regularly see this in workout situations: the management team that was recruited to grow a business cannot adjust “psych-ologically” to what they perceive is the “bait and switch” of shifting to workout and down-sizing actions. Compounding this issue is that owners and lenders are resistant to creating financial incentives for the manage-ment team now playing defense in a workout situation. In essence, the attitude of owners and lenders is management should “help us out of the mess” without any incentives. In our experience, this attitude is a mistake, because owners and lenders should want to align the financial interests of senior management, owners and lenders. Having incentives is basic Motivation Theory 101. Until we develop managers within organ-izations who are good at managing troubled companies—and are rewarded financially and professionally for their success—turnaround consultants will continue to tap an unending flow of work.

Given all of the above factors, my prognosis is that business will be slow for turnaround professionals through the end of 2005. This trend will create a much needed shake-out of many “Johnny Come Lately’s” to the industry…and just in time for 2006’s pickup.

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